bubblechain.jpgSure sign of a bubble about to burst when China and India now get lumped together in a single investment theme called “Chindia”

The Association of Investment Companies in the UK runs through the spectrum of fund managers' views on these two emerging economies, which are both highly fashionable as far as investors are concerned. Some fund managers prefer China, others opt for India and then there those who like both — the so-called Chindia concept.

Richard Lander, who writes a blog for the excellent Citywire site, is sceptical about the potential of this “ghastly hybrid” and so are we. It reminds us of the clutch of “Bric” funds launched in recent years.

The argument goes that Brazil, Russia, India and China, known collectively as the Brics, are destined to overtake the developed economies as the new engines of economic growth and global trade. The term Brics was coined by economists at Goldman Sachs.

These four countries already account for 15 per cent of world trade — double the figure in 2001 — and in less than 40 years their combined size could grow to overtake the G6 economies of the US, Japan, the UK, France, Germany and Italy. Indeed, China, having already overtaken the UK is poised to surpass Germany this year and become the world's third largest economy.

The Brics theme has had a favourable wind behind it in the past couple of years, but before you pick up the phone to buy one of the Brics funds that has not yet closed to new investors, its worth remember that, as with all investment themes, they work well… until they stop working.

Older investors among us will remember the fashion for “emerging markets” funds in the early 1990s, which suffered from similar hype and then spent ten years trying to recover their former glory. The big problem with all these investment themes is that seek to lump disparate countries together in the same basket. They also play on investors' expectations that above-average economic growth will translate into above-average stock market growth.

Despite their impressive growth, sooner or later, emerging economies will hit a rough patch, or an unpredictable exogenous event like a military coup, monsoon, etc. The stock exchanges of many emerging markets are volatile and illiquid, which means that what goes up can come crashing down.

China, of course, has its own giant-sized problems. China's economy grew 10.4% in the fourth quarter of 2006 and inflation accelerated, prompting speculation that interest rates will have to go up. Meanwhile, China's exports grew a phenomenal 27% and the US trade deficit with China ballooned to $144bn.

The flood of cash from China's trade surplus makes it hard for the government to curb lending and investment. That adds to the money supply, boosting the risk of bad loans, rising inflation and investment in unneeded factories.

China's domestic stock markets are showing all the signs of a speculative bubble forming. In the past 12 months the Shanghai A share index has risen 168% and the government is looking at ways to curb the inflow of money, by liming approvals for new mutual funds or imposing mandatory holding periods.

We're not saying that China and, indeed, India are not going to be major players in the world economy. They are already and will be even more important in the future. But economic might does not guarantee above-average stock market returns — the US was one of the worst performing stock markets in 2006, for example. Caveat emptor.


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