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The Chinese sharemarket has hit a few bumps over the past couple of months. After charging up nearly 200% in the past 12 months the Shanghai A Share index has been bouncing up and down in a 5% range since May. That was when the Chinese government tripled the stamp duty rate on share transactions in an attempt to rein in the runaway growth. More recently the Ministry of Finance issued a huge tranche of special bonds to try to divert money away from the stampeding sharemarket. It seems to have worked – the number of new trading accounts being opened dropped to 70,000 a day in early July, whereas in early May it was up at 300,000 a day.

For the millions of Chinese investors who have piled into the sharemarket recently – many who have pulled their life-savings out of the bank deposits that were their havens during the five year bear-market to do so – it has been a nerve-wracking time. For investors here itching to take a ride on one of the more remarkable growth stories on the global sharemarket, the question is whether this is a bubble about to burst, or a correction that is setting the Chinese market up for its next run.

Stuart James, of Aberdeen Asset Management, which has been managing money in Asia for 20 years, says it’s more likely the former. He believes the Chinese domestic sharemarket is dangerously overheated. “This is domestic investors bidding up their own market,” he says. “There’s a real gambling mentality in China. Small investors have been sitting around at work during coffee breaks talking about their stocks. They’re thinking that it is a no-brainer; that you can’t fail to make money.” But valuations of up to 50 times earnings are not supported by the fundamentals, he says. “It’s completely irrational and unfounded that the Construction Bank of China, for instance, with its limited experience of lending money commercially has had a larger market capitalisation than the proven and established Hong Kong Shanghai Banking Corporation (HSBC).”

It’s not that Aberdeen is down on China as a growth story, James says. “China is a fantastic macro story. By 2027 it’s estimated to be the largest economy in the world.”

And there’s no doubt that in the past few years the quality of the China A sharemarket has improved enormously, he adds. “It’s just that those shares are now overvalued.” Shanghai A Shares for instance are trading at a price to earnings ratio of 36 times, while H Shares listed on the Hong Kong Stock Exchange are trading at 21 times. Many Chinese companies are listed on both exchanges, and of those that are, A Shares are trading at a 40% premium on average to their H Share counterparts.

Aberdeen refuses to invest in A shares at all for its Aberdeen China Fund, believing it can get its coverage of China purely through the more established, better regulated H Shares trading on the HKSE. “We may not get the short term outperformance of the A Shares, but the valuations are more grounded in reality, there’s better liquidity and better corporate governance.” And when the crunch comes, as he’s convinced it will, the H shares will better weather the downturn than A shares, James believes. “Whenever there’s global correction people sell off their riskier assets.”

Another view comes from Shane Oliver, the chief economist at AMP Capital Investor. He believes that the current volatility on the Chinese sharemarket is a short-term phenomenon. “It might go through a period of wobbling around,” he says, “but beyond this short term consolidation it’s likely to remain very strong.” The momentum behind China’s growth is too powerful to let up any time soon, he says.

And while those PE ratios do look high, that’s against a backdrop of a growth in earnings that will soon peg them back to more reasonable levels. After a couple of months of sidewards movement the Shanghai A Share index has already pulled back from a PE Ratio of over 40 times. “By any standards that’s still pretty high,” he says, “but for a country with a GDP growth twice ours, those higher PE ratios can be justified. You just can’t measure a market like the Chinese against ours.” A Shares give a broader exposure to the Chinese economy than the Hong Kong based H shares, Oliver claims.

* To invest in Chinese shares you’ll need to invest in managed funds, although AMP Capital’s China Growth Fund, which invests in China A Shares, is listed on the Australian Stock Exchange. The Premium China Fund also invests in A Shares, while many others, including the Fidelity China Fund and the Challenger China Share Fund invest in a mixture of H and A Shares as well as other overseas companies with an exposure to China. The Aberdeen China Fund does not invest in A Shares.