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Frontier markets: Mainland China - opportunities limited by State control

Despite the fact that it is expected to grow three times as fast as the US and twice as fast as Brazil over the next two years, few firms are engaged in investing directly into mainland China, writes Richard Hemming.

This is principally because of the restrictions that apply on entry and exit into a market that is effectively State controlled and owned – a fact that qualifies it to be a frontier market.

Investing in companies based in mainland China is further complicated by issues such as exchange controls and tax. Even Hong Kong's direct exposure to the mainland is in the form of about 92 "red listed" companies, which does not give an aspiring investor much choice. Further, returns do not often reflect the growth in China because they are manipulated by speculators.

Chris Palmer, Gartmore's head of global markets, has several large families who invest in his funds and says if you want real exposure, you need to buy local shares. "Where possible we invest in the local market because the quality of local information from brokers and analysts gives us more insight. It puts us in a more direct relationship with the underlying asset," says Palmer.

Many investors looking at mainland China get exposure through the bigger companies via vehicles such as American Depository Receipts – certificates issued by US banks that represent a specified number of shares in a foreign stock that is traded on a US exchange – that replicate ownership.

When you buy ADRs their movements are heavily influenced by the market in which they trade, namely whether the Dow Jones goes up or down by a significant fraction. This makes them less attractive when compared to investing directly, says Palmer. But this is difficult to do.

David Livingston, portfolio manager with the private wealth management firm Thurleigh Investment Managers, says the most pressing concern is the taxation treatment of profits on assets and indeed on the assets themselves. On this issue there is a great amount of uncertainty.

The structures in place are incredibly complicated and are constantly changing as China's government looks to gain its slice of the funds that are attracted to the country.

An important factor is that Hong Kong remains an offshore jurisdiction of China, comparable to Monaco. But this is changing. In 40 years' time its law and regulations will be directly governed by China.

Livingston says that it is difficult to get advice in such a climate because even private banking operations are left clueless.

He does however have one unusual piece of advice for those intent on investing more than $10 million in China – look out for the so-called taizidang ("princelings" in English), who are sons of senior officials in China and who dominate private equity in the region.

Winston Wen, for example, helps run a private equity fund in China, the New Horizon Growth Investment Advisory Limited. His father is Wen Jiabao, premier of the People's Republic of China. Another is Hu Haifeng, the party secretary of Tsinghua Holdings, the group which controls Nuctech and 30 other companies. Hu is the eldest son of Hu Jintao, China's President.

If you can hook on to the coat tails of a princeling it will no doubt augur well for your investment returns.

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