Growth in china is starting to sputter due to weakening external demand and the lingering effects of tightened monetary policy. But the country of 1.3 billion people — now the world’s second-largest economy — is likely to continue its relentless march ahead in 2012 as China’s government forges a balance between stimulating growth and taming inflation.

Economic growth is expected to drop to 8% by the end of 2012, from around 9% in 2011 and the red-hot rates of more than 10% in previous years. But 8% is still healthy enough to maintain employment and social stability.

“The past 10 years have been the golden decade for China, with double-digit growth and low inflation,” says Chuk Wong, portfolio manager of Dynamic Far East Value Fund, sponsored by Toronto-based Dynamic Mutual Funds Inc. “Going into the next decade, we are not likely to see the same combination, with growth rates in the 7%-8% range and inflation of 4%-5%. In the near term, we are likely to see a soft landing, as China has the resources and tools to stimulate growth if necessary.”

Data from China’s National Bureau of Statistics show inflation fell to 4.2% in November 2011, down from 6.5% in July. That’s low enough for concern to shift to external factors, with the European debt crisis and the economic slowdown in U.S. growth potentially affecting demand in China’s two largest export markets. China’s year-over-year export growth slowed to about 16% in October from 20% to 25% in the first half of 2011.

If exports weaken severely, further increases in the yuan could be delayed to keep the cost of goods competitive. (China is under pressure from the U.S., which has a huge trade deficit with China, to appreciate its currency and allowed it to rise by more than 4% against the U.S. dollar in 2011.) Some relief from export fatigue should come from growing domestic demand, which could be bolstered by increased infrastructure spending or tax cuts to avert a harsh slowdown.

Fiscal revenue rose by 33% in the first 10 months of 2011. But China will proceed cautiously, having “learned its lesson” in 2008, says Eng Hock Ong, portfolio manager of AGF China Focus Class Fund (sponsored by AGF Investments Inc. of Toronto) in Singapore, when its US$586-billion stimulus package caused a strong economic rebound and incited inflationary pressures.

The resulting overheating in property values in major centres still has not abated. Mark Lin, Montreal-based vice president of international equities with CIBC Global Asset Management Inc. and portfolio manager of CIBC Asia Pacific Fund, says 1,000-square-foot condos in Beijing are selling at a whopping US$1 million or so, despite government-imposed lending restrictions designed to cool speculation.

Still, there is already stimulus in place in targeted areas. The building of social housing for low-income earners recently became a government priority.

Monetary policy is also easing. China’s central bank had raised interest rates and tightened the reserve ratio over much of last year to tame the country’s inflation rate and the surge in property prices. But by the end of 2011, the bank cut its reserve ratio, a move coinciding with a report that showed manufacturing activity had shrunk in November for the first time in three years.

“The cut in the ratio is a signal that policy-makers are changing direction and are past the tightening phase,” says Ong. “How much loosening happens will depend on how the global economy does from here.”

Lin is concentrating the CIBC fund’s Chinese holdings in areas that will benefit from China’s strong domestic demand. Among his favourites is Want Want China Holdings Ltd., which makes convenience foods such as instant noodles.

Henry Chan, portfolio manager of Fidelity AsiaStar Fund (sponsored by Fidelity Investments Canada ULC of Toronto) in Hong Kong, is looking at sectors that could benefit from the government’s loosening policy. “Some areas were underperforming as a result of the previous tightening, including real estate, financials and materials,” he says. “You can find companies in those areas trading at attractive valuations.”

Chan also favours stocks tied to domestic consumption, particularly high-end spending or the necessities rather than the middle ground, which is vulnerable to a slowdown. Among his favourites is Lifestyle International Holdings Ltd., which runs upscale department stores.

Also in the consumer area, William Fong, portfolio manager of Excel China Fund (sponsored by Excel Funds Management Inc. of Mississauga, Ont.) in Hong Kong, is partial to Dah Chong Hong Holdings Ltd., a car dealer based in Hong Kong that is now spreading its reach throughout China.  IE