Perhaps it's not hyperbole to suggest that China is the greatest economic growth story ever told. Its economy grew at an average annual rate of 10% from 1981 through 2006, an unprecedented achievement. And the country is expected to crank out more double-digit growth this year and maintain its robust pace over the next decade or so as its export machine produces higher-margin goods and its huge domestic market of 1.3 billion people earn more money and boost their personal consumption.

The U.S. remains the reigning global economic titan, having gradually attained its preeminence over a few centuries' worth of manifest destiny that was nurtured by the ideas of Adam Smith, blessed by abundant natural resources and fueled by hungry immigrant labor.

In China's case, the country was an economic mess after Mao Zedong launched the ill-fated Great Leap Forward and Cultural Revolution programs during the 1950s and '60s, twin disasters that, among other things, mandated peasant communes to make steel in backyard furnaces and exiled some of the country's brightest minds to shoveling manure on collective farms.

But in the roughly three decades since Deng Xiaoping launched economic reforms that awoke the sleeping giant, China's growth has significantly impacted the global economy in many ways. It is a sponge for foreign investment and a magnet for jobs that have been displaced from developed nations, leading to calls for protectionist measures in the U.S. and elsewhere. It is a voracious consumer of raw materials whose appetite played a big role in the spike in global commodity prices. And it is a heavyweight in geopolitics, as well as economics, to the point where social activists are calling for a boycott of the 2008 Beijing Olympics unless China uses its influence to pressure its trading partner, Sudan, to end the Darfur tragedy.

Meanwhile, China has made investors lots of money in recent years. And many observers believe the growth story should continue for the foreseeable future, though not without a bumpy ride for investors. Indeed, investors were jolted by the global aftershocks after the two sudden, precipitous drops in the Chinese domestic stock earlier this year. China has lots of moving parts, and despite mind-boggling growth it remains a work in progress.

"China is growing like the dickens but is poor as dirt," says John Rutledge, an economist and the chairman of Rutledge Capital, a private equity investment firm that invests in China. He notes that China's average income is less than $2,000 a year, and that the vast majority makes less than $300.

"It has all of the problems associated with rapid changes in opening up a country" that has shifted from totalitarian communism to capitalism, says Rutledge, citing such problems as corrupt local government officials and rampant pollution. The latter takes a toll both on human health and on economic growth because of medical costs and damaged crops. "To keep the machine rolling," he says, "it needs to maintain social stability. And to do that the government must keep delivering growth by bringing in foreign capital."

Growth isn't a problem-China's gross domestic product grew 11.9% in the second quarter, an 11-year high. China overtook Great Britain as the world's fourth-largest economy in 2005, and at its current pace could pass Germany for third place as early as this year. But the government fears the economy is expanding too fast, and it's trying to slow it down enough to prevent overheating and inflation. Annual consumer price inflation rose to a nearly three-year high of 4.4% in June, much of that due to rising food prices. That was almost two percentage points higher since the start of the year.

China raised interest rates in July for the fifth time in 15 months, and has lifted the bank reserve ratio a handful of times this year to curb lending activity and reduce liquidity. It has launched or plans to launch various other cooling measures that range from targeting rebate taxes on exports to reducing the tax on interest income to encourage people to boost savings and reduce spending.

But restrictive monetary policy and excessive belt tightening could go too far in restricting growth. Another conern is that policy-makers need to monitor the nation's growing urbanization as job seekers empty out rural regions in search of factory jobs in the booming coastal cities. "They need infrastructure that links together different areas of the country so they don't disenfranchise other regions," says Hugh Simon, the Hong Kong-based chief executive of Hamon Investment Group, the sub-advisor for the Dreyfus Premier Greater China fund.

For now, Simon thinks the central government 's policies won't choke growth, and he's encouraged by increased spending in the rural areas aimed at creating jobs and distributing income more evenly throughout the country. "Investment is strong with the government's spending on infrastructure and from the private sector," he says. "Investment return is far above funding cost, and the liquidity is plentiful with strong company earnings."

Simon says the Dreyfus Premier Greater China fund is more focused on domestic spending drivers than on China's export side. That includes infrastructure sectors such as railways, subways, airlines and airports and highways. It also includes telecommunications infrastructure such as wireless and broadband. And he says the country's vast pollution problem will benefit companies selling pollution control equipment.

"These are the macro, longer-term trends," says Simon. "We're not encouraging investors to play the short-term liquidity in China. We're encouraging investors to take a ten-year view."

On the consumer side, job creation means more personal spending. People are buying property, and the private property development sector is taking shape. The consumer credit and mortgage businesses are growing, and people are spending more money on cars, jewelry and travel. "What we're looking at is where the next move is," says Simon. "What else will people spend on?"

The Dreyfus fund's three-year annualized return is 46%. One of its top holdings is China Travel, a Hong Kong-listed tourism services company that owns hotels in China and whose travel and online booking Web site, Mango City, is already China's third largest after just one year in operation, says Simon.

Another top holding is Bengang Steel, which will see increased orders from the government's plans to boost railway and building construction. Simon believes its possible merger with China's top steelmaker, Angang Steel, will enhance its value.

Valuation Concerns
At the Matthews China fund, co-manager Richard Gao and his team have trimmed back high-flying positions in the financial and property sectors and are building positions in industries such as utilities, infrastructure and telecom that he says have relatively cheaper valuations. "Our goal is to find good growth companies," says Gao, "but in recent months the valuations are getting more expensive. The valuations have to be justified by the growth prospects."

The fund, which has three-year annualized returns of nearly 40%, traditionally has focused on small-cap and mid-cap stocks. But the appreciation of some existing holdings has turned enough mid-caps into large caps that the latter now constitute more than 70% of the portfolio. "Mid-caps comprised more than 50% a couple of years ago," says Gao.

Chinese stocks tend to be volatile, and Gao says he expects to see even more going forward because he thinks that Chinese stocks listed on Hong Kong's Hang Seng  exchange--the market of choice for many foreign investors who play Chinese equities, and which generally sports lower valuations than China's domestic exchanges--are at peak levels.

The run-up in Chinese stocks makes valuations a foremost concern among many investors, but the variegated Chinese market has several different components with their own particular risks and valuations. This multi-tiered structure offers investors several different avenues when seeking to participate in the boom. Shanghai-listed Chinese "A" shares have been in the news this year with their stunning rise and spectacular tumbles. The A-share market is open mainly to domestic investors only, save for a very limited number of approved qualified foreign institutional investors. The market is a frothy, highly speculative venue dominated by retail investors.

Chinese B shares listed in Shanghai and Shenzhen are more open to foreign investors, but the most transparent markets for Chinese companies are the Hong Kong-listed H shares and the ADRs listed on the New York exchanges.

Many investment pros are alarmed by the valuation of the A-share market, which traded at 44 times trailing earnings as of mid-year, and 31 times on a forward p/e basis. Simon, the sub-advisor for the Dreyfus Premier Greater China fund, says he eschews the A-market and that he's comfortable with the fund's holdings in the B- and H-share markets, which he says have valuations at about half of those of the A shares.

At mid-year, the H shares traded at 18 times 2007 estimated earnings, a valuation Simon thinks is reasonable given the projected earnings growth rate of 20% to 25% for the Hong Kong-listed universe. "We believe the EPS growth will be further revised up after the interim results are out," he says.

Both the domestic and the offshore China equity markets are impacted by events within China, and as more Chinese companies list in Hong Kong the correlation between the two groups has increased somewhat, says Simon. Conversely, the H shares are more impacted by global economic activities and capital flows such as problems with U.S. subprime loans and the yen carry trade.

Observers say Chinese equities listed in Hong Kong or New York could stumble if the domestic equity markets tanked and consumer spending suffered as a result.

For now, though, the portion of the Chinese population taking part in the economic boom is spending like Americans. And that's a big reason why China Merchants Bank is among the top holdings in the globally diversified Thornburg International Value Fund. "What separates it from other banks is its huge credit card base that will tap into rising consumerism," says fund co-manager Lei Wang.

Wang says the fund breaks down value into three different categories, and that a lot of Chinese companies fit into the emerging franchise category where expected growth rates create value even when the P/E multiple looks pricey on the surface.

The fund, which has an annualized three-year return of 27%, counts China Mobile as one of its top holdings. Wang says the wireless company has EBITDA margins of 55% and that it added 5.2 million subscribers in June. "That's more people than many countries," he says.

Red Flags
James Oberweis, co-manager of the Oberweis China Opportunities fund, says that benchmarks measuring China tend to be massively weighted toward the biggest blue chips, a group he says generally has significant state ownership. "They're boring and fully valued," he says.

Oberweis looks for smaller, cheaper companies run by entrepreneurs with material ownership stakes and personal wealth wrapped up in their companies. Many such operations aren't household names to foreign investors. One example is Li Ning, an athletic apparel maker with solid results and a product that ties into the growing buzz created by the upcoming Olympics.

"The valuations in our portfolio are higher than when we started the fund in October 2005," says Oberweis, whose fund is up roughly 70% during its brief existence. "But they aren't absurd given the growth in China."

Some skeptics say that Chinese corporate accounting is a black hole, and Oberweis acknowledges that it makes sense to be suspicious. To combat that, his five-member Hong Kong research team frequently visits Chinese mainland companies to talk with management to ensure that their interests are aligned with those of investors.

"It helps, but obviously it's not enough," says Oberweis. "You have to go in with eyes wide open when looking at Chinese companies, and there's no substitute for going out and kicking tires."

John Rutledge, the economist and private equity investment manager, believes that among the biggest short-term risks to the China growth story--and to the overall global economic growth story--are the growing calls for protectionism in the U.S. and other nations.

Rutledge, who also is a visiting professor at the Beijing Academy of Sciences and a Bush administration advisor, is especially critical of proposed congressional action aimed at forcing China to make its currency float and rise in value, a move that could make its exports more expensive. An ardent free trader, Rutledge believes this could lead to potentially unsettling inflation in China. And citing the long period of Japanese deflation, which he says was triggered by U.S. efforts to revalue the yen in the 1980s, Rutledge offers that American currency meddling could possibly lead to deflation in China.

"How would you like to be an American company competing against Chinese companies with falling costs and prices?" he asks.

Others expect China to make some currency concessions, but ultimately to do so at its own pace. Meanwhile, the China growth story likely will continue for the rest of this decade, if not beyond. "I don't think the game is over yet," says Oberweis.