‘It’s quality, not quantity in this new China’

But what does this domination of state-owned businesses mean for those investors looking for exposure to Chinese equities?

According to Philip Ehrmann, for investors in the Jupiter China fund that he manages the answer is not that much.

“There are a lot of state-owned enterprises in the Chinese stockmarket and there are plenty more that are not listed and are more or less a law unto themselves,” he explains. “However, we are not exposed to these companies because we do not feel that there is any reason to invest in them.”

Instead, Mr Ehrmann prefers to back innovative, privately-owned Chinese companies, of which there is also a wide choice.

“There are a lot of driven, entrepreneurial companies in China at the moment, tapping into sectors such as consumer goods and even environmental efficiency,” he adds. “These are the growth companies of the future.”

That is not to say the state companies will not change for the better, too. A new government came into power in China this March, and Xi Jinping’s administration is keen to promote rising incomes for those at the bottom. “The government wants to introduce reforms that will help people at the lower end of the spectrum, including migrant workers who do not currently enjoy the same rights as those born in the region they live,” Mr Ehrmann says. “To fund this, they will need the state-owned businesses to start making money and paying dividends.”

Consequently, he expects to see an interesting list of reforms when the current government announces its plans in autumn this year.

However, for Richard Gao, portfolio manager at Matthews Asia, a US-based Asia-only investment specialist, the reform of China’s state-owned enterprises is already under way.

“While state-owned businesses still have a long way to go in terms of improving efficiency, disclosure and corporate governance, policies such as mandatory dividend payments have been rolling out to focus on earnings quality,” he explains.

There is no escaping that the value of the Shanghai Stock Exchange is down by roughly a fifth since February. Stuart Parks, head of Asian equities at Invesco Perpetual, says: “China is currently cheap at below 10 times 2013 earnings – but it is cheap for a reason, as investors have limited conviction about the ability of those earnings to grow.

“This is partly due to banks being such a large part of the index, with concerns over the mushrooming of non-performing loans in the next couple of years, concerns that I would probably share.”

Legal & General Investment Management’s emerging markets strategist Brian Coulton believes reform of the state-owned enterprise sector is one of the keys to delivering continued strong growth.

“The Chinese economy has seen a significant increase in credit as a proportion of GDP in the past 12 months, which has fuelled concerns that China may be more prone to a hard landing. One of the unintended consequences of recent stimulus measures has been to support the role of less efficient state enterprises, reducing investment returns and productivity growth,” he says.

“However, reform of the state-owned enterprise sector and encouraging the private sector will help boost productivity.”

The problem is that this could cause further problems, mainly because the Chinese economy does not operate under the same rules as those in Europe. In fact, the wider Chinese economy is still largely closed – Beijing retains capital controls, which limits the amount of money that can flow in and out of the country. It also decides whether interest rates go up or down and controls liquidity.

All this power has allowed the government to people’s savings to provide cheap loans to industry – one reason the economy has been able to keep growing since the global financial crisis in 2008.

Any attempts to move away from this unsustainable model by the new government are likely to result in further pain for the Chinese economy.

“China faces significant challenges as part of its transition to an economy with a moderately slower growth rate,” Mr Coulton explains.

Mr Ehrmann argues, however, that this should not scare off emerging market investors. “In this new China, the catchphrase for investors has to be quality not quantity,” he adds.

Jessica Bown is a freelance journalist