China has demonstrated breathtaking growth rates, steady foreign investments, tremendous foreign reserves and the rapid emergence of a consumer class, according to a white paper from The Boston Company Asset Management, a Boston-based equity manager within BNY Mellon Asset Management.  Still, the report, China at the Crossroads, notes that China faces challenges to its upward momentum. Inflation, a potential real estate bubble, misallocation of capital, a poor demographic profile and widening wealth dispersion are among the hurdles that China faces, according to the report. The Boston Company does not believe that these challenges will derail China's development as a leading global economy, but cautions that inefficient management and lack of transparency in some areas could weigh on margins and investor returns.  

"Good economic growth does not always mean profit growth, and investors should take note of China's changing landscape," said D. Kirk Henry, senior managing director and senior portfolio manager for The Boston Company and a co-author of the report.  

On inflation, The People's Bank of China has responded by increasing both interest rates and bank reserve requirements.  However, the report calls this a difficult balancing act that requires targeted policies to contain the frothiest industries, such as property development, without jeopardizing local demand for basic goods and services.  

One example cited by the report of China's inefficient capital deployment is the credit-driven over-investment in housing and construction.  The Boston Company notes that the home price-to-income ratio is now 20 in Beijing and 16 in Shanghai, compared with six in the U.S. at the peak of the real estate market.

However, the report also notes most of the new housing supply is being constructed in Tier II cities rather than the overly speculative Tier I group and that supply and demand will come back into balance as 10 to 20 million rural residents migrate to urban areas each year.

"Housing is just one example where China faces challenges," said Henry. "We believe that China ultimately will succeed in overcoming these hurdles, but not with same government control and unproductive capital allocation that we see today."

The report questions whether future leaders will be more authoritarian than the current group, and if a move to tighter controls will undercut efforts to make the economy more open and better able to raise living standards for the many Chinese who are still poor.

In addition, China faces challenges in becoming less reliant on exports, as the developed world that serves as an important market for China continues to deleverage, The Boston Company said.  China also needs to do more to encourage consumption, which depends on further boosting living standards; improve its environmental record; and focus more on technological innovation, according to the report.

"China most likely will be successful in dealing with its many challenges, providing investors with significant opportunities," said Andrea M. Clark, director, senior research analyst and portfolio strategist for The Boston Company and the other co-author of the report.  "However, picking winning investments in China will require careful analysis of individual companies.  The days of investing without careful selection are over."