Martin Currie's James Chong explains why the recent corporate governance issues in China are not shaking his conviction.

As if slowing growth and rampant inflation were not enough for investors in China this year, allegations of accounting malpractice at a couple of overseas-listed Chinese firms have added further clouds to an already gloomy sky.

The companies in question, the Canadian-listed Sino Forest and the US-listed Longtop Financial Technologies, certainly have questions to answer. But fears of widespread problems with corporate governance have led to a dramatic sell-off in overseas-listed Chinese stocks. Small-cap stocks have been hit particularly hard. So, for multi-cap investors, the relatively modest decline in the main Chinese indices this year does not tell the whole story.

Given the range of global issues besetting investors recently, it is easy to see how fears about accounting scandals have spread. In general, nervous market participants have been all too eager to sell; the recent allegations have simply provided a trigger.

But we should remember problems with corporate governance are not confined to China. The Enron and WorldCom scandals are the most obvious instances, but we should not forget the crisis threatening to engulf News Corp. Indeed, Chinese firms often argue such examples show Western models of corporate governance are not necessarily the best ones to follow.

Corporate governance in China has improved markedly over the past decade. The government has tightened regulations and has been looking to develop high-calibre domestic accounting firms that can compete with the ‘Big Four’.

Some companies, however, have persistent problems. This underlines the importance of adequate due diligence and in-depth bottom-up research when picking stocks, but it should not obscure the real opportunities in well-run Chinese firms. Some overseas-listed companies we invest in have been hit by the wave of fear that followed allegations at Sino Forest and Longtop. But the widespread panic has not shaken our conviction in these holdings. An example is VanceInfo, a NYSE-listed firm that provides IT outsourcing. VanceInfo’s shares have fallen sharply, but it has been able to maintain its margins despite higher costs and should be able to reassure investors with its results in August.

Our conviction in these opportunities is bolstered by signs the Chinese authorities are beginning to get inflation under control. Premier Wen was bullish in his recent statements on inflation, indicating that officials are confident their tightening measures are working. That suggests we could soon see a peak in CPI.