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Volatility continues to be the watchword for stocks trading on the Chinese mainland. Just last Friday, Chinese share prices enjoyed their biggest gain in six weeks on heavy buying volume. By Monday, the trend was in reverse as shares suffered their biggest loss in nine weeks.

With Shanghai markets being predominantly driven by retail investors, fear and greed hold sway. Fear took center stage again over the weekend as domestic and foreign concerns piled on.

Overseas, the biggest buyer of Chinese exports, Europe, looked increasingly weak as new concerns arose about the financial stability of the region. At the same time, a weekend statement by Premier Wen Jiabao created confusion and more uncertainty about the domestic economy. Premier Wen warned that the country faces tough choices in moderating economic growth and Beijing must avoid piling on adjustment policies and risking "negative consequences."

Wen is talking about the difficult balancing act that his government faces in tempering inflation and soaring property prices without squeezing the growth momentum out of the Chinese economy. The Premier’s open warning about “negative consequences” suggests that he is aware that real estate may be in a bubble and excess pressure could cause an implosion with widespread negative consequences. Although Beijing has taken many measures to soak up excess liquidity in the economy, more will inevitably be done but Wen is cautioning his officials against clamping down too hard.

Stock markets took the Premier’s call for regulatory restraint as a warning about the fragility of the economic recovery. Property developers lost heavily in Shanghai trading. North American indexes trading in Chinese ADRs were also volatile, driven partly by Shanghai and partly by the festering European debt problem.

The question for investors is plain enough. Is the Chinese economy weakening or are shares inexpensive in view of long-term economic prospects?

The World Bank has now weighed in with a clear answer. According to a senior World Bank economist, highly effective investment in infrastructure by the Chinese government (as part of its economic stimulus program), plus the ongoing urbanization process in China, will ensure a continuous rapid growth of the Chinese economy over the next 20 years. We can only wish that the World Bank would make the same prediction about the economic recovery of the United States.

The Chinese government apparently learned a valuable lesson during the Southeast Asian financial crisis in 1997-98. Beijing overcame the economic development bottleneck in Asia during the regional currency crisis by stimulating infrastructure investment, just as it is doing now. Justin Yifu Lin, chief economist and senior vice president of the World Bank, said China’s actions in the nineties laid a solid foundation for the development of an export-oriented Chinese economy. Beijing is laying a strong foundation for future growth again amid worldwide weakness, he believes.

Lin spoke at the “China and the Future of the Global Economy” conference at the University of Chicago, saying:

Since the financial crisis in the second half of 2008, the Chinese government implemented a dynamic financial policy and heavily invested in infrastructure. It propelled China's economic growth and contributed to the global economic growth as well.

Lin’s prediction was not entirely positive, although he did endorse Beijing’s ongoing efforts to clamp down on property speculation. In the longer term he worries about the gap between rich and poor and the undercapitalization of small independent Chinese enterprises.

Nevertheless, a 20-year prediction of growth on the mainland from a non-Chinese government authority is a notable indication that Chinese stocks may be undervalued in the short-run, considering the economy’s long-term prospects.

Disclosure: No positions

Source: China Economy: Short-Term Volatility, Long-Term Stability