By Saikat Chatterjee and Nishant Kumar
HONG KONG (Reuters) - China's first-ever domestic bond defaults, a weakening currency and slowing growth are not normal buy signals, but money managers see them as a sign that the country's reform drive is genuine and that stocks offer long-term value.
Attracted to stock valuations near their lowest in at least a decade, investors have pushed the Shanghai Composite Index <.SSEC> up about 6 percent and an index of the top Chinese listings in Hong Kong <.HSCE> up 13 percent in a rally that started roughly three weeks ago.
While investors are not convinced the recent bounce in Chinese assets will blossom into a true rally, they said the sheer scale of Beijing's financial sector reforms would be positive in the medium and longer term.
"Things are heading very much in the right direction," said Bill Maldonado, chief investment officer in Asia-Pacific for HSBC Global Asset Management.
"What would you call the widening of the currency bands? What would you call the way that that default happened? What would you call the increase in quotas? All these things are clear evidence of reforms," Maldonado said.
HSBC, which manages assets worth $428 billion globally, is overweight on China in its regional portfolios.
Since unveiling an ambitious reform blueprint last October, Beijing has embarked on reforms including overhauling its bloated state-owned sector, widening the currency's trading band and increasing investment quotas in a push to allow market forces a greater say in its markets.
Those reforms have included allowing smaller companies to default, with China recording its first domestic debt default in March.
This has spooked many credit investors, but money managers said this would lay the foundation for sustainable economic growth and possibly higher stock prices in the near term.
Funds are now raising their exposure to China even though some investors have pulled cash from these funds over the past few months because North Asia-focused funds have underperformed funds invested in other regions.
A March report from HSBC said stock mutual funds had raised their exposure to Chinese equities to near five-year highs, significantly turning overweight on China from being underweight three months earlier.
Another reason for this shift is that Chinese equity valuations now look cheap after a wave of aggressive selling early in the year. Investors pulled out about $1.8 billion from China-focused equity and exchange-traded funds in the first quarter, according to Lipper data as of April 3.
Andrew Swan, head of Asian equities at the world's biggest money manager BlackRock, said the reforms added stability and better growth prospects, and would improve the way companies are managed in China by allowing market forces to direct credit to the most productive sectors of the economy.
"We can't just disregard China because of the problems of the past, because it's actually very cheap with change happening," Swan said.
Swan manages BlackRock's $654 million Asian Dragon Fund, 39.4 percent of which is invested in Chinese- and Hong Kong-listed companies as of the end of February.
Even after their recent bounce, Chinese equities are still 50 percent below their April 2007 peaks. By contrast, India's markets hit a record high last week, while Indonesia is approaching last year's peaks on reform hopes.
The IBES MSCI China Index trades at 1.33 times book value, near its cheapest levels since Thomson Reuters Datastream began compiling the data in 2004, and more than 77 percent below its 10-year median.
The index trades at 8.3 times forward 12 months earnings, 26 percent below its 10-year median. By comparison, India trades at 14.4 times, while the broader Asia-ex-Japan market is trading at 11.6 times, according to Thomson Reuters Datastream.
Money managers said that without far-reaching reforms, cheap stock valuations would only get cheaper in the coming years as growth faltered.
"In the case of China what we are seeing is change starting to actually happen. Without change, the risk is that markets and stocks would be a value trap," Swan said.
Not all investors are so optimistic, however. Some caution that the reforms, while necessary, would be painful and could cause growth to slow in the short term.
These more bearish investors said they were sticking to sectors such as property, railways and banks that would benefit from any minor stimulus measures Beijing might launch in order to shore up growth.
"There's no such thing as painless reform. The price you pay is to have slower growth. That's the whole idea," Franco Ngan, chief executive officer at Zeal Asset Management, said at the Credit Suisse annual conference held in Hong Kong late last month, suggesting valuations were low precisely because prices reflected lower growth prospects.
While corporate earnings in China have surged 75 percent in the past seven years, the MSCI China Index has plunged 40 percent, Ngan noted, reflecting the extent of negativity already being priced into the Chinese equity market.
"I do think valuations are arguably a bit more detached than fundamentals," said Tai Hui, chief markets strategist at JP Morgan Asset Management in Hong Kong.
In a sign of how beaten down some of these valuations have become, stocks from the financial and industrial sectors, often seen as front and center for any China-related problems, have led the market rally in recent weeks.
(Reporting by Nishant Kumar and Saikat Chatterjee; Editing by Nachum Kaplan and Chris Gallagher)