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Morgan Stanley is really bullish on China, here's what's behind the contrarian call

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Investors around the world are predicting a number of calamitous downturns for China's economy, but a team of experts from Morgan Stanley are making the opposite call: Asia's largest economy will manage to avoid a financial shock and it will "continue to present significant investment opportunities for global investors."

The analysts forecast that China will overcome recent macroeconomic challenges and the prospect of a financial shock to transition into a high income economy by 2027. That will see the country's per capita incomes reaching $12,900 from the current $8,100, they say.

This is despite of their projection that China's growth could slow to an average of 4.6 percent in 2021-2025. The analysts say that rate of growth "will sufficiently support (China's) transition towards a high income economy."

That development will allow the MSCI China to continue to outperform the broader MSCI Emerging Markets Index. MSCI China has outperformed MSCI Emerging Markets by 3 percent per annum in the last 15 years, the Morgan Stanley analysts note in a 118-page report.

"MSCI China has also outperformed the S&P 500 by a far greater amount over this long time horizon, though the outperformance has paused in recent years. Our end of 2017 target for MSCI China is 66 (set at the end of November 2016 when MSCI China was 61), driven by a cyclical upswing in earnings and some modest multiple expansion on Southbound flows through the Connect programs," they say.

The Connect programs refer to the tie-up between China's mainland markets, Shenzhen and Shanghai, and Hong Kong's stock exchange. The programs allow foreign investors to buy China A shares through Hong Kong with fewer restrictions.

The Morgan Stanley report also says that China's transition into a high income economy will further push the country towards growth led by consumption, the services industry and high value-added manufacturing.

That bodes well for the IT, consumer and healthcare sectors, the analysts say. And among their picks of Chinese firms that would do well are Alibaba Group, ANTA Sports Product, Bank of China Limited and Ctrip.com.

Risks remain high

Despite the optimism, the Morgan Stanley analysts acknowledge that China continues to face both external and domestic risks that could derail its growth prospects.

They note that most middle income economies have not managed to transition to high income status. Such lacklustre track record could weigh on China's chances of making a successful shift. Moreover, the country's transition is happening at a time when the global economic environment is less supportive for growth.

And with the increasing risk of trade protectionism, China may be hit hard as it is the world's largest trading nations, the analysts say.

"Going beyond the direct impact on China's exports growth, a protectionist environment would adversely affect corporate sentiment. More importantly, with significant manufacturing capacity and with select sectors still facing challenges of excess capacity, extreme trade protectionism would exacerbate existing issues and lead to the re-emergence of deflationary pressures for China," they say.

"More broadly, the reduced competition and flow of goods, services and people in a more protectionist environment would reduce the exchange of ideas and slow the rate of technological transfer that has been one of the driving forces of China's rise towards middle income status."

Domestically, the slow pace of reform and a debt cycle not handled well would weigh on productivity and overall growth. China's debt has risen from 147 percent of Gross Domestic Product (GDP) in 2007 to 279 percent in 2016, leading to concerns about the sustainability of the debt build-up and risks of a financial shock.

But the analysts downplay such risks in the report, saying the build-up in debt has been funded by the country's own savings and has been used to fund investments rather than consumption. China's strong net asset positions, current account surplus, high level of foreign exchange reserves and the lack of significant inflationary pressures mean that it could avoid shocks.

"Our confidence … stems from a few reasons. First, policy levers and buffers remain adequate, leaving room for policy makers to maneuver and manage the debt cycle. Second, significant headway has been made in a number of the key transitions that would be needed to be taken," they say.

"Hence, as the economy moves steadily in the right direction, we expect steady growth and continued progress towards a status of high income."