SHANGHAI - Fidelity International's Anthony Bolton is betting on a rally in Chinese shares even as the central bank steps up measures to curb inflation. UBS AG Strategist Chen Li predicts the nation's equities will fall a further 10 percent.

The Shanghai Composite Index has dropped 3.6 percent this year after tumbling 14 percent in 2010, the most among the world's 10 biggest stock markets. The Shanghai gauge's decline has driven down valuations for its 924 companies to an average of 17 times reported earnings, compared with the 12-year average of 34 times, according to data compiled by Bloomberg.

"The growth is going to be quite strong, particularly in the first part of this year," said Bolton, who oversees $246 billion as president of investments for Fidelity International. "Emerging markets are going to have to live with a structurally higher level of inflation than they have in the past, but I don't think this is a showstopper."

China is seeking to preserve growth while combating inflation and asset bubbles through tighter lending and administrative measures such as sales from government food stockpiles.

The Shanghai Composite has fallen 14 percent from a six-month high on Nov 8. The declines will end when the price-earnings ratio for the Shanghai Composite drops to 11 or 12 times last year's estimated earnings, UBS's Chen said. The index is valued at 13.1 times projected profit for the next 12 months, according to data compiled by Bloomberg.

"That's about a 10 percent decline for the Shanghai Composite or the CSI 300 Index before the market reaches the bottom," Chen said.

Smaller Chinese companies may fall as much as 20 percent this year because their shares are too expensive relative to future corporate earnings, Chen said on Monday.

"There will be far fewer opportunities to achieve above-average returns from small-cap stocks this year than last year," Chen said. "Good stocks are already not cheap."

Related readings:  China's stocks hit record low  China's stocks may decline in 2011

China has lagged behind counterparts across Asia in raising interest rates to fight inflation as food and commodity costs climb in the wake of economic recovery in the region. Thailand raised its main rate for the fourth time in seven months on Jan 12. Since March, India's central bank has lifted rates six times and Malaysia three times, according to Bloomberg data.

"China has a difficult balance; it needs to sustain growth and constrain inflation," Bolton said on Monday. "China has lots of ways of controlling inflation, particularly food inflation. It probably has more ways of controlling inflation than most economies."

The central bank will probably use administrative policies to soak up excess liquidity and limit inflation, including direct orders to banks to limit lending, and may sell bills to commercial banks, Fan Gang, a former central bank adviser, said on Jan 10.

Faster economic growth in developing nations will continue to lure investors to Asian equities, Bolton said. Gross domestic product in China may rise 9 percent in 2011, based on the median economist estimate from a Bloomberg survey. That compares with growth of 3.1 percent in the United States and 1.5 percent for countries in the European Union, the projections show.

Emerging-market stock funds took a record $92.1 billion last year, compared with outflows of $62.4 billion for funds that buy developed-market shares, according to the Cambridge, Massachusetts-based research company EPFR Global.

The Fidelity China Special Situations Plc, a closed-end fund that Bolton manages, has risen 15 percent since it began on April 19. That's double the 7.7 percent advance for the MSCI China Index, based on data compiled by Bloomberg.

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