Although Merrill Lynch believes Hong KongÆs benchmark Hang Seng Index (HSI) is on the pricey side at its current level, it remains overweight in that market within its regional model portfolio and sees any correction as a good buying opportunity.

Strong liquidity inflows, asset reflation, strong economic growth, convergence with Shenzhen and the Pearl River Delta, solid corporate balance sheets, and upward earnings revisions are among the reasons investors should stay loyal to Hong Kong shares, according to a recent Merrill Lynch report.

ôInvestors worry that the upside in the Hang Seng index is limited now after it has surged 55% since August 17, and is trading on 22 times (price/earnings forecast for 2007). While not inexpensive, we argue structural changes in the market should continue to drive a re-rating.ö

Overall, analysts at Merrill Lynch expect more positive earnings revisions from Hong Kong-listed companies.

ôOur belief is that the Hong Kong market will continue to outperform the region next year and deserves a premium valuation based on the future earnings outlook.ö

Merrill Lynch notes that the spread between Hibor and Libor has narrowed, but a strong demand for the Hong Kong dollar implies robust liquidity inflows.

ôWe expect this trend will continue as Asian currencies appreciate, and as money from China and Taiwan comes to Hong Kong. A weak US dollar, negative real interest rate and improving household income are reasons to expect more asset reflation.ö

David Cui, Merrill LynchÆs China strategist, believes Hong Kong will see an inflow of around $55 billion from the qualified domestic institutional (QDII) program and the qualified domestic retail investor (QDRI) by the end of 2008. That figure is based on a few assumptions in terms of sources of inflows.

First, Merrill Lynch expects 15 fund management firms to get QDII approval by the end of 2008, raising an average $4 billion, of which 35% or $21 billion is likely to be allocated to Hong Kong.

Second, it expects 25 banks to get QDII approval by the end of 2008, with total quotas of $18 billion, of which $10 billion will be allocated to Hong Kong.

Third, it expects around 15% of the total insurance assets in China, which it estimates at RMB2 trillion ($268.6 billion), to be invested overseas under the QDII program. It expects around 20% of that or $7 billion to be invested in equities, with half going to Hong Kong.

Fourth, it expects five brokers to get QDII approval, each getting a $1 billion quota that will end up in Hong Kong.

Fifth, it expects around 200,000 accounts to be opened under the QDRI program, with each account having a minimum of RMB500,000 ($67,152), which will also end up in Hong Kong.

Meanwhile, Merrill Lynch has revised its 2008 GDP growth forecast for Hong Kong to 6%, and its average growth projection for the next five years to 5.5%.

ôWe believe neither ChinaÆs macro adjustments nor the US sub-prime fallout and economic slowdown will drag Hong KongÆs economic growth down. Ten announced infrastructure projects will improve links between Hong Kong, Shenzhen and Peal River Delta, making it one day a mega city.ö

Merrill Lynch notes the Hang Seng large- and mid-cap indices have underperformed the broader HSI. Thus, it recommends that investors buy blue-chip companies and continue to favour large developers, large banks and conglomerates.

Valuation-wise, Merrill Lynch that the fair value for the HSI is 30,000, given its expectation of a 13.1% earnings per share growth in 2008. Its best case scenario shows the HSI could trade to 36,000.