But he concedes that non-performing loans resulting from the borrowing binge could have a negative impact on some individual banking stocks. That viewpoint has led him to substantially underweight the financial sector relative to the MSCI China Index, and to fill the financials sleeve of the portfolio with privately owned insurers, financial conglomerates, and well-managed regional banks with better-quality loan portfolios.

He points out that China is also unlike many developing economies that have experienced credit meltdowns in the past. It has a substantial current account surplus and a self-funded, liquid banking system. And though credit has expanded and loans have increased, so have bank deposits. Since much of the credit boom has focused on local governments, real estate and infrastructure projects, corporate balance sheets remain generally healthy by historic standards. In addition, China has recently drafted new rules aimed at containing risks in its shadow banking sector and is apparently trying to regulate these lenders.

Betting On The Chinese Consumer
Gao believes certain sectors, including industrial and infrastructure companies involved in the build-out of roads, railways and other public facilities, will grow more slowly than in the past as China becomes less dependent on exports and economic expansion proceeds at a more measured pace. And while he sees no systemic risk to the banking system, the likely increase in non-performing loans in the coming years makes individual bank securities a risky bet. Weeding out the winners from the losers is particularly difficult among banks, which are owned by the government and do not have transparent financial reporting.

On the other hand, the migration of China’s population from rural to urban areas and the expansion of its middle class provide the opportunity for faster growth among consumer and service sectors such as retail and health care. That transition is well under way, according to an analysis by the McKinsey Global Institute, which predicts that over the next 20 years China’s urban population will expand by 350 million to top 1 billion. Already, the government and private sectors have pulled millions of these rural-to-urban immigrants out of poverty by expanding housing, health care, jobs and education. In 2000, China turned out only 1 million college graduates a year; that’s risen to about 6 million in recent years.

“In the past, industrials accounted for most of China’s GDP growth,” says Gao. “But in 2013, for the first time, the service sector was the biggest contributor to growth. People are generally overly pessimistic about China because they are focusing on concerns about banks and real estate. They’re not seeing reform efforts and the important changes that are going on in the economic structure.”

The positioning of Matthews China reflects the changing face of the Chinese economy. The fund has a low 18% weighting in financial stocks, about half the level of the MSCI China Index. Another 18% of assets are in consumer discretionary stocks, significantly more than the 5% weighting for the index. In addition to having the potential for faster growth, these consumer-driven sectors tend to have a more entrepreneurial bent and more transparent financial reporting than banks.