Just a few quarters ago, an increasing number of data points yielded an impression that the Chinese economy might soon be in distress. The housing sector looked overbuilt, the banking sector was carrying a rising number of non-performing loans and the Chinese government was soon headed for a possibly rocky transition. 

But even as the country’s leaders prepared for a once-every-five-years transition, they still managed to pull many levers to aid the economy, led by a robust stimulus package focused on infrastructure investments. In response, the Chinese economy managed to grow at a 7.9% annual pace in the fourth quarter of 2012, up from 7.4% in the previous quarter. Although the economic statistics that the Chinese government releases are notoriously unreliable, many private economists concede that the economy turned the corner late in the year.#-ad_banner-#

So this begs the question: Is it now time to invest in China again? Let’s dig a little deeper for the answer…

Exports or domestic consumption?
Economists now expect the Chinese economy to grow roughly 8% in 2013, though growth is likely to be moderate in 2014 and beyond to the 5-7% range as the era of ever-expanding exports finally winds down. To be sure, Europe and the United States, which still absorb more than 50% of all Chinese exports, will probably look healthier into the mid-decade. But China is slowly losing its competitive edge in exports as its currency strengthens, the seemingly endless supply of fresh (and inexpensive) labor starts to dry up and neighboring low-cost Asian nations build a head of steam in their export efforts.

As a result, China will need to look inward for growth. This means it will have to generate sustained growth in consumer spending. In a bullish sign for consumer spending, Chinese home prices are finally rising again after a two-year slide, and that should boost confidence among consumers.

And consumers do indeed appear to be in a spending mood. Retail sales rose 15.2% in December 2012 compared with a year earlier. That’s up from the 14.9% rate posted in November 2012 and the highest reading since March 2012. 

It’s helpful to keep making the analogy to the U.S. economy in the 1950s. Heavy infrastructure investments such as the U.S. interstate highway system fed a robust economic expansion in many regions and many workers moved up from lower-income jobs to middle-income jobs, setting off a spending boom. That same trend, though already underway in China, should continue for many years to come. 

For investors, this means it’s time to think about China-focused investments again. Many already have: the exchange-traded funds (ETF) iShares FTSE China 25 Index Fund (NYSE: FXI) has surged from $33 to a recent $42 since September 2012. But a much longer time frame shows that this index is still in a multi-year trading range, though perhaps due for a breakout if the economic data released in coming months are similarly robust.

Of course, investors have been badly burned with individual Chinese stocks listed in U.S. exchanges, so we still haven’t seen real progress on that front, which explains why Chinese initial public offerings have disappeared from the docket. That’s why it’s wiser to focus only on the strongest Chinese companies, a handful of which I discussed last month in this article.

I prefer to focus on mutual funds and ETFs such as the iShares fund noted earlier. And though ETFs are often a wiser path than mutual funds these days, thanks to their lower cost structure, investment firm Matthews Asia has built up impressive mutual funds focused on China that get high marks from Morningstar.

The Matthews China Investor fund (Nasdaq: MCHFX) receives a Gold star from the fund-rating firm: “Matthews is a first-rate Asia specialist and has an exceptional collection of regional experts on staff,” notes Morningstar, adding that the fund has delivered returns in the top quartile of its peer group on three-year, five-year and 10-year basis. The fact that this fund owns a number of Chinese consumer stocks is another plus in light of the steady shift in the Chinese economy toward domestic consumption.

The Matthews China Dividend Investor fund (Nasdaq: MCDFX) also holds great appeal and is “the top-performing China-region fund since opening in late 2009,” according to Morningstar, rising 8.9% on an annualized basis while its peers have averaged 1% annualized losses. The fund focuses on companies that have strong financial statements and have expressed a desire to maintain and boost their dividends. 

Risks to Consider: The Chinese economy still has risks. The looming banking crisis of last summer is still unresolved as many Chinese banks hold too many non-performing loans. Real estate construction continues, so a glut of unsold homes and office buildings remains in some regions. And China is winding down its stimulus program, which may impede economic growth in 2013.

Action to Take –> Investing in China is a long-term proposition. Chinese stocks surged in the last decade, but dropped sharply by the end of the decade and have been in a trading range ever since. Looking ahead, the share price moves are likely to be less dramatic than a decade ago, simply because the Chinese economy is now much larger and poised for a phase of solid, but not sizzling growth. Yet a long-term economic expansion should help Chinese stocks to generate returns that exceed markets in more mature economies.