Why more bankruptcies would be good news for investors in China

Should you invest in China?

There are worries about the state of the country's financial system. China's first-ever corporate bond default is due to happen today, and if you look at the returns generated on capital investments, Chinese stocks don't look particularly cheap.

The fact is that China as a whole doesn't invest its money very efficiently.

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So there are plenty of reasons to worry.

But as someone who's already put money in China, I have to admit that I feel quite comfortable sticking with my investment.

Reasons to be gloomy about China

Let's start with the reasons to be negative on China. Firstly, there's that corporate bond default. Barring a last minute bailout, a small Chinese solar power company, Chaori Solar, won't be able to meet its payment obligations to some bondholders today.

Some observers believe this could be the start of a Chinese credit crunch. According to this view, we'll reach the crisis stage within a year.

I won't discount that view completely. But I think it's highly unlikely. That's because I think the Chinese economy will carry on growing at a pretty decent rate. If that happens, it'll be easier for banks and other financial institutions to cope with debt problems in a more orderly manner.

The really interesting point about the Chaori Solar story is that it illustrates China's big problem with capital misallocation. In other words, too much money has been invested in some sectors of the economy, which means that the providers of capital are getting a poor return on their investments. Both the public and private sectors have taken part in this investment binge.

In the case of Chaori, China now has too much capacity in solar panel manufacturing. As a result, solar panel prices have crashed and Chaori has been unable to cope.

So the reality is that this story may not be as depressing as it sounds. Although it sometimes feels that we've been conditioned in recent years to treat any defaulted loan payment as a potential economic catastrophe, defaults and bankruptcy are part of life. It's a vital aspect of a healthy business environment.

If Chaori is being permitted to default, it's encouraging it suggests that China's government understands that it has to let some businesses go bust. It's the only way to make sure that capital gets to the right parts of the economy and delivers the highest possible returns.

Of course, Chaori and the knock-on effects are hardly China's only problem. The country is losing its cheap labour advantage as the economy grows, workers have been able to push for higher wages. On top of that, the US and other developed markets have been able to fight back with efficiency measures such as using robots. Meanwhile, the shale revolutionhas slashed American energy prices and made the country far more competitive.

On top of all that, because of the terrible misallocation of capital, you could argue that Chinese stocks are not cheap. That's because many Chinese businesses aren't delivering great returns. The Shanghai Composite index currently has a return on equityof around 13%. For the US Dow Jones index, it's about 19%. And I suspect that the returns generated by many unlisted Chinese companies are lower, meaning they are using their capital even more inefficiently.

In the long run, Chinese companies will get more efficient and profitable

However, it's not all bad news. If you focus on profits instead, the Shanghai Composite index looks far more attractive. It has a price/earnings (p/e) ratioof ten, compared to 17 on the FTSE.

That looks cheap, particularly as in the longer run I believe we'll see decent profits growth. At the China's National Peoples Congress (NPC) this week, the Chinese finance minister confirmed that this year's GDP growth target is 7.5%. That's an important move as Standard Chartered points out, China hasn't missed an annual growth target since 1989.

Don't get me wrong, I'm not dismissing the point about returns on capital outright. It's a real issue. I just think that China can gradually sort it out as long as we continue to see decent GDP growth rates.

China's biggest challenge is to achieve a smooth transition from being an investment-led economy to one focused on consumption. Last November at the Third Plenum, the government committed itself to support reforms that help that transition. These should also boost growth and make it easier for businesses and banks to repair weak balance sheets. The financial system will gradually become stronger.

It may not be a smooth journey, but China will get there in the end. And as a private investor, I'm not too bothered about what happens over the next year. Maybe share prices will fall and there may be a cheaper entry point for new investors. Maybe there won't.

But in the longer run, China won't stay this cheap. And so I'm happy to focus on the long-term growth story. And, in my view, China definitely fits the bill. You can read more about how to invest in China in a recent MoneyWeek magazine cover story from my colleague John Stepek. (If you're not already a subscriber, get your first three copies free here.)

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