Partly because of excessive lending, there’s been frequent chatter lately about a property bubble in China, both residential and commercial.

Recently, we learned that Fitch has downgraded ratings on two Chinese banks -- one of which was one of China's most well-capitalized -- calling into question the quality of loans doled out during China’s lending spree. Given all of this, how strong is China right now? Should investors be skeptical?

“I think it’s always right to be skeptical on anything, but there seems to be a lot of worry and gloom about China right now, and I think we would generally be relatively relaxed,” Mark Edwards, vice president and portfolio manager for T. Rowe Price Emerging Market Stock Fund, said in an interview.

Edwards says banks did do a lot of lending last year, but that regulators in China have acted to ensure sufficient capital reserves to deal with any problems. He also said the quality of the lending, particularly from the big banks, has been a lot better now than in the 1990s, when China experienced a big boom and bust on the lending side. “By and large,” he says, “we think that the asset quality will be OK, and that the banks are in pretty good shape.”

Funds were lent mainly to state-owned enterprises (SOEs) in the area of infrastructure, which is badly needed in China, Edwards says. “Although the economic returns on some of these projects may be a problem at some stage, we think the local governments will be willing to fund the gap if there is some sort of fund squeeze,” he says.

A rebound in the second half
Edwards says he thinks there is a little more tightening yet to come, but that he thinks profit growth will still be strong. What’s more, Edwards prognosticates that China’s cooling actions will bring GDP growth down from a rampant 11% to a still strong 9% this year. “So we think [that during] the second half of this year and into next year, the Chinese markets should do quite well,” he said.

Where to invest now
Infrastructure continues to be a major trend for investors to cash in on, but Edwards says it’s getting more mature at this stage. He cautions investors to keep an eye on the supply side, stating that China has a tendency to experience intensive mini-cycles in each industry.

For example, cement capacity suddenly surges when cement prices go up. Similarly, when steel prices increase, every provincial government wants to own a steel plant. “Although the government tries to intervene and manage that capacity surge, nonetheless, you end up with sharp cycles,” Edwards says. “Therefore, as an investment, if you’re buying a cement company or a steel company -- as an example -- you need to be careful that the supply side is not about to overwhelm the profitability of that industry.”

Aside from infrastructure, Edwards favors the consumer space. “Though the stocks have done well and they’re not that cheap anymore short-term, we think there’s long-term growth, just like the U.S. in the ‘80s and ‘90s. We saw a very sustained period of growth and stock appreciation from leading consumer names in the U.S. We think the same thing will happen in China.”

He also sees the financial services sector as a good growth area that remains relatively underdeveloped in China. Specifically, he favors the areas of insurance and banking. Internet plays are also a favorite: “With over 300 million subscribers of the Internet in China, there are some very good companies emerging in that space.”

Edwards’ favorite companies right now include:

  • Baidu (Nasdaq: BIDU), a competitor of Google (Nasdaq: GOOG)
  • International (Nasdaq: CTRP), a hotel and airline ticket-booking organization similar to Expedia
  • Sina Corp. (Nasdaq: SINA), which is similar to the likes of Yahoo! (Nasdaq: YHOO), as a portal in China

“Those are all high-growth and have all done well, so they’re not that cheap for the short term,” said Edwards. “But as I said, they are very high-growth names.”

In direct opposition to some of my Foolish colleagues, Edwards favors SOEs, noting that they’re well-run and can dominate their industries. He cites China Mobile (NYSE: CHL) in the telecom space, which he says has executed extremely well, and PetroChina (NYSE: PTR) in the oil space. “They operate very closely with the government, so they know what government policy aims are,” Edwards says. “So, very often, they’re extremely powerfully positioned.”

It’s true there are reasons to be careful in China, but in the end, the long-term investing story is still intact. You can take advantage of it by putting capital in the right sectors and carefully choosing the most prudent stocks.

For Related Foolishness:

Baidu and Google are Motley Fool Rule Breakers selections. Sina is a Motley Fool Stock Advisor pick. International is a Motley Fool Hidden Gems selection. The Fool owns shares of China Mobile.

Fool contributor Jennifer Schonberger does not own shares of any of the companies mentioned in this article. You can follow her on Twitter. The Motley Fool has a disclosure policy.