China: “it may not be as bad as you think”

When the Biden administration announced it would ban some US private equity investment into China’s quantum computing, advanced chips, and AI sectors, it was a stark reminder that investors must cope with competing regimes as well as monetary regime shift.

Economic growth in China is deteriorating, and a lack of urgency from the government to stimulate activity has forced Schroders’ economists to cut their projection for GDP growth this year to 4.8% from 6.5% previously.

Could it be that Chinese Covid policy has had a pernicious effect on its consumer? And what does this mean for the ambitious Chinese dream of self-sufficiency and common prosperity?

 Themes such as AI and electric vehicles (EVs) are inflating market bubbles elsewhere in Asia. So, with emerging market (EM) equities so dominated by this region, where does the investor find the value?

A panel of experts - Sir Sebastian Wood, former Ambassador to China, David Rees, Senior Emerging Markets Economist, Abbas Barkhordar, Asian Equity Fund Manager and Vera German, Emerging Market Value Fund Manager – offered their insights into the current situation. Stuart Podmore, Investment Propositions Director, chaired the debate.

What’s the story with China?

Sir Sebastian Wood:  I’m just back from a trip to Beijing.  I detected some cautious confidence that we would see some more robust growth in the second half of the year, that there’s an underlying momentum in domestic consumption and we’ll see that manifest itself in the coming months.

Geopolitics  is an important factor in the psychology of the Chinese economy at the moment. We are in an era of heightened geopolitical tension between the US and China and that is a watershed shift in global affairs. Both governments are trying to manage these tensions, but the underlying drivers remain quite concerning. In the medium term we are likely to continue to see US efforts to restrict trade and investment with China in areas of technology that are sensitive, or which have defence applications.

The risk of near-term military conflict with Taiwan is often overstated by the media. People assume the Chinese leadership has a short time-frame for reunification (with Taiwan), but the only time-frame the Chinese leadership has put out for reunification is 2049. In the near term, the Chinese leadership realises that if it were to take aggressive action on Taiwan it would find itself in military conflict with the US. The risks of that would be too great.

Is the Chinese government doing enough to stimulate the economy?

David Rees: The economy has been weaker than we assumed, and we have cut the growth forecast quite substantially. We saw a boom in travel, but this didn’t translate into broader growth, which has been disappointing. There’s also been a structural change in the housing market. Housing had been an important driver of growth over the last 10 to 20 years. But that has started to become excessive, with lots of empty properties that people were buying as investments, storing up problems for the future and a possible housing bubble.

So, the government has stepped in to try and address that, and that’s led to weaker growth. What’s been surprising is that the government seems to have a much higher tolerance for slower growth than we had assumed it would have had. There’s been a small amount of stimulus, but no big urgency which has caused disappointment in the market. However, the flip side is that by not going back to its old ways, the government is pursuing what it terms as “better quality growth.” There’s been a change in the government’s approach to managing the economy.

How does this fit with the “3D Reset”?

David Rees: The demographics in China are poor. The population is shrinking, so to offset that you need to raise productivity. In terms of deglobalisation, China wants to be more self-sufficient as it’s worried about being carved out of certain areas, such as technology and the supply of semiconductors. Decarbonisation also fits into this as China’s industry is miles ahead of the rest of the world in a lot of the decarbonisation technologies such as electric vehicles and solar energy equipment.

What opportunities are there in China?

Abbas Barkhordar: We have been underweight in China for quite some time, due to some of the issues David (Rees) mentioned, in terms of some of the structural challenges they have. We do think there needs to be a big shift in the drivers of economic growth, towards consumption. Property was a very important part of the economy. It still is, but it’s clearly not a growth driver anymore.

The disappointment this year has been the lack of consumer confidence and that really took a nosedive last year during lockdowns, as people lost faith in the zero-Covid policy. As that was removed, we saw a bit of confidence return, but the ongoing issues in the property sector and lack of growth means that we haven’t seen much of a shift in terms of the composition of the economy. Some of the biggest changes in recent years have been to do with domestic regulation. We have seen that in the technology, healthcare, and education sectors.

How do you think the situation in China will play out?

Sebastian Wood: There’s been a shift in the political mindset in China in the past decade or so. It’s been characterised by some commentators in the West as a shift away from the market and towards Marx. I think that is a caricature. What we are seeing is a shift from a laissez faire period of economic growth to a much more managed and interventionist style of economic governance, which is designed to ensure “high quality growth.”

There are a number of challenges that this growth needs to satisfy. The first is to cut the risk of asset bubbles, which is why they are not going to have a massive stimulus. The second is decarbonisation. China is deadly serious about achieving carbon neutrality by 2060. Thirdly, limiting income inequality under the rubric of “common prosperity.” The last area I’d highlight is self sufficiency. The perception is that the US will not easily accept China emerging as the world’s largest economy and will seek to contain China, so China needs to develop its own capabilities in areas such as technology.

In all of those areas I think we can expect to see the Chinese government intervening and regulating and seeking to redirect capital when it perceives that there are emerging business models that could undermine those core objectives.

David Rees: A social safety net could help boost growth in China. The household savings rate in China is enormous. People save a lot of money to buy a house and to cover any issues as there isn’t a social safety net there. And because they are saving that money, they aren’t spending it. So, there could well be reforms that offer a bit more support to people, so they don’t have to save so much money and so they spend a bit more, helping to rebalance the economy towards consumption.

Sebastian Wood:  There are other structural reform levers the leadership could pull to unlock more growth, for example relaxing the residence rules to permit China’s very large population of migrant workers to settle more permanently with their families in China’s cities.  We should watch out for reform initiatives at the forthcoming 3^rd Plenum of the Central Committee – this is a meeting which traditionally focusses on economic policy.

What impact will the changes in China have on other emerging markets?

Abbas Barkhordar: Clearly there are going to be beneficiaries of the supply chain diversification in China. The Covid crisis highlighted the danger of an over-reliance on supply chains from a single country. There’s now much more demand to have a back-up in your supply chains.

Vietnam is a real success story, but the issue with Vietnam is that it’s 100 million people. It can never replace China, with 1.4 billion people. There are other high population countries in Asia –  India is a standout example. However, this is not going to be an overnight process. It’s unrealistic to expect to be able to cut China out of supply chains overnight. It’s going to be more of a slow drip.

Vera German: The number one country that always crops up when we talk about beneficiaries of the reorganisation of supply chains is always Mexico. Mexico is everyone’s darling in the emerging markets world because it was already something of a manufacturing hub to sell into the US. And now if the US wants the manufacture of stuff it consumes to be closer to home then Mexico is the perfect jurisdiction. It has plenty of issues but is a well-regulated market where the rule of law is very much in place. But that comes at a premium and is one of the most expensive places for components in the emerging markets universe.

Sebastian Wood: The political influence of the BRICS (Brazil, Russia, India, China, and South Africa) is often overestimated. At the heart of the BRICS, you have these two giants – China and India – whose relationship is dominated by a longstanding and bitter border dispute. There’s significant mistrust between the two countries and it’s hard to image the grouping developing a strong geopolitical, let alone military, component. They now want to enlarge the group by bringing in other large, emerging economies, which also have significant disputes with each other. Enlargement makes the possibility of a coherent policy platform even less likely than it is now.

In summary

Sebastian Wood: If I had to sum up everything I would say “China: it may not be as bad you think.” There are geopolitical risks, there are Taiwan risks, structural slowdown risks and change in the mindset of the leadership, but these factors are often overstated in the Western media.

David Rees: Growth in China is going to be slower over the medium term but it’s still going to be an economy that’s growing at a decent clip and is going to be developing in different areas. And now, the pessimism compared to the reality is probably a little overdone.

Abbas Barkhordar: Compared to where we were six months ago, I think there’s a lot more pessimism about China and that impacts all of Asia. But I don’t agree with the opinion that China is uninvestable. It’s a very broad, deep market and there’s a lot of opportunities there, but you’ve got to be very selective.

Vera German: For us, this is a great opportunity to do a deep dive in China and see what’s available. The opportunity set is richer than before, but of course you need to be selective.