Is China’s growth story due for an ominous twist? In mere decades, the country has transformed from a closed nation into the world’s second-largest economy just behind the US. Behind its brisk expansion, however, tensions have been brewing. China now faces a potent mix of external and internal challenges that threaten to curb its momentum.
Brisk expansion potentially losing steam
Start with the US-China trade standoff. China’s hefty trade surplus has drawn Washington’s ire. But so have its technology transfer and intellectual property policies, seen alongside its ambition to become a high-end manufacturing power. Embodying that ambition is China’s “Made in China 2025” program, which lays out its goals to become a dominant player in strategic industries such as robotics and aviation in the coming years. So far, the twists and turns of trade talks have shaken markets. Both countries have raised tariffs on each other’s goods. The US has also restricted sales of advanced components and other types of technology to specific Chinese companies. Trade frictions have yet to undercut China’s dominance in global supply chains, but prolonged uncertainty could cause companies to have second thoughts about investing and producing in the country.
While China’s trade surplus has been a lightning rod for debate, a general weakening in its external accounts has gathered much less attention. China’s current account surplus—a source of support for the yuan—has been narrowing over the years, as illustrated in Exhibit 1. In late 2018, the yuan touched a 10-year low against the US dollar.1 At first glance, China should welcome a weaker currency as that makes its exports cheaper. Yet a sharp drop in the yuan is unlikely to be in its interest, not least for the additional heat it would attract from the US. A fragile yuan could also trigger capital flight and hit wider market confidence.
Sources: World Bank, International Monetary Fund, Balance of Payments Statistics Yearbook and data files, and World Bank and OECD GDP estimates, as of January 2019.
New uncertainties arising
More worryingly, trade tensions have collided with China’s efforts to restructure its economy. Massive industrial production, infrastructure spending, and other forms of debt-fuelled stimulus all helped propel China’s growth, especially during the global financial crisis. But the economy appears to be feeling the strain. Overcapacity in industries such as steel and coal, rising home prices in top-tier cities and high leverage are among the most visible problems in China today,2 forcing officials to pivot the country from a path of fast growth to one of sustainable development.
Certain policy moves in China have also caught markets off guard. From restructurings in government ministries to the arrests of high-profile businessmen linked to debt-laden acquisitions, as well as a perceived renewal in support for state-owned enterprises (SOEs), pockets of regulatory uncertainty have added to market unease.
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Broader tensions at play
China’s longer-term prospects will hinge greatly on how well it handles these challenges. It also needs to confront broader systemic tensions between its goals as it tries to achieve economic growth while pursuing structural reforms; liberalize the economy while maintaining state control; and seek peaceful development while managing relations with the US. We are watching developments closely.
For a start, can China continue walking the tightrope between growth and reforms? The task may prove increasingly thorny. China’s economic strains are deep-rooted, fuelled by years of loose credit, subsidies and implicit guarantees from the state. Addressing imbalances will involve tough policy choices, and it may be tempting to ease reforms, or even reverse them, when economic growth is at risk. Given the state’s outsized role in the economy, policy missteps can have far-reaching consequences.
China’s attempts to liberalize its capital and foreign exchange markets demonstrate another conundrum that it faces. Progress has stalled as it comes up against a classic policy trilemma3, which prevents it from having free capital flows, a fixed exchange rate and independent monetary policy simultaneously. Economic theory suggests that just two of the three policies can be pursued at any time. In the long run, China is keen to boost the global use of the yuan, which calls for free capital flows. But this will require the state to give up either exchange rate controls or monetary autonomy, both of which are crucial economic levers in a shaky environment. For now, China has chosen to clamp down on capital mobility, which will likely delay the yuan’s internationalization. On balance, China’s prioritization of domestic economic stability and growth is likely the wiser course. Naturally over time, as China increases its economic and geopolitical heft, the yuan is likely to see increased usage abroad, although historically the internationalization of a rising power’s currency has substantially lagged its economic development.
Meanwhile, despite China’s stated goal of pursuing peaceful development, its relations with the US have been uneasy. The trade spat may be just a flashpoint in a widening rift between the two major powers as a bipolar world order takes shape. The US has labelled China a strategic competitor, suggesting growing rivalry across the economic, technological and geopolitical spheres. While we would welcome a US-China trade deal—and note that China’s rapid rise in patent applications generates a growing incentive to abide by international intellectual property norms—we also think it is unlikely to mark the end of competitive tensions.
Never underestimate China’s strengths
Against this backdrop, our near-term view on China is cautious. We expect its economic growth to slow in the next few years as it focuses on resolving the array of challenges. That said, a slowdown is not a crisis. We believe there are ample strengths in China’s institutions and economy to prevent a hard landing.
The first is China’s ability to implement policies. Its system of central rule, though imperfect, has allowed it to tamp down problems at a speed and scale that is virtually unmatched by other large developing nations, such as India. Consider the steps that China has taken to tackle excess capacity, high leverage and other economic and financial risks. In the coal industry, for example, the government shut thousands of coal producers and put numerous coal-fired power projects on hold to reduce overcapacity. The high degree of compliance underscored the administration’s execution ability. And a result of this was a sharp recovery in coal prices, which supported cash flows and the debt-servicing capability of many coal related companies.
Such supply-side policies, replicated across several industries, have helped address one of the key systemic risks in China— the concentration of debt owed by “old economy” SOEs. We have witnessed this much vaunted deleveraging taking place.4 More importantly, these policies are part of a bigger package of reforms that government agencies have rolled out—all without dealing a major blow to overall GDP growth.
China has also retained control of its external accounts so far, which should set a floor for the yuan. The government tightened capital controls after a bout of volatility in China’s stock and currency markets in 2015, which helped to stem outflows. Measures include restrictions on companies’ investments abroad, as well as caps on overseas cash withdrawals using Chinese bank cards. These limits, coupled with slowing domestic monetary growth amid a deleveraging drive, have helped shore up the yuan.
China’s “new economy”
Beyond economic and fiscal policies, China has shown a formidable ability to innovate, spurred in part by the government’s research and development (R&D) push. Illustrating this, China has overtaken developed markets (DMs) such as the US and Germany in the number of patent applications filed, as Exhibit 2 demonstrates.
Sources: World Bank, World Intellectual Property Organization (WIPO), WIPO Patent Report: Statistics on Worldwide Patent Activity, as of January 2019. The International Bureau of WIPO assumes no responsibility with respect to the transformation of these data.
Across various industries, China has become the innovator to watch. For instance, rapid improvements in lithium-ion battery production have helped turn the country into the world’s largest electric vehicle market by both production and sales. In China’s pharmaceutical industry, government policies favouring the development of novel drugs over generics have encouraged local companies to scale up R&D expenditures. This could sow the seed for a pipeline of groundbreaking treatments from Chinese drug makers.
Especially impressive is a new generation of mega companies that have found success through consumer-focused innovation. They are keenly attuned to the needs of a rising middle class that is eager to spend, and these companies are devoting their know-how to fulfil these needs. In many cases, hypercompetitive companies have leapfrogged established business models, overtaking Western peers shackled by sunk investments in legacy systems. Take Chinese internet giant Tencent as an example. The company’s popular WeChat application began as a simple instant messaging platform. Since then, it has evolved into a one-of-a-kind ecosystem for social media, e-commerce, mobile payment and a host of other services. Aided by WeChat, Tencent has embedded itself into the lives of more than a billion active users.5
Such companies have become emblems of China’s “new economy,” which centres on technology and consumption. We view China’s consumer market as a force to be reckoned with. As highlighted in Exhibit 3, China’s consumer market has exceeded those of DMs such as the UK and Japan in size after a breakneck pace of growth in the past 20 years. We believe the uptrend can continue as incomes increase. On top of this, the consumer base is diverse, with coastal cities and inland regions at different stages of economic development exhibiting different spending patterns. Altogether, we expect China’s large and diverse consumer market to cushion an economy undergoing transition.
Source: World Bank national accounts data, and OECD National Accounts data files, as of January 2019. Data for Japan available to 2016. Household final consumption expenditure (formerly private consumption) is the market value of all goods and services, including durable products (such as cars, washing machines, and home computers), purchased by households. It excludes purchases of dwellings but includes imputed rent for owner-occupied dwellings. It also includes payments and fees to governments to obtain permits and licenses. Here, household consumption expenditure includes the expenditures of nonprofit institutions serving households, even when reported separately by the country. Data are in current US dollars.
Also positive are the government’s recent efforts to unleash consumption further to counter the trade row’s dampening effect on the economy. Personal tax cuts—with more potentially on the way—should help stimulate consumer spending as individuals feel wealthier from the tax savings.
For companies, China’s consumer market offers a wealth of business opportunities. They can potentially improve their earnings prospects by selling more products and increase their market penetration resulting from increased consumer demand. Alternatively, they can supply better-quality and more expensive goods—a trend known as “premiumization”—to increase revenues.
Even with these new opportunities, the “old economy,” represented by the manufacturing sector and the numerous jobs it provides, remains vital.6 China is among the world’s largest producers of a wide range of goods and is unlikely to lose its lead easily.7 Moreover, its factories have shown remarkable agility in moving up the value chain, using business processes and resources to produce higher-margin products. Since the early 2000s, China’s contribution to high value-add exports such as advanced equipment and aircraft parts globally has surged, as shown in Exhibit 4. Though the manufacturing sector has come up against headwinds such as rising labour costs, the “Made in China 2025” plan is likely to rev up its capabilities through innovation and technology.
Source: Intracen, as of December 2017. High value-add exports include electrical machinery and equipment and parts thereof; sound recorders and reproducers, television, machinery, mechanical appliances, nuclear reactors, boilers, parts thereof; optical, photographic, cinematographic, measuring, checking, precision, medical or surgical, plastics and articles thereof; vehicles other than railway or tramway rolling stock, and parts and accessories thereof; aircraft, spacecraft and parts thereof. See www.franklintempletondatasources.com for additional data provider information.
Navigating China’s opportunities selectively over the long term
In our assessment, the longer-term outlook for China still holds promise, if its rebalancing efforts result in an economy that is sturdier and more sustainable. Nonetheless, we believe the complex investment landscape requires an active stock-picking approach. Buoyant economic growth and loose liquidity previously had helped most companies— even mediocre ones—deliver quick and sharp gains in stock markets. But amid slowing growth, waning liquidity and increasing consolidation across industries, we foresee stronger companies pulling ahead, resulting in a greater dispersion in stock returns. We expect the most compelling long-term returns from companies with sustainable earnings power, trading at discounts to their intrinsic worth. And experience has shown us that solid fundamental research will be needed to identify them.
Equally important is keeping a long-term investment perspective. In our view, investors should brace themselves for further rounds of market volatility in the near term, as China grapples with daunting obstacles and works through challenges. The encouraging news, however, is these obstacles do not appear insurmountable for a country that has an array of proven tactics and new economic opportunities. The age-old desire for progress is a powerful force, and we expect it to lead China toward sound policies that promote higher incomes and a better quality of life for its people. This bodes well for the next chapter of its secular growth story.
1. Source: Bloomberg data, as of October 2018.
2. Source: 3 April 2018. “Report on the Work of the Government,” delivered at the First Session of the 13th National People’s Congress of the People’s Republic of China on 5 March 2018. Reproduced by People’s Daily Online.
3. According to the open-economy trilemma, a country can pursue two of the following three macroeconomic policies: free capital flows, a fixed exchange rate and an independent monetary policy. The trilemma is a corollary of the Mundell-Fleming model, based on research by economists Robert Mundell and Marcus Fleming in the 1960s. As an example of how the trilemma works, a country that allows free capital flows and fixes its exchange rate against the US dollar would have to align its interest rate with that in the US. If its interest rate is higher than the federal funds rate, foreign capital seeking higher returns would enter the country and put upward pressure on the local currency, eventually breaking the peg to the dollar. If the country’s interest rate is lower than the federal funds rate, capital would leave and force the local currency lower. Sources: Eichengreen, B. Winter 2018. “The Open-Economy Trilemma in the Long Run” The Korean Economic Review—Volume 34, Number 1, Winter 2018, 5-28; 27 August 2016. “Two out of three ain’t bad.” The Economist.
4. Stanway, D. 13 July 2018. “China state firms draw up plans to deleverage, cut debt ratios: paper.” Reuters.
5. Source: Tencent, as of 30 September 2018.
6. Source: National Bureau of Statistics of China, 2017 data, as of February 2019.
7. Source: 17 February 2017. “China remains world’s largest manufacturer and major network power.” State Council of the People’s Republic of China.