7. Feb. 2024
In European mythology, dragons breathe fire and terror; in Chinese mythology, water and prosperity. As China celebrates its year of the dragon, that difference in perception sums up the debate about China’s long-term structural challenges. We tend to side with those who think China’s trajectory is better than current valuations imply.
It’s important to remember how we got here. The property market downturn that is dampening animal spirits in China at present was the result of a deliberate decision taken by authorities, who consider this a type of ‘cross-cyclical policy’. That can be interpreted as ‘taking action sooner, in smaller steps and with a focus on the longer term’. In other words: taking short-term pain for longer-term gain; with imbalances managed over multiple cycles. This drives China’s regulatory cycle, which has followed a pattern over the past decade: When the economy is doing well, new regulations are introduced to address structural issues. When the economy is weak, prior regulations are often wholly or partially repealed as authorities seek to boost confidence.
The authorities can be deliberate in targeting imbalances because China is a command economy with a relatively closed capital account. As a result, Chinese authorities broadly control the flow of money and credit across the economy. This differs from capitalist economies. Therefore, credit cycles in China are the result of deliberate policy decisions. Chinese economic weakness today may well be a product of policy overconfidence—itself a reflection of underlying strength. Is this fire or is this water?
Allocators are concerned about four main structural challenges.
Real estate is the most pressing. Chinese authorities identified this as a key issue some time ago. After a decade of rapid growth, its share of GDP peaked in 2014 and has declined modestly since, according to IMF data. China’s objective is to manage this sector lower over multiple cycles. This is therefore not a sector in which we want to invest.
The current down-cycle in real estate is policy driven. Various macroprudential regulations were introduced from late 2020. However as economic challenges mounted in recent years, Chinese authorities repealed many of those measures and have provided targeted stimulus with the objective of stabilising the real estate sector. We expect this to continue.
A second key imbalance is local government leverage, which is well known to authorities. They clamped down hard on this through the first part of 2021 in seeking to address off-balance sheet liabilities or ‘hidden debts’. At July’s Politburo meeting, Chinese authorities pledged to “implement a comprehensive debt solution” for local governments. In recent months, debt swaps have been announced for a number of provinces, and state banks have been told to do the same more broadly. This is effectively a refinancing of debt, extending maturities at much lower interest rates. Yes, it is a bailout. It will allow local governments to continue to function, but it will reduce the profitability of Chinese banks – another sector to avoid.
Demographics also represent a headwind, with the overall population having peaked and the working age population beginning to decline. One counter to this is the prospect for further urbanisation, with China’s urbanisation rate standing at close to 65% at the end of 2022, compared to urbanisation rates of 70-90% in most developed economies. Our central case would be that these forces largely offset one another, making demographics neutral for the rest of this decade. It is therefore productivity gains that will be required to drive growth and it’s a key reason why authorities have been seeking to address monopolistic behaviour and are directing stimulus at technological development and science to drive productivity gains.
‘De-risking’ by the developed world in recent years and the reworking of supply chains have reduced foreign direct investment into China and exports to the US, for example. Our central scenario is a multi-polar world, where connectivity between the developed world and China is reduced, but decoupling is impossible due to the degree to which economies are interconnected. While this is a headwind for Chinese exports to much of the developed world, trade with other countries around the world has been rising sharply. As a result of the increasing importance of countries outside of the G7, Chinese exports have continued to rise in recent years and remain stable as a percentage of global exports.
On any measure, sentiment towards China is incredibly bearish at present. We continue to see opportunities in businesses with structural tailwinds that have been performing well, and growing, in recent years, but trade at sale prices. The long-term outlook is more benign than current fears imply. The dragon might not be breathing fire but turn your back at your peril.