How demographic challenges are shaping China's investment story

March 11, 2022 10:27
Photo: Reuters

China’s latest national population census revealed some interesting demographic trends. The country has 264 million people aged 60 and above, which equates to 18.7% of the population, considerably higher than 13% in 2010. The 12 million births recorded in 2020 were the lowest since 1961. In addition, the working population has declined from 70% to 63% over the past decade. A rapidly rising dependency rate has become the elephant in the room.

Why should this matter to investors? For starters, demographics are a major driver behind recent regulatory reforms targeting education, health care and property. These three sectors are known as the “three mountains” that Beijing aims to overcome to take pressure off households, solve its demographic challenges and achieve “common prosperity”, an overarching vision that incorporates quality growth, social wellbeing and environmental sustainability.

Despite the scale and complexity of China’s demographic challenges, the country’s unique governance and policy system has proven efficient when it comes to taking action. Examples include reforming the after-school tutoring system, drastic cuts in generic drug and medical device prices, as well as curbing speculative activity in the property sector to keep real estate prices in check.

While a degree of regulatory overhaul would likely create complexities in China’s investment story going forward, the country’s commitment to solving its demographic deadlock remains strong and future policies will likely revolve around this agenda.

Regulatory reforms could be here to stay

Even though the “three mountains” are obvious candidates to receive further regulatory attention, investors should keep in mind that other sectors could also be targeted.

In the technology space, industry heavyweights were hit with multiple penalties for breaching antitrust regulations in 2021. According to President Xi Jinping’s vision of common prosperity, reforms could be undertaken anywhere the authorities believe changes can promote social and economic stability as well as healthy competition.

Looking at China’s current regulatory and policy trajectories, there are several developments we anticipate in 2022 and beyond:

• Further measures to eradicate monopolistic behaviours by restricting excessive or abusive horizontal expansion. Alternatively, regulators could follow the approach taken in the US technology space and encourage companies to expand market share through vertical expansion. This approach also ties back to the common prosperity agenda as Beijing looks to level the playing field for small and medium-sized enterprises (SMEs) to grow.

• More local champions could expand globally. Rising geopolitical tensions have prompted China to focus on investing in domestic production and technological capabilities, especially in strategically important sectors that have historically been more reliant on imports. This shift has seen China grow to become a huge exporter of high-end manufacturing components such as electric vehicle (EV) batteries, solar inverters and panels.

• Another segment that could see more Chinese companies flex their muscles globally is health care, where Chinese contract research organisations (CROs) and contract development and manufacturing organisations (CDMOs) are supported by a strong talent base, increasing technological edge, cost advantages and an influx of venture capital. If these companies are able to continue their current growth trajectory, they could very well become the next batch of global Chinese brands.

• Higher scrutiny on data security and protection. The new Personal Information Protection Law could lead to more companies localising technology infrastructure and ringfencing data domestically. Excessive data mining, a common practice among Chinese e-commerce platforms, would also come to an end.

• Lower health care costs. In recent years, China has been actively cutting the costs of medical supplies and drugs to reduce the financial burden on patients. Notable initiatives include the Two Invoice System and the growing National Reimbursement Drug List (NRDL). Making health care more affordable remains a key priority for China and the government’s next focus will be to reform the pricing of medical services provided by public hospitals.

China property: down but not out
The property sector is a strategic pillar of China’s economy accounting for around 29% of its GDP. China has recently introduced a series of policies to rein in surging housing prices, restrict speculation and reduce leverage for developers, which have triggered an increase in bond defaults among developers and led to fears that this could be China’s ‘Lehman’ moment.

These concerns could be overblown as China has a solid track record in terms of managing corporate collapses in recent years.

Some of the steps China has taken to loosen the policy tone since the third quarter include:

• Encouraging banks to accelerate mortgage and developer loans
• Cash reserve requirement ratio cuts for banks to free up lending capacity
• Allowing property developers to resume issuing asset-backed securities (ABS)
• Easing of land sales in some cities

These steps should ease concerns about systemic risks and provide developers with much-needed relief.

Investors can also take comfort in China’s prudent use of monetary stimulus during the COVID-19 pandemic. The benchmark one-year loan prime rate has declined by only 55 basis points since COVID was declared a pandemic in March 2020, compared with a 300 basis points drop during China’s last easing cycle in 2015 to 2016. This means the country has room to cut interest rates if required.

Investors are also increasingly focusing on property management as an up-and coming sub-segment. Unlike developers, property management firms tend to be asset-light and less cyclical because of their stable streams of recurring cash flows (management fees). In addition, many of these companies are expanding into lucrative community value-added services such as property brokerage, financial services, public space utilisation and housekeeping services.

China’s monumental energy transition

It wasn’t that long ago that China made the promise to achieve carbon neutrality by 2060.

Given that environmental sustainability is an important element of China’s common prosperity agenda, many local governments have been working to drive down coal consumption. In what could now be described as ‘overexecution’ or ‘over-interpretation’ of central government policies, China found itself with a dangerously low stockpile of coal in September 2021.This episode highlighted China’s over-reliance on coal and the complexities of such a large-scale energy transition. This will continue to impact the security of China’s electricity supply and make it less resilient to shocks.

Another interesting dynamic is to consider the intermediate replacements for coal. Natural gas’ status as an energy form of choice is likely to be at risk over the longer term, but could experience a surge in demand at least until 2030. Gas distributors may see another decade of growth but their businesses beyond that will depend on their ability to adapt to a low or no carbon energy future.

It is undeniable that after the developments of 2021, a level of regulatory and policy uncertainty will be coming out of China in the years ahead. This could lead to a higher risk premium for China-related investments, although the country remains one of the most attractive markets in the world given its growth, entrepreneurial culture as well as broadening and deepening financial markets.

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Investment Director, Capital Group