Post Covid bounce masks profound shifts in China's growth

February 20, 2023 10:05
Photo: Reuters

China will likely experience a rapid, short-term economic lift this year as the global economy recovers from the pandemic. Beyond the issues on the surface, the Chinese economy is undergoing a more profound transformation that presents unique opportunities for long-term investors.

Within Emerging Markets, China occupies a unique position not only due to its massive size and scale that asserts a powerful influence on neighbouring markets and the global economy but also because that size and scale generates its own rules – creating challenges and opportunities unique to the world's second-largest economy.

As the post-pandemic recovery gathers pace, investors are focusing strongly on China – and with good reason: emerging markets are likely to do well initially, driven by China's re-opening. According to data provider MSCI, Chinese equities are valued at 25% cheaper than historical levels.[1]

Hurdles ahead

But there are challenges too: the trifecta of US geopolitical rivalry, peak Covid-19 infection levels, and property sector problems will test the resolve of the Chinese leadership. These problems mean the debt-fuelled growth model is irrelevant, rendering historical valuations less meaningful for investors seeking viable China themes.

Looking ahead, China is unlikely to grow over 6% in real GDP terms, and a mid to low-single-digit outcome is possible considering China’s constraints. The post-Covid re-opening trade risks becoming too crowded.

Profound shift

Beyond the issues at the surface, China's economy is transforming, driven by necessity, demand, or technological evolution that offers opportunities for long-term investors. The opportunities include:
• Digitisation
• Localisation of critical technologies
• Metaverse
• Renewable technologies
• Biotechnology
• Financialisation of savings

Most of these relate to technology: the ongoing modernisation of the country's infrastructure and the inescapable need to green the economy aligning with the Chinese government's stated goal to achieve net-zero carbon emissions by 2060.

Digitisation still has a long way to go. In several industries, China is at an early stage of digital and cloud adoption – amid slowing growth, its corporations are likely to invest in new technologies that will enhance efficiency and productivity. New regulations will provide incentives for tech uptake.

Amid the geopolitical head-butting with the US, China is also undergoing a process of localisation around critical technologies. This development presents exciting investment opportunities for investors in chip design, manufacturing software, and related industries.

Related to the digitisation and tech localisation themes, the immersive technologies comprising the metaverse have caught regulators' attention as a potential growth area. Last November, the Ministry of Industry and Information Technology (MIIT) and four other government departments published the Virtual Reality and Industry Application Integration Development Action Plan. This four-year strategy supports incorporating virtual reality innovations into industrial applications – requiring new investment.

Green is good

The medium- to long-term future of renewable technology is bright for China. It is a global leader in solar and energy storage technologies and has a sizeable wind turbine manufacturing supply chain. Cost economies associated with the sector's scale represent a significant pricing advantage for China's manufacturers, while rising demand at home and abroad bodes well for sustained growth.

Of course, technology is a broad term with room for developments in biological and physical sciences. Biotechnology, for example, is providing new advantages over traditional chemical-based drugs – and China is rapidly building out the skills and expertise to industrialise these innovations.

This trend is growing momentum across the value chain, promising longer-term gains for big pharma, local champions, and biotech start-ups.

Changing savings

There are changes too to the way Chinese consumers save. Long reliant on the property sector as a store of wealth, savers are now looking to diversify, driving a rapid financialisation of investments. According to the People's Bank of China (PBOC), nationwide household renminbi deposits grew by a record Rmb17.8tn ($2.6tn) in 2022, and savers are likely to seek new financial products and services to grow their savings securely.

Remaining risks

As much as we perceive potential opportunities, the current setting in China also holds significant risks for investors.

It is crucial to avoid any sectors related to geopolitical issues, such as the US Bureau of Industry and Security (BIS)'s Entity List. Companies in cyclical industries with excessive borrowing and returns below the cost of capital are best avoided.

A selective approach remains critical for investors.

Runway for growth

China has made commendable progress in multiple fields, but there is potential for the economy to achieve more. Progress in the future will depend on the pace of economic reforms and the further opening of the economy. Globally, economies rarely cross the US$10,000 per capita income threshold without institutional-level reforms.

China has already crossed this level thanks to its previous growth model. As property, infrastructure, and exports decline in relevance, China will need to find new drivers to sustain income levels and ensure a higher quality of life for its people. We believe focusing on these themes will offer investors a long runway for growth.

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Head of Global Emerging Markets, Federated Hermes