Why we are bullish on China
We expect China to avoid a financial shock and achieve high income status by 2027. Our view is that moving to higher value-added activities will propel the economy forward and drive the continued medium term outperformance of MSCI China versus MSCI EM, providing significant investment opportunities.
* China’s macro challenges have been well-telegraphed – a high leverage ratio, excess capacity in industrial segments, an over-reliance on investment as a growth driver. More recently, the risks of protectionism have cast an additional shadow. There is much common ground amongst investors on the need to address these challenges. However, that's where the debate starts. There is wide dispersion on views on the steps needed to be implemented to resolve
these challenges and what the end outcome will look like.
* Investors appear most concerned about the risks of a financial shock happening in China and, by extension, there has been greater and rising scepticism on whether China can ensure continued prosperity. This caution is also reflected in the fact that EM investors have consistently held an underweight position in China equities relative
to the benchmark and the underweight position is at a decade-low.
--> However, we take a positive view that China will be able to navigate these challenges:
1) We view the risks of a financial shock as low because of the specific characteristics of this debt cycle.
Investors are concerned that China could face a financial shock similar to that of the US in 2008 and Asia in 1997/98, as debt has risen from 147% of GDP in 2007 to 279% in 2016, leading to concerns about the sustainability of the debt buildup.
However, there are three mitigating factors at play. First, the buildup of debt has been funded by China's own savings and has been used to fund investment, rather than consumption. Second, strong net asset positions both domestically and externally (with a positive net international investment position of 15% of GDP) provide adequate buffers against shocks.
Finally, from a macro stability management perspective, the starting point of a strong external position in the form of current account surplus, high level of FX reserves and the lack of significant inflationary pressures does mean that China will be able to manage its domestic liquidity conditions and thus avoid a financial shock.That said, the high levels of debt to GDP reflects that China has borrowed a lot from the future. The payback will be in the form of a significant slowdown
in growth rates.
A connected debate is the issue of a potential one-off, sizable devaluation of the currency. It is our view that policy makers would not opt to devalue the currency as it would risk upsetting the management of the trilemma pressures, which could potentially lead to a spike in interest rates and cause a period of risk aversion in the financial system.
That said, we do recognise that there will be manageable, moderate currency depreciation ahead.
2) Notwithstanding slower growth in the years ahead, a high income status is attainable and is the most likely outcome over the next decade.
The second key macro debate is whether China can transition towards high income status (US$12,500) from its current
status of middle-high income (US$8,100). In the context of the recent macro challenges and the prospect of a financial shock, investors have expressed reservations as to whether China will be able to continue on its journey towards high income status.