China's economic transition

China is undergoing an economic transition which should result in lower but more sustainable growth.

In light of an expanding middle class and further urbanization, CIO expects the Chinese economy to be increasingly driven by household consumption and the service sector. Meanwhile, the domestic markets have grown significantly in recent decades to USD 20trn. At USD 8trn, China's equity market has become the world's second largest, and at USD 12trn, the bond market is the third biggest globally. Despite the size, foreign participation in Chinese equity and bond markets remains very small, at only around 2%. CIO believes this will change significantly as China has been gradually opening up its capital markets in recent years.

The motivation is clear: China wants foreign capital to help deepen its capital markets and increase efficiency in capital allocation. In addition, the resulting capital inflows should help create a two-way currency market and ultimately support the internationalization of its currency, the yuan or renminbi (RMB). Recent efforts, including the launch of stock and bond connect programs and the lifting of restrictions regarding foreign ownership in the financial sector, demonstrate China's desire to open up its capital markets.

Global investors are also increasingly recognizing the importance of Chinese assets in their portfolios. MSCI included A-shares into its benchmark indices in June 2018, and Bloomberg announced in March the likely inclusion of China onshore bonds in April 2019.

Despite the opportunities, CIO highlights key risks that could flare up and result in periodic stress in China's domestic capital markets. These include:

Concern #1: Debt and overcapacity

China's Debt-to-GDP ratio rose to 272% in 2017 from 152% in 2007. Some investors are concerned that China might face a looming financial crisis and crumble under the massive debt buildup. Meanwhile, oversupply in 2015 depressed steel prices so much that the profit from producing one ton of steel could not even pay for an ice cream cone, according to the China Iron and Steel Association.

Concern #2: The impossible trinity

Economic theory suggests that a central bank cannot have a fixed exchange rate, an open
capital account and an independent monetary policy at the same time.

Concern #3: Demographics

Some market observers highlight China's unfavorable demographics as a headwind. While it's true that its population is aging, we think the economic impact should be manageable as growth driver shifts to services.

Download the full report for more insights about the longer-term trends, key milestones, investment opportunities and risks from China's structural economic shift.