The future just happened

08 Jan 2019
  • Long-term forecasts predict China to take the lead as the world’s largest economy in ten years;
  • China is already the number one driver of global economic growth;
  • Trade, debt, and reform issues might cloud the short-term outlook but they are manageable;
  • Longer term drivers like financial reform, data-driven innovation, growing consumer demand, industrial upgrading, and trade reorientation will sustain China’s growth and present significant investment opportunities.

Economists might disagree on a lot, but they all agree China will overtake the US as the world’s largest economy. Estimates range between 20261, 20292, and 20303 but the emphasis now is on ‘when’ rather than ‘whether’ it happens.

That is fine for futurists but focusing on China’s longterm leading position misses what’s happening now and, clearly, the future just happened.

China led the world economy in 2018, and is forecast to do so in 2019, adding 27.2% of total global growth during the period, exceeding the 12.9% from India and the 12.3% from the United States, according to the IMF.

This may come as a surprise, particularly after recent rapid growth in the US, but looking across a range of sectors, it is clear that China is the most influential market globally.

Contribution to global GDP growth,2018-2019 (f)

Source: IMF, World Economic Outlook, January 2018

Near-term concerns

But as we move into 2019, we are focused on China’s near-term growth prospects, and we forecast 6.1% growth for China in both 2019 and 20204 – slower than previous years but still 25%+ of expected global economic growth during the period.

Two themes dominate the outlook: namely, headwinds from the US-China trade dispute, and government support for the economy in the form of targeted monetary and fiscal policies.

Crucially, our outlook considers that near-term challenges, like trade, debt, and reforms, are manageable, and are being actively managed. Our views on these issues break down as follows:

Trade tensions: short-term headwind, long-term catalyst

The US-China trade dispute weighs on growth prospects but a compromise looks likely at the time of writing. China is opening sectors, like autos and financials, to overseas investors and we expect heightened pressure in the US to cause a roll back on the hard line taken during the past year.

In the case of continued pressure, however, the key question is whether trade tensions will impact China’s ability to sustain its growth rate over the longer term. In this sense, trade tensions are a short-term headwind, but a long-term catalyst for China.

They are a catalyst because they will accelerate the ongoing trend through which Chinese companies diversify and reorient their export markets away from the United States. This process, supported by new government efforts to forge new free trade agreements around the globe, will position China’s export machine in markets like Asia, Africa, and the Middle East which are expected to grow rapidly in the coming years.

Inward FDI into China YTD (CNY billions),2014-2018

Source: Bloomberg, November 1, 2018

Additionally, trade tensions will accelerate the shift in China’s economy toward consumer demand. This transition has been ongoing for years and is a key government strategy. Policy is supportive, but urbanization, rising incomes, premiumization, and the shift to organized retail are four fundamentals driving this process.

Finally, the US challenge to China over trade will actually force further reforms in China. There has been some opening in recent months and further steps can be expected in the future.

It is important to remember that, despite a raft of trade measures through 2018, foreign direct investment in China actually increased y-o-y; clearly, corporate decision-makers are looking beyond trade tensions and positioning for continued growth.

Debt: manageable, not malign

China’s debt-to-GDP ratio grew to 261% in 20175, raising fears of liabilities in the financial sector, burdens on Chinese companies, and obstacles to long-term growth.

But a crucial part of this narrative came next, because government measures brought growth of the debt pile to a standstill in 2018 amid a raft of new financial regulations and controls on credit that tightened liquidity in onshore markets.

Wealth Management Products,December 2014 – December 2017

Source: Bloomberg, November 1, 2018

Shadow banking flows (RMB trillions), January 2017 – July 2018

Source: Bloomberg, November 1, 2018

And this clampdown on credit reached as far as the shadow banking sector, a long source of concern about hidden debts in the financial system.

These measures show that the Chinese government is serious about controlling the debt pile and that steps taken have been substantial.

With the recent cases of monetary policy easing, it has been more a painkiller to the economy at a time of stress, not a steroid-like monetary stimulus that will
accelerate another build-up in China’s debt pile.

Longer-term, the debt build-up will be a management issue for the government, not a burden on the private sector.

Most of China’s debt is concentrated in the state-owned enterprise sector6 and owed to the government, rather than international institutions. In contrast, companies in the private sector, particularly those that are in the consumer-led sectors that are powering the new economy, have comparatively low debt levels.

Reforms: ongoing, with much more to come

China’s ability to grow not only rests on managing trade relationships and debt, but delivering on a reform agenda – and there has been marked progress in the
past year7:

  • Liberalization: opening up RMB forex derivative markets and domestic bond markets to direct foreign institutional investors, easing of restrictions on overseas investment in autos and financial sectors, expansion of free-trade zones to 11.
  • Supply-side reform: capacity cuts in steel, coal, coal-fired power plants, reduced corporate and personal taxes, revisions to rural land laws and the launch of a new carbon trading scheme.
  • SOE reform: three rounds of mixed ownership reform pilots across 50 SOEs, supervision of stateowned assets further streamlined.
  • Social welfare and environment: medical coverage expanded to more non-hukou locations, relaxation of hukou policies in selected tier 2 cities.

And we expect to see further changes in the future, including the opening up of telecoms, internet, healthcare, and education sectors to foreign businesses, tax breaks for advanced manufacturing sectors, tougher controls on SOEs, and expanded social welfare.

Taking the lead

In summary, besides taking the lead in the global economy, China is taking the lead in addressing the near-term challenges it faces.

But focusing too much on challenges risks missing out on the investment opportunities that China presents.

There is a series of thematic trends driving China’s economy in the future, including the rebalancing of global capital toward Chinese markets, data-driven
innovation, industrial upgrading, sustained growth in the consumer sector, and the reorienting of China’s trade relationships.

So while there is lots of noise about China, most of it is negative, investors may want to take a long-term strategic view around the new trends and themes
detailed in this report. This approach has brought numerous benefits to investors in the past and, as China continues to take the lead in the global economy, the future should be no different.

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