As Covid-19 swept across China early last year, it looked as if its three-decade-old economic miracle was showing signs of slowing down. The country has faced criticisms for both its seemingly unsustainable growth model and the way it handled the pandemic in the earlier months. Many observers were thus pessimistic about the continuation of its exponential growth.
“There was this thread of doom running through the Western analysis of the Chinese economy,” says Tom Orlik, chief economist at Bloomberg in an Aberdeen Standard Investments podcast.
Much of this pessimism towards China stems from the unprecedented speed with which it has accumulated debt. From 150% of GDP in 2008, China’s debt in 2015 had bloated to 250% of GDP — countries less encumbered have in fact run into financial crises.
China’s numerous state-owned enterprises (SOEs) have also been characterised as inefficient, inflexible, and indebted. They have thus often been seen as potential drags on China’s economy, says Orlik at a webinar organised by US think tank the Centre of Strategic and International Studies (CSIS) recently.
When lockdowns were imposed and the economy dropped 6.8% in 1Q2020 — in contrast to four straight decades of growth — China seemed on the verge of an economic “day of reckoning”.
Of course, this doomsday scenario never happened. Following a traumatic period of aggressive Covid-19 induced lockdowns early last year, China has emerged as the only major country in the world that recorded positive growth figures last year.
Swift recovery
The truth is, China experienced a softer landing and swifter recovery than other major economies. Fund managers and analysts have continued to bet on Chinese financial markets. Chinese growth equities are prized for their still considerable growth potential and Chinese government bonds for their higher yields and insulation from global market shocks.
Ironically, the very factors that have been cited as weaknesses in the Chinese economy have proven to be strengths. While SOEs are not the most efficient firms, tighter government control of these behemoths made it easier for policy goals to be implemented. For example, SOEs stepped up hiring to stave off unemployment; state banks and state-owned industrial firms can be directed to invest in times when private and foreign-owned businesses shy away.
China’s high debt levels have also turned out to be less of a problem than expected. While high debt levels are indeed a drag on growth, the “Chinese bubble” never seems to pop due to extremely high savings rates and tight controls over capital outflows. Chinese banks remain very well-funded despite the high debt levels. After all, it is not bad debt in itself per se that triggers a financial crisis, but rather banks running out of money and becoming insolvent.
Chinese leaders are also perhaps more effective in economic management than they are given credit for. Orlik says the Chinese government has moved to implement interest rate and financial exchange liberalisation to drive efficiency gains in the economy. Policymakers also sought to aggressively tackle the country’s debt challenges, swiftly passing a “deleveraging agenda” that has at least succeeded in de-risking important parts of Chinese shadow banking.
“Because we view China’s leadership through a kind of ‘red mist’, I think we are unable to recognise some of the important progress they do make on reform,” says Orlik, who has spent more than a decade working in China.
Many of these misconceptions and missed insights stem from the West’s lack of understanding of Chinese conditions, and a tendency to impose preconceived notions on the world’s second-largest economy. “If the West and China are to engage with each other constructively, it is imperative that the West understand China on its own terms, not through a Western lens,” notes veteran banker James Stent in his book, China’s Banking Transformation: The Untold Story.
One mountain, two tigers
Nevertheless, the next stage of China’s development journey is unlikely to be completely plain sailing. Obstacles to growth include an ageing population, the long-term growth drag of high debt and reduced space to catch up with the global technology frontier. But ultimately, geopolitical risks will likely prove the main challenge to China’s prosperity as tensions with the US grow steadily worse — it is now often said that Beijing no longer has any friends in Washington.
Deteriorating US-China ties over the past few years have inspired comparisons to the Cold War — with more pessimistic observers even hinting at a “Hot War”. According to Harvard Kennedy School professor and former US Assistant Secretary of Defense Graham Allison, rising China’s ambitions and established America’s fear of being displaced have placed both powers within a “Thucydides Trap” where conflict is more likely than not to take place. Having analysed sixteen similar historical cases, he finds that twelve eventually led to war.
Allison does not see a US-China war as inevitable or even desired by both sides. Nevertheless, he sees the structural security conflict between the two powers as a difficult reality that they will have to grapple with in the long-term. Careful management is needed from both sides to prevent the rivalry from escalating to mutually-detrimental proportions.
Speaking at UBS’s Year Ahead 2021 — The Next Big Thing virtual wealth management conference, Allison reckons Joe Biden is a “normal president” who will seek to avoid unnecessary geopolitical escalation — a stabilising factor in US-China relations. Cooperation on climate change, as well as the fear of “mutually assured destruction” arising from war are likely catalysts for cooperation despite Biden viewing China as a genuine strategic competitor.
On the economic front, Allison is also convinced that China’s deep enmeshment into the global economy will make decoupling difficult. For all of Donald Trump’s “America First” bluster, the US lost out from the outgoing President’s tariffs, recording its highest trade deficit in a decade in 2019. With the US depending on China for about half of its face mask stocks, Allison only expects some “ringfencing” of national security-related supply chains rather than full-on decoupling.
Orlik and Bloomberg colleague Björn van Roye modelled two decoupling scenarios to examine the impact of economic disengagement. The first, sees only the US decouple from China, and the second, where the US and its allies decouple from China. The former case would see China’s forecasted potential growth in 2030 fall from 4.5% to 3.5%. The latter scenario, however, predicted a catastrophic drop in potential growth to just 1.6%.
China and the US, says Allison, must therefore learn to be “rivalry partners”. He cites the Chanyuan Treaty between China’s Song Dynasty and the Khitan Liao Dynasty in 1005 CE as an example, where both powers agreed to compete in some areas and cooperate in others through mutual balancing and adjustment. While the treaty is often considered a failure since it provided peace for only 120 years, Allison says such an enduring pact would already be seen as a success in the context of the US’s much-shorter history.
The only way is up
So what is next for China in the new year? Investors see 2021 as a year of strong recovery. David Rees, senior emerging markets economist at multinational asset management company Schroders, predicts 15% to 20% y-o-y growth in 1Q2021 and 9% y-o-y growth in 2021 overall, from an estimated 2.1% in 2020. This is due to the lagged impact of economic stimulus and the effect of a low base last year, with growth rates seen to eventually decelerate closer to normal.
“One issue that may deter policy normalisation in the near term is a bout of deflation in early 2021, once the spike in food prices earlier this year washes out of the annual comparison,” Rees adds. While core inflation is likely to eventually pick up again in 2021, he sees near-term deflation in a period of high debt levels troubling policymakers and markets in the new year. China’s consumer price index rose to 0.2% y-o-y in December last year, from –0.5% in November.
Portfolio manager Julia Ho, who is the head of Asian macro at Schroders, is bullish on Chinese bonds. Attractive valuations and sound economic fundamentals are supportive of demand and returns in 2021. Aidan Yao, senior emerging Asia economist at AXA Investment Managers in Hong Kong, also notes that renminbi (RMB) interest rates are already back to pre-Covid-19 levels, which will likely result in more attractive yields. Ho also adds that as Chinese bonds are largely held domestically, they are less vulnerable to volatility in global capital flows.
As of end-November, the China 10Y Government Bond yields stood at 3.3% while US Treasury yields are around 0.8% — a record yield spread. The US dollar is likely to weaken in the long-run due to the US’s large fiscal and current account deficit and unlimited quantitative easing, supporting RMB-denominated bonds boosted by a record trade surplus and capital inflows. Nevertheless, Yao warns that this FX advantage will gradually erode once Covid-19 recovery sets in, which will likely result in a recovery of interest rates and global production.
The dragon’s gate
Simon Weston, senior portfolio manager for Asian equity at AXA Investment Managers, sees the normalisation of the Chinese economy as a positive for Chinese equities. New economy plays that have benefited most from the pandemic such as e-commerce will continue to do well. In particular, Weston predicts greater focus on areas such as healthcare and a policy drive for renewable energy, which will increase investor interest in these areas.
“We believe sectors providing exposure to long-term growth themes in the country will continue to outperform. In particular, we like areas including industrial automation, electric vehicles and components, and supply chain localisation amid international trade tensions,” say Schroder’s head of Greater China equities Louisa Lo and China A-shares fund manager Jack Lee. They also see cyclical stocks benefiting from global recovery, with valuations cheaper than growth plays.
Robin Xing, chief China economist for Morgan Stanley, agrees. He says Chinese households will be looking to unwind their especially high household savings (37% vis-a-vis a more typical 30%) in 1Q to 3Q of 2020. Strong manufacturing recovery is also expected to bring about three to six months’ worth of wage growth, increasing private consumption in travel, tourism, entertainment, lodging and catering.
Covid-19 has been an existential crisis that has severely stress-tested China’s economy. In Chinese mythology, a carp can transform into a dragon if it overcomes great adversity. It must first swim up the Yellow River and subsequently leap over the Longmen Falls (literally “dragon’s gate”) between Shanxi and Shaanxi provinces.
So, will 2021 be the year that China leaps triumphantly across the dragon’s gate? Only time will tell.
