As China gets richer, it shifts its economic goals from producing wealth to ensuring better industrial self-sufficiency. To reflect this change in direction, China has made its growth objective more flexible. In the short term, as the first nation to enter and then exit the Covid-19 pandemic, it is now the quickest to normalize its fiscal and monetary policy. This is not without consequences for the holders of Chinese assets.
Earlier this month, at the National People’s Congress (NPC), the government set a flexible growth target of over 6% for 2021. For the first time, the CPN’s five-year plan does not set an average growth rate for GDP. Historically, the plans defined strict production quotas inspired by the economic model of the Soviet Union. Since 1953, these plans have served as a communication tool between the central Beijing government and the regions. Due to the Covid-19 pandemic, China has not met its annual GDP growth target of 6.5% for the period 2015-2020.
“We will keep the main economic indicators within an appropriate range and set our annual growth targets in light of real conditions,” Premier Li Keqiang said at the last NPC. “We will thus obtain better quality, more efficient, more equitable, more sustainable and more secure development. ”
China recorded economic growth of 2.3% in 2020, its lowest rate since 1976, even though it surpasses those of other major economies. Last year, the CPN did not set an annual target because the pandemic made the economic outlook too uncertain.
If annual growth in 2020 were below its target, growth in the fourth quarter of 2020 was strong and even taking into account the tightening measures, the country could record a GDP increase of 9% for 2021. China also plans to reduce its deficit from more than 3.6% last year to 3.2% in 2021. Certain strategic sectors, such as research and technological development and the military budget, are excluded from these restrictions. We estimate that the People’s Bank of China (PBoC) will begin to hike policy rates by 30 basis points, in three steps, later this year. This should impact growth next year by reducing the increase in GDP to around 5%.
For its part, the US Federal Reserve revised upwards its growth outlook for the US economy last week, while stressing that it does not plan to hike key rates before the end of 2023. As we publish these lines, the yield on 10-year Chinese government bonds stood at 3.26% versus 1.67% for 10-year US Treasuries.
The cost of credit
China’s growth comes at a cost. Credit may have peaked as the government attempts to balance financial risk in the economy and reduce debt. The PBoC has already withdrawn some of the liquidity from the Chinese financial system because it wants to avoid the formation of speculative bubbles in sectors such as real estate. As a result, the country leaves its businesses, including those of the state, to be in default, reforming bankruptcy rules and restructuring inefficient businesses while prioritizing employment. A fifth of the 10 billion USD of bankruptcies of Chinese companies registered this year concern real estate developers.
The rating agency Fitch gives China an “A +” rating with a “stable” outlook. The agency, however, spoke of the credit reduction process, which “could lead to a risk of downgrading this rating. ”
China has also started to apply increased regulatory oversight to tech companies, especially with regard to competition rules. This month, the state regulator said it had fined twelve companies, including Tencent, Baidu and SoftBank, for violating anti-monopoly laws.
China is on track to achieve its ambition to become a high-income economy and double its GDP within fifteen years. The World Bank considers an economy to be “high income” when the gross national income (GNI) per capita exceeds USD 12,535. In 2019, China recorded a GNI per capita of 10,410 USD, ten times that of 2001. At the current rate of growth, the country could cross the threshold of “high incomes” within five years. However, the Chinese administration will also need to reduce inequalities, as an estimated 373 million Chinese still earn less than $ 5.50 per day.
However, China’s path of recovery and economic growth puts it on a collision course with the United States. In December 2020, the United States banned exports of semiconductors to China, the world’s largest importer of these components. Given their importance to its industrial ambitions, China is trying to accelerate its domestic industry in order to become self-sufficient. The Chinese government has provided subsidies to this industry and added more than 10% to its research budget to support the deployment of 5G and fiber optic networks.
When China joined the World Trade Organization in 2001, its centrally planned economy was expected to gradually align with Western liberal democracies. Instead, the world seems more polarized than before. The more China gains economic influence in the world, the more it is steadfast. Since 2009, its share of global GDP has increased from 13% to over 17% and many economies have become dependent on its activities.
After several years of trade tensions between the United States and China, it was believed that the tone of dialogue would subside under the Biden administration. However, nothing like this happened last week. On March 18, statements made to reporters just before the start of negotiations between the United States and China in Anchorage, Alaska, escalated, with each delegation expressing frontal views on the other side’s policies, breaking down with diplomatic protocols. Given the context, these statements appear to be aimed at their respective national audiences. A few days earlier, the UK released a strategy paper containing an assessment of China and warning of the “systemic challenge” it poses to our security, prosperity and values.
Military spending is not part of China’s cost reduction program. The defense budget is expected to increase 6.8% to 1.355 billion yuan, following a 6.6% increase in 2020.
The good news is that the most contentious disputes between China and the West remain compartmentalized and latent. These include the treatment of Uyghurs in Xinjiang, questions relating to strategic technologies, notably concerning Huawei, import taxes, the status of Taiwan and support for North Korea.
Manage exposure to Chinese assets
When looking at investments in Chinese assets, it is worth distinguishing between the short-term and the long-term outlook. Our argument in favor of a strategic allocation to Chinese assets remains intact over the long term. In the shorter term, however, last year’s growth momentum has weakened. The country is the most advanced on the road to recovery and is therefore among the first to normalize its monetary and fiscal policies. In addition, the MSCI China index is less exposed to cyclical sectors likely to benefit from this change in environment.
We have therefore reduced our exposure to Chinese equities, as we believe that global small caps offer better opportunities. We are maintaining our exposure to Chinese debt, given the attractive spreads against US Treasuries and the low correlation with rising US rates.
The Chinese currency, which we overweight, has remained remarkably stable during this period. The strength of China’s balance of payments and rising rates should support the renminbi, and we expect the Chinese currency to outperform against the dollar, euro and Swiss franc.