What could slower Chinese growth mean for investors?

A recent headline in Foreign Affairs sums up the collective market sentiment around China – “The End of China’s Economic Miracle”.

The Chinese stock market is on track to post negative returns for the third year in a row. This gloom has pushed share valuations to the bottom end of their historical range.

However, for those willing to look through this darkness, there could be opportunities on offer.

This article isn’t personal advice. All investments can rise and fall in value, so you could get back less than you invest. If you’re not sure whether an investment is right for you, ask for financial advice. Past performance isn’t a guide to the future.

The end of a 40-year boom

Deng Xiaoping became supreme leader of China in 1978, ushering in a series of pro-market reforms. This led to rapid economic development. Over the following four decades, China increased its income per head 25-fold, lifting more than 800mn people out of poverty.

The authorities opened the Shenzhen and Shanghai stock markets in 1990 and opened markets to foreign investors in 1992.

The government bond market welcomed foreign investors in 2010 and gradually made access easier.

These markets are huge – the largest countries in the MSCI Emerging Markets Index and the J.P. Morgan Emerging Markets Local Currency Government Bond Index.

However, over the last few years, a combination of drivers have slowed growth:

1. The working-age population peaked
2. A bubble in residential housing burst
3. Xi Jinping was appointed president for an unprecedented third term
4. Russia’s invasion of Ukraine led investors and politicians to reassess their relationships with China

1. Working population peaked

Going back to 1980, China introduced a one-child policy that was kept in place until 2016.

In practice, the number of children born to each woman averaged 1.7 in the first two decades of the millennium. But this decade birth rates have fallen to 1.2, following the global trend of having fewer children.

As a result, the population – and the working-age population – is expected to shrink over the next thirty years, while the population of over-65s increases. Naturally, fewer people means less economic activity.

2. Residential housing bubble burst

China underwent a housing boom, accounting for more than a quarter of economic activity in some years. Then the boom turned to bust in 2021. Figures are hard to come by, but an estimated fifth of city apartments were unoccupied in 2018.

The bust has hit property developers hard, with Evergrande – then the largest developer – defaulting on its debts. House price growth has also stalled. This impacts consumer sentiment and puts pressure on the finances of local governments, whose income is reliant on land sales.

China’s strong growth was being driven by high levels of investment – around 44% of Gross Domestic Product (GDP) between 2008 and 2021 compared to a global average of 25% and below 20% in the UK.

This investment was financed by high levels of savings. The flipside was that Chinese consumption made up only 38% of GDP, this being around two thirds in the US.

In 2007, premier Wen Jiabao said that the Chinese economy was “unstable, unbalanced, uncoordinated and unsustainable”. But little was done to rebalance the economy.

Excess investment has led to a fall in the returns on that investment. The profitability of state-owned enterprises is lower than privately owned assets. But investment in these firms has still risen year-on-year since 2015.

One reason that consumers save a high proportion of their income is that unemployment benefits and government funding for healthcare are relatively small.

The government could take measures to boost consumption, but we’ve seen little appetite for implementing policies that increase individuals’ freedom to make their own decisions.

3. Xi’s third term

For thirty years, China’s presidents were limited to serving two five-year terms.

In 2018 this limit was removed, and President Xi started his third term as leader earlier this year. With no signs of a future leader being groomed to take over, political analysts see signs that he intends to hold power indefinitely.

The history of third-term governments in emerging countries is not encouraging. Policy goals tend to shift towards sustaining power at the expense of the broader economy. Political appointments favour loyalty over expertise.

We’re seeing less and less economic data released. When the rate of graduate unemployment rose to worrying levels, they simply stopped publishing the data.

4. Russian invasion of Ukraine

The Russian invasion of Ukraine has led some investors to focus on China’s policy towards Taiwan. President Xi has said that “reunification” with the island “must be fulfilled”, and he hasn’t ruled out the use of force to do it.

After the sanctions imposed on Russia, some investors are growing increasingly concerned of losing access to their assets. Companies have also become more cautious about investing in China.

Google announced it will make its smartphones in India and on the political front, there’s growing tension with the US and its allies.

The full picture is summed up in economists’ forecasts for the next decade. The International Monetary Fund (IMF) expects growth to be below 4% over the next few years, less than half its recent record. Capital Economics, an independent research firm, sees growth falling to 2% by 2030.

Where are the opportunities?

There are reasons for optimism.

The key positive is that – with so much pessimism around – Chinese shares are trading at valuations lower than their historical average. We think investors have readjusted their expectations for the country. And low valuations are typically associated with higher future returns, although of course there are no guarantees.

While economic growth has slowed, it’s still expected to exceed that in the developed world for years to come. The potential for catch up is still there. Other economies, like Korea and Taiwan, have recovered from the sort of crisis that China is experiencing today.

In the shorter term, the government has boosted spending to try and reverse the downtrend. And the central bank has cut interest rates. With consumer prices falling 0.2% year-on-year in October, the authorities aren’t constrained by the need to tackle inflation.

Economic dynamism is clear in many companies and sectors of the economy.

Chinese auto manufacturers are global leaders in electric vehicles. The technology sector is benefiting from government support. This type of industrial policy was an ingredient in the success of the sector in the US, Korea and Taiwan. The potential for China is visible in its world-leading rate of applications for patents.

The structural shift to a lower growth is real. But so is the fact that markets are driven by emotions and fundamentals.

Valuations at 20-year lows is a good measure of where sentiment is today. This suggests that there are opportunities for investors willing to look through the gloom.

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