China: A view through the looking glass

Daniel J. Graña

Daniel J. Graña
Portfolio Manager, 01/24/18

China: A view through the looking glass

  • President Xi Jinping’s second-term in office may herald an era of faster reforms
  • Growth is expected to slow in 2018 as government reins in spending
  • Tech companies take advantage of consumer demand for e-commerce, financial products, and mobile payment services
Picking up the pace of reforms

President Xi secured his second term in office at the culmination of the 19th Congress of the Communist Party in October 2017. The Congress ended with the Politburo Standing Committee — the Party’s decision-making body — having no obvious successor to Xi. This points to the possibility that Xi may hold on to power for a third five-year term in 2022.

What does this mean for investors? Xi has emerged as China’s most powerful ruler since Mao Zedong and Deng Xiaoping. He can pursue reforms that affect strong vested interests. Xi, for example, has pledged to escalate economic and financial reforms. We believe there will be an increased pace of change going forward. However, the president is not a believer in unfettered free markets. China’s one-party state will continue to pursue a government-directed path of economic development.

Among the challenges facing the government will be the occasionally frothy property market, the seemingly ever-rising financial leverage of the economy, and the capital inefficient state-owned enterprises (SOEs). The SOEs are critical for Xi’s vision of economic development, and policies that foster more efficient behemoths and less fragmented industries would benefit the economy.

Pivoting from growth-enhancing policies

We expect growth to decelerate in 2018 as China has pivoted from growth-enhancing policies to those that rein in credit expansion and encourage more environmentally friendly development that includes closures of polluting facilities. Over the long term, economic growth that is less dependent on credit is a necessary condition to avoid a hard landing.

The world’s second-largest economy grew 6.7 percent in 2016, and expanded 6.8 percent in the third quarter of 2017. Growth was largely fueled by state spending, the booming property sector, and foreign trade. Previously, annual growth rates often surpassed 8 percent, and even reached 13 percent in 2007. China is expected to release full-year economic growth figures for 2017 this month.

Can China avoid a hard landing?

The government has the incentives and policy tools to curb rising property prices and deal with debt risks to prevent an uncontrolled slowdown. The economy does not rely on foreign flows, the domestic savings rate is high, and credit underwriting standards that underpin the housing market do not concern us.

While the rapid buildup of financial leverage in the broader economy concerns us, debt is more sustainable in China than in other pre-crisis emerging markets because, in this case, it is domestically funded. These factors reduce the risk of a sharp downturn in the economy. Should the government prove unwilling to accept the near-term pain of financial deleveraging, our concerns about the debt trajectory would rise.

The rise of the tech giants

Slower growth hasn’t stopped investors from piling into Chinese technology companies. The gain of 37.3% by the MSCI Emerging Markets Index last year was largely driven by 10 tech stocks, including China’s e-commerce giant Alibaba, and Internet companies Tencent and Baidu. These Chinese behemoths have given Silicon Valley's top tech stocks — Facebook, Apple, Google, and Amazon — a run for their money. Tencent is currently valued at more than $539 billion, second only to Facebook’s market capitalization of about $543 billion.

China’s tech boom is being fueled by the rapid growth of e-commerce, digital payment services, and innovations in financial technology. Rising wealth and high levels of savings have boosted the purchasing power of Chinese households. Millions of Chinese shoppers are using Alibaba’s Alipay and Tencent’s TenPay — two payment apps — to make purchases using their smartphones instead of using cash or bank cards.

These companies are also leading the way in financial technology that will enable consumers to purchase investment products and secure consumer loans. The Chinese banking system is largely dominated by SOEs that are focused on corporate- and government-related lending. That facilitates the entry of Chinese tech companies into financial services for consumers.

We believe the growth of these Chinese tech stocks will last much longer than what has been priced in the markets. As a result, we expect tech stocks will remain a bright spot among the Chinese equity markets.

Individual companies identified are for informational purposes only and should not be considered a recommendation to purchase or sell any security. It should not be assumed that an investment in the companies mentioned was or will be profitable.