Perspectives on China: Key considerations for institutional investors
Global Investment Insights
with Matthew Gertken, Vice President, Geopolitical Strategy, BCA Research
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Matt is currently Vice President, Geopolitical Strategy, at BCA Research. He oversees the firm’s coverage of market-relevant geopolitical, political, and policy developments across the world. He holds an MPhil from the University of Cambridge and a PhD from the University of Texas at Austin.
Matt shared his perspectives on China and the many considerations for Australia (and other Western economies) in managing their relationship with this great power, both in its region and globally, in this exclusive interview with Global Investment Institute (GII).
Q. How has China transformed to date and what key geopolitical and thematic trends are unfolding that investors ought to monitor?
A. China rose from being the twelfth-largest economy to the second-largest over the past 43 years. Its economy entered a difficult transition with the Great Recession in 2008 and it is still very much in the midst of this transition.
Investors should view the domestic and international context as negative for Chinese risk assets. They should wait for China to take concrete and irreversible steps to improve the investment environment and foreign relations before committing new capital to China.
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Xi is restructuring the economy by redistributing wealth, raising taxes and regulations on old growth sectors, and promoting new growth sectors.
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The Xi Jinping administration rose to power in 2012-13 and began reviving strongman rule, Communist Party ideology, and Chinese nationalism. The idea was that a strong central government would be needed to convert China’s economic power into political and strategic power at home and abroad. The result was partial economic rebalancing and a trade war with the United States.
The COVID-19 pandemic interrupted this process but the Xi administration is now redoubling its efforts.
Xi is trying to cement his status as leader for life at the five-year political reshuffle in autumn of 2022. He is trying to restructure the economy by redistributing wealth, raising taxes and regulations on old growth sectors (property, low-value manufacturing), and promoting new growth sectors (high-value manufacturing and technology, though not social media).
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Investors should look for concrete signs that China is easing fiscal policy, regulatory policy, and normalising relations with the US before upgrading Chinese assets.
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The key geopolitical trend is the confluence of internal and external risks: autocracy at home and cold war abroad. These trends will continually bring negative surprises for global institutional investors. Beyond that, the key economic trend is the desperate need to boost productivity, which will lead to more government support for industry but also more clashing with the West over technology. Investors should look for concrete signs that China is easing fiscal policy, regulatory policy, and normalising relations with the US before upgrading Chinese assets.
Q. How important is a strong and lasting relationship with China for Australia, both in the short-term and over a longer-term time horizon (10+ years)?
A. In the short run, Australia’s relationship with China remains important because exports to China are equivalent to 7.5% of Australian GDP and still growing. Australia’s overall reliance on trade is also growing, which is significant since China greatly affects global trade. Australia’s economy is geared toward commodity exports and its exports to China are vastly concentrated in commodities. So, the political and geopolitical need to decrease dependency on China is limited in the short run by the need to maintain economic growth and stability.
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For Australia, the political and geopolitical need to decrease dependency on China is limited in the short run by the need to maintain economic growth and stability.
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Over the long run, Australia’s relationship with China will be very important but in the opposite way: geopolitics will trump economics. Australia will need to break with China’s economy to preserve its sovereignty and security. China’s economic growth will slow and its economic structure will become less resource intensive and less dependent on Australia.
Australia’s growth will also need to shift. China’s growing power will become a greater threat to Australia’s security, punctuated by China’s conflicts with its neighbours (most obviously Taiwan), and Australia’s need to restore the US alliance for the sake of mutual self-defence.
Q. How can Australia (and its allies) manage the tension between the need to cooperate with China, while dealing with the adversarial challenge it potentially poses?
A. Australia and the United States and other allies and partners have given some indication of how they intend to manage China through recent agreements and initiatives. These suggest that tensions with China will outweigh cooperation and will ultimately be unmanageable.
The AUKUS agreement will strengthen Australia’s national defence over the long run by giving Australia the capability to manufacture and operate nuclear submarines and by further strengthening ties with the US and UK defence establishment. Over the past decade the US also shifted 2,500 marines to Australia. These countries are preparing for potential military contingencies with China.
The Quadrilateral Security Dialogue is improving strategic relations between Australia, the US, Japan, and India. This forum is evolving from mere talks into concrete policies. It forms the template for what will likely eventually become a full-fledged mutual defence alliance.
The Trans-Pacific Partnership (CPTPP) will increase Australia’s economic diversification and trade relations with partners other than China. China’s membership will be vetoed, whereas the UK and ultimately even the US will join this agreement.
The US and Australia will variously seek to improve relations with Taiwan, with other democracies, and to promote democratic values in cyber-space, while defending each other in the information and cyber realms.
All the while, trade with China will continue and there will be various efforts to maintain trade channels and cooperate in some areas, such as climate change. But these efforts will constantly be obstructed by diplomatic and strategic disputes.
Q. What risks threaten China’s continued path to prosperity?
A. Autocracy, or the reversion to strongman rule, permanently increases governance and political risk for China. A single person who does not face substantive checks and balances can easily make catastrophic mistakes.
Economic history shows that autocracies are not the wealthiest states. Productivity will suffer due to government misallocation of resources. Civil society and foreign ideas will lead to information asymmetry and exacerbate economic, financial, and policy distortions.
The lack of economic reform is another risk. Despite Xi Jinping’s personal power, he has not had much success restructuring the economy. He has not been able to boost consumerism, so he has recently decided to return to export-manufacturing. But China’s demographic shift and Xi’s “common prosperity” agenda will push wages up, which will make manufacturing uncompetitive. Similarly, Xi is trying to shift the economy away from excessive property development, but that sector accounts for 25-30% of GDP and there is no ready alternative, especially given that the heyday of manufacturing is over. Attempts to reform the economy will weigh on growth until a crash looms, at which point the government will boost the economy through fiscal spending, which will increase debt and decrease productivity, as in the past.
The third risk is international conflict. If China closes off its market and tries import substitution (“dual circulation”), then it will provoke a protectionist backlash from the US and even the EU. If China tries to double down on manufacturing growth and uses industrial subsidies or currency depreciation to maintain manufacturing competitiveness, then this will also provoke protectionism. Furthermore, foreign investors are already diversifying away from China for their own economic security and strategic reasons.
Q. Where do you see greatest investment opportunities for global institutional investors to deploy capital into China across asset classes within the next 12 months and what are some key longer-term themes (5+ years) investors should look to capture in their portfolios?
A. Over the next 12 months, the lead-up to the twentieth National Party Congress will continue to produce negative surprises in both domestic politics and international politics.
Chinese stocks and corporate bonds are not the place to be. Chinese government bonds make more sense, but even here, large global institutions could be subject to sanctions if geopolitical risks materialise.
From a US perspective, sanctions are not the Biden administration’s first choice, but they will be used if China stages any aggressive foreign policy moves, which is entirely possible. Also, many Chinese companies listed on US exchanges will be delisted or will de-list themselves. Global investors who participate in China’s offshore markets also face risks as offshore bond markets look to suffer from neglect as Chinese companies default on bonds.
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In 2022, inflation should ease, while fiscal policy will likely aim to stabilise the economy.
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Beijing has not started easing monetary, fiscal, and regulatory policy substantially due to near-term inflation. In 2022, inflation should ease, while fiscal policy will likely aim to stabilise the economy by the time the party congress comes around in the fall. This could present a future opportunity for investors who believe their exposure to US sanctions is limited.
Consumer staples are least threatened by the Communist Party’s recent policies. Health care stocks have long-term tailwinds, despite near-term regulatory issues.
Q. What common pitfalls do global institutional investors face investing in China and how are they best avoided/managed?
A. Global institutional investors tend to underrate the significance of China’s economic transition, its domestic political risk, and geopolitical risk.
To recap, the Chinese economy is at the end of a long arc of successes that benefited the manufacturing sector, the property sector, and the tech sector. The government has not been able to drive growth based on consumerism, the post-pandemic surge in exports will abate, and the property boom is turning into a bust.
Meanwhile, China’s governance is deteriorating as the country shifts toward strongman rule, populism, and nationalism.
Finally, the US is removing support and engagement for the Chinese economy. The US has played an integral role in all phases of East Asian economic development.
China is trying to make the transition to upper-middle-income status that other rich East Asian economies made but it is trying to do so by turning less democratic and less friendly toward America, rather than more democratic and more friendly to the US, like Japan, South Korea, and Taiwan.
This is an unprecedented experiment and investors should assign a high probability that it will fail, that productivity will suffer, and that risk-adjusted returns will suffer.
Q. Is China too big to ignore? Can global institutional investors afford not to be invested in China?
A. China is big, but its trajectory is negative rather than positive when it comes to economic productivity and growth. However, China faces much greater headwinds than disappointing income growth and earnings growth. It faces a historic geopolitical conflict with the United States and the world’s liberal democracies. Institutional investors will ultimately face negative consequences from governments and voters if they pursue a strategy of above-benchmark allocation to China.
Disclaimer
The views expressed in this publication are solely those of the individual and do not reflect those of their employer organisation.
All information contained within this publication is general advice only, as the knowledge levels and needs of all individual and corporate investors vary greatly this publication should not be used solely as a decision-making tool, further opinions and information should be sought before making an investment decision. It is the recommendation of Global Investment Institute (GII) that you seek the opinions of a fee-for-service, independent investment adviser before making any investment decision.
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For more information about BCA’s geopolitical strategy please contact: Mark Trevena, mark.trevena@ndr.bcaresearch.com; Linda Cheng, linda.cheng@ndr.bcaresearch.com.
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