China’s integration into the global economy has been accelerating. Among the most visible signs, Chinese A-shares equities became part of the MSCI Index in 2018, and they will see a further increase in their inclusion factor in 2019; bonds of Chinese government and policy banks joined the Bloomberg Barclays Global Aggregate Index earlier this year. For global investors, these developments hold the potential for diversification and scalable alpha opportunities. But they also make the Chinese economy more exposed to external shocks, and global markets more sensitive to Chinese market reverberations.
To be sure, our baseline remains that China’s economic expansion will slow gradually. We see this as natural, the result of the country having attained middle income status as well as deteriorating demographics. Nonetheless, as discussed in PIMCO’s latest Secular Outlook, we consider China a potential source of disruption.
In our view, China poses three key structural challenges to the status quo – all of which have potential investment implications for portfolios.
MANAGING INTERNAL GROWTH DECELERATION AMID DEBT DELEVERAGING
Avoiding disruptive deleveraging amid slowing growth is the main domestic challenge for Chinese policymakers. The country’s potential growth should remain relatively high by global standards – about 5% by our estimate. However, managing a smooth transition will not be easy.
Without doubt, China’s growth dynamics have been shifting to consumption from exports and investment, the traditional engines of growth over the past 40 years. That’s part of what’s necessary to escape the middle income trap.
But China also must create more innovative, higher tech products that can compete in global markets. That will be made more difficult by a rapidly aging population. Indeed, the Chinese labor force peaked in 2015. Urbanization still has some room to run but is also mature.
Debt leverage is another challenge. It has grown rapidly over the past 10 years – in firms, local governments and, more recently, households. Asset prices remain elevated, particularly in residential housing in major cities. Financial vulnerabilities are increasing in shadow banking credit, while loan quality at small- and medium-size regional banks is difficult to ascertain.
Accordingly, potential growth rates will inevitably slow over the secular horizon.
In the event of a material shock to the Chinese economy, a key question is whether Chinese policymakers have internalized the lessons of balance sheet recessions in Japan and Europe. In contrast to most developed economies, where fiscal-monetary coordination is constrained by independent central banks and politicized budget processes, coordination between fiscal and monetary policies is inherent in China’s political reaction function. This offers the possibility of a more rapid and decisive response to any shock.
Nonetheless, as growth slows and the rivalry with the U.S. intensifies, China is likely to strengthen efforts to insulate itself economically and financially. Inevitably, China faces a trade-off between economic efficiency and political control. Years of public investment stimulus will affect the calculus: The marginal effects of additional fiscal stimulus and monetary easing may decline, while sustaining these pump-priming policies will likely create undesirable side effects – not least of which is implicit moral hazard, postponement of key structural reforms, and a crowding out of the private sector. In an adverse scenario, the Chinese authorities could be forced to accept significant currency depreciation, which would send a deflationary shockwave through the global economy.
DISRUPTIVE TECHNOLOGY INTERACTS WITH TECHNOLOGY DISRUPTION
Even in a relatively benign Chinese growth scenario, Chinese efforts to move up the ladder to higher value-added manufacturing will likely disrupt supply chains of producers in Europe, Japan, the U.S. and Southeast Asia.
Complicating the picture is the fact that for many Asian economies, China has become the biggest source of trade, investment and tourism. Yet many of these countries depend on the U.S. for their security. Singaporean Prime Minister Lee Hsien Loon aptly described the dilemma last year: “We do not want to end up with rival blocs forming or countries having to take one side or the other.”
However, the growing belief that China is rising at the expense of the U.S. has already spilled over into the technology arena. Washington’s policy response has shifted from forcing China to protect foreign intellectual property toward containment. For example, Chinese firms have built a commanding lead over competitors in 5G telecom technology. The U.S. ban on Huawei Technologies Co. Ltd. reflects deep-seated fears of Chinese technology controls. Chinese artificial intelligence and advanced robotics firms may face similar sanctions.
In response, China may retaliate by penalizing U.S. firms that comply with the ban, most likely by restricting access to China’s domestic market. Relative to other potential threats – such as reduced holdings of U.S. Treasuries, a ban on exports of rare earth metals or, indeed, a strategic currency devaluation – China’s strongest and most likely economic weapon is access to its domestic consumers.
Even if not yet fully realized, these concerns are disrupting global trade. At a minimum, a bifurcation of supply chains is likely. Given tariffs and other restrictions, multinational firms will experience higher operating costs due to reduced scale and specialization. While they may use existing manufacturing capacity in China to satisfy Chinese domestic demand, fresh investment outside China may be needed to supply U.S.-aligned export markets.
COMPETING FOR GLOBAL INFLUENCE
Most broadly, China’s growing economic power and ambition to establish a global sphere of influence could further disrupt the established geopolitical order dominated by the U.S. since the end of World War II.
As key regional powers, China and the U.S. are actively angling to gain regional influence via the Belt and Road Initiative and the Indo-Pacific Strategy, respectively. Beneficiary countries could be those along the belt and road that receive Chinese investment and low-cost funding, although debt dynamics and sustainability will need to be watched. Other low-cost manufacturing economies, such as Mexico, Vietnam and Bangladesh, may also benefit from revamped supply chains. In turn, countries and companies that are more integrated into Chinese growth- and export-oriented supply chains may require a higher risk premium.
We are keenly aware that these disruptive forces might not be limited to trade, technology and geopolitics. The line between commercial and military tension is thin – consider the coupling of advanced technology into both military hardware and telecommunications infrastructure. The hegemonic fight for global dominance could yet spill over to financial markets in the form of currency wars, financial sanctions and capital controls.
Yet, unlike the Soviet-U.S. nuclear arms race, there are no established rules, norms or forums that seek to prevent cyber warfare and state-sponsored hacking attacks from triggering a broader conflict. A central question is the extent to which the high degree of economic interdependence between the U.S. and China constrains the fight over security and influence.
As investors, we are mindful of this trade-off. Over the secular horizon, we are tilting toward Asian markets that are more immune to, or even beneficiaries of, Sino-U.S. strategic tensions. Domestic demand-driven economies with sizable populations, such as India and Indonesia, are likely to be more immune to volatility associated with this rivalry.
The proximate risk is that China retreats from the successful template of market opening as it tries to insulate itself from geopolitical pressure. However, our baseline remains that the economic cost to all sides of disintegration is so high that a “great decoupling” is more likely to be avoided.
Over the secular horizon, given the current volatile political and economic dynamic, we anticipate this will be a bumpy path but one where flexible allocation and active portfolio management will have the opportunity to seek substantial alpha.