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China’s post-Covid challenges

Chloe Lim
Chloe Lim10/13/2022 10:32 PM GMT+08  • 13 min read
China’s post-Covid challenges
A video featuring Chinese President Xi Jinping at the Beijing Museum of the Chinese Communist Party. Xi is likely to secure a precedent-breaking third term in power.
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All eyes are on China on Oct 16, as the 20th National Congress of the Chinese Communist Party (CCP) opens. With China’s economy and markets playing a pivotal role in world economy and trade, political, economic and social changes will be closely watched.

The meeting — held once every five years — is attended by representatives from across the economic, political, social and defence sectors. It will also see a new round of leadership appointments, including the apex body and the politburo standing committee. The top appointment is not likely to turn up any surprises. With China altering its state constitution in 2018, President Xi Jinping is all but expected to serve an unprecedented third term.

Xi’s departure from the two-term limit occurs amid several international and domestic developments. The trade and tech war started by former US president Donald Trump remains a hot-button issue. While many major world economies have consciously opened up and tried to put the pandemic behind, China has thus far maintained its zero-Covid policy that has restricted people flow and business activities, leading to lower GDP forecasts. Curbs were especially felt by China’s technology and property sectors. The former no longer enjoys supernormal earnings, while the latter is forced to confront its ballooning debt load. Under the overarching “Common Prosperity” (a policy to bolster social equality) introduced by Xi earlier this year, growing wealth inequality is to be tempered, if not reversed.

Suan Teck Kin, head of research and executive director of global economics and markets research at United Overseas Bank (UOB), says China has an excellent reason to put curbs on the property market like a “hammer” and trigger the downturn. Within a basket of 100 Chinese cities, there are more with home prices declining month-on-month (see chart 1). Like Hong Kong, the market is dominated by profit-maximising private developers.

UOB’s Suan Teck Kin says the market prefers a certain level of policy consistency to have more predictable market outcomes. Photo: Albert Chua/The Edge Singapore

See also: Business red tape in China gets a trimming

Developers in China are likely to continue to go through quite a bit of challenge as the speculative fervour of the market is being removed. “If prices are too high, and properties become unaffordable, then you have a problem as people will complain,” says Suan in an interview with The Edge Singapore.

As for the tech industry, titans like Alibaba Group and Tencent Holdings have been enjoying supernormal earnings, making multi-billionaires out of Chinese business magnates like Jack Ma and Pony Ma. That changed over the last year, with the start of the curbs marked by the last-minute cancellation of Jack Ma-linked Ant Group’s IPO.

Suan believes that the Chinese government’s aim is not to crush them, as the likes of Alibaba still provide valuable functionalities and services for the economy. “You have to toe the line. There is the so-called consolidation phase now; growth will be slower; they are not returning to those double-digit growth rates.”

See also: China Evergrande will swap defaulted debt in court restructuring

In year three of Covid-19, China’s 2022 GDP growth target remains at 5.5%, a significant slowdown from the 8.1% reported for the year before. But in July, China conceded that this year’s figure might fall short. Private sector economists are more direct in their calls, as they revise their numbers downwards with the frequent pandemic-related curbs in various cities throughout this year. Goldman Sachs is expecting 3%, UOB is seeing 3.3% (see chart 2), and Nomura 2.8%. The International Monetary Fund, expects 3.3%, versus an earlier estimate of 5.6% last year.

The Shanghai Composite Index, one of the market benchmarks, has dropped around 20% from the recent peak in September 2021; the Shenzhen Composite Index was down around a quarter from December 2021. Hong Kong’s Hang Seng Index has dropped by a third since the recent peak of February 2021.

In May, JP Morgan called China’s stock market “uninvestable” amid the fog of regulatory uncertainty. That report helped erase about US$200 billion ($287 billion) from US and Asian markets and prompted one Chinese technology company to downgrade the bank’s underwriting role on an upcoming IPO. The analysts reversed the downgrades two months later, reports Bloomberg.

Optimism on the horizon

The Chinese market may be unnerving, but optimism seems to be on the rise for the second half of this year and 2023. The Chinese government is not oblivious to the economic challenges arising from its recent approaches to coping with the pandemic. No one could also imagine the world’s second-largest economy reversing back to its pre-economic liberalisation era before 1978. The meeting this week will be a platform to mark a new phase. “Policy announcements to boost the growth recovery would also be closely watched,” says UOB in its 4Q2022 outlook report.

Allianz Global Investors’ global chief investment officer for equity Virginie Maisonneuve says it is China’s controversial decisions over the past years stirring up volatility that is paving the way for the country’s new phase of evolution as a global economic powerhouse.

“Objectively speaking, China’s five-year plans over the decades have truly driven the country to achieve a large amount of economic progress in a relatively short period,” says Maisonneuve in an interview with The Edge Singapore. “From a long-term historical perspective, such plans’ continuation [and evolution] shows excellent promise for China’s markets moving forward.”

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Virginie Maisonneuve of AllianzGI believes investing in China should be a long-term game. Photo: Bloomberg

In her recent report, China’s Phase 3: a new chapter in its epic story, Maisonneuve writes that the country is entering its third phase of “transformation” as Xi drives the economy onward to overtake the US as the world’s largest economy by 2029.

“China’s political system, combined with its domestic and global economic stature, will make this a uniquely challenging balancing act, both for itself and the world,” says Maisonneuve, with China’s success bearing considerable implications on the world’s stability over the next decade. “To succeed, China must safeguard its economic prosperity and growth while keeping at bay global geopolitical tensions.”

Additionally, Maisonneuve says that China might shift its focus from a US-style growth model — powered chiefly by services and consumption — to a more balanced model, like that of Germany or Japan. Industrial policies would be a critical driver of long-term growth in this setting.

“If China can continue building up its hightech manufacturing capabilities, it would help address some of the country’s most obvious vulnerabilities in a world where trade tensions restrict the ability to transfer technologies from one country or entity to another,” Maisonneuve writes. “It should also help boost innovation to a new level.”

She sees “national champions” emerging at this stage — companies that can support import substitution and drive China’s global competitive advantage moving forward. Key focus areas include national security, data, innovation and technology advancement.

Observers believe China’s manufacturing sector to be a key priority. China has been known for decades as a low-cost mass production base. Still, it has recently made strides in advanced manufacturing in areas such as industrial automation that bring more value. The US leads this field for now but watches the gap closing. “We see that China is increasingly much more willing to pour resources into this area to build a stronger manufacturing base [for itself],” says UOB’s Suan.

Elsewhere, manufacturing maintains its growth, albeit at an uneven pace across the different key sectors, with output for the transport and environment sectors showing more growth than others. In August, industrial production grew by 4.2% y-o-y. It was an improvement from 3.8% in July, though still weak by China’s usual standards, reports ING Group.

No immediate turnaround

Pundits like Suan continue to approach Chinese markets more cautiously, given how sentiment remains poor for now. The party congress is an essentially political event, and specific economic policies favourable for the market are not expected immediately. “There can be no immediate game-changer for Chinese markets, as political re-shuffling and its effects often take time to set in.”

He acknowledges that the changes in certain party members — particularly the stepping down of Premier Li Keqiang — will have some effect on the change of pace in policies. However, it remains difficult to pinpoint what changes that might bring. “It is unlikely that a theatrical change will occur from the style of the ruling of the previous government; however, realistically speaking,” says Suan, considering the very high chance of the re-election of Xi, “though if anything, people are likely to appreciate that consistency to gauge more predictable market outcomes in the near-term.”

Redmond Wong, market strategist for Greater China at Saxo Markets Hong Kong, shares Suan’s sentiment that any change, and its effects, will take time to set in for Chinese markets. “Some investors are hopeful that following the party congress, more policy support will be seen, in addition to the greater easing of Covid-19 restrictions,” says Wong, adding that the various appointments that make up China’s massive party and government apparatus will take time.

Wong would only be “selectively optimistic” for the coming months towards Chinese markets. “Markets might not do as well or see as much change as investors hope for, considering how the new [configuration of] leadership would still be in the process of establishing their control.” He does acknowledge that in the likely event of the re-election of Xi, a continuation of his policies at an incremental pace would be in order. “Xi has notably pushed his agenda [fervently] in the first term and proceeded to do so even more rapidly in his second,” says Wong. “In his [likely] third term, we stand to see an [continued] acceleration of policy changes to get more things done [in his favour].”

“High growth is not at the top of the party’s agenda,” he adds. “Rather, China is more concerned with stability [for its economy],” like its yuan management against the US dollar and the recent “expensive” levels against the much devalued-Japanese yen and Korean won. “China wants to avoid any kind of rapid [economic] fluctuations [particularly with regards to its currency] as much as possible that could cause panic in the market,” Wong says. “Instead, the government is likely to work towards an orderly, managed depreciation [to maintain control over their currency.”

Caution remains when approaching Chinese markets in the near term, considering its pertinent volatile characteristics that the Chinese government attempts to control, which continues to be a work in progress. “There continue to be opportunities in China; it’s just about being selective [and careful],” says Wong.

“We believe areas aligned with the government’s long-term goals offer the most opportunities for investors,” says Michael Lai, portfolio manager at Franklin Templeton. “Common prosperity, for instance, could expand the aggregate size of disposable income and support social welfare as lower-tier cities remain a largely untapped market for many consumer products and services.”

Other areas liked by analysts include healthcare and biotechnology. Simultaneously, the war between Russia and Ukraine — which caused energy prices to spike — will help drive the new energy vehicles (NEVs), solar, wind power and energy storage sectors. “Green development, with orderly decarbonisation to avoid disruption to economic growth, should enable Chinese companies to secure global leadership in supply chains spanning from NEVs to solar power,” says Lai.

He is optimistic about an overall recovery, given how both the valuation and sentiment of Chinese equities are now at “unsustainable lows”. “While we can expect the realisation of some degree of slowing growth, policy tools are available to underpin the economy, so it should not be fully derailed."

When, not if

Before the Covid-19 related curbs, China has enjoyed open borders for decades, and the flow of goods and people has only grown. The Peterson Institute for International Economics (PIIE) says mainland citizens’ trips in and out of China had dropped by 79% versus 2019 — the first full year before the pandemic broke out in 2020.

China is suffering from reduced competitiveness as a result and has become less attractive to international investors, expatriates and students. “This may accelerate China’s decoupling from the rest of the world,” says PIIE research fellow Tianlei Huang. Therefore, China must eventually exit zero-Covid if it wants to avoid “indefinite isolation and paralysis.”

DBS Group Research analyst Bryan Lam is similarly optimistic and expects stimulus measures on economic recovery and a gradual exit from the zero-Covid policy to likely be at play for a better 2HFY2022. “We recommend new economy stocks to play the likely rebound, given its attractive valuation and signs of easing regulatory developments.” However, he awaits more concrete policies to be set in stone before expecting improvements in China’s banking and real estate sectors.

Yu Zhang, portfolio manager at Matthews Asia, sees the constriction on the economy by the stiff pandemic policies as a blip in the bigger scheme of things. “We believe it is a case of ‘when’ not ‘if’ China relaxes its Covid-19 protocol, and we are likely to learn more in October [at the 20th Congress Party of the Chinese Communist party].” He made this observation after Xi’s recently made his first post-pandemic trip to Kazakhstan and Uzbekistan and the increase in long-haul flights into China.

But of concern to investors is China’s relationship with the US, particularly in Taiwan. While Zhang sees a military conflict between China and Taiwan as a “low probability” event, he says this may open several interesting angles for investors with regional perspectives. “For China, technology, energy and food independence will become increasingly important, which may present some interesting investment opportunities at a domestic level. Any sign of the US diversifying its supply chain away from China may also be positive for emerging economies, such as Vietnam, Indonesia and India, which are each well placed to fill the void.”

Investors have reasons to be optimistic about the outlook for these economies, particularly Vietnam, where several favourable structural tailwinds are currently in play. “Despite the headwinds witnessed through much of this year, Asia’s multi-year structural growth story continues to unfold, particularly in emerging economies such as Vietnam.”

China will remain a key player in today’s global economy and markets. “The adoption of a more pragmatic approach to managing the pandemic, dovetailed with a more supportive environment for economic growth, will go far in reversing negative sentiment towards Chinese equities, particularly while valuations are suppressed,” says Zhang.

AllianzGI’s Maisonneuve says investors should play the long game. The upcoming meeting is crucial, but there is a long road ahead. “No one buys into China for the short-term,” adds Maisonneuve, “which is, in fact, a good thing because it helps us focus on quality [investments] while playing long-term trends of China’s continuation of a more prominent place in the global economy.”

Xi’s existing policies, such as the dual circulation strategy and shared prosperity, could continue to be a practical economic approach on many frontiers to benefit domestic and international companies. “We need to work on a new mindset towards China,” says Maisonneuve, encouraging investors and public members to turn away from blanketing China as “risky terrain”. The world may be shifting, but you cannot ignore China, as it “demonstrated a mindset of innovation,” she adds.

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