China’s Long-Term Game

Over the past few decades, Western governments have prioritised short-term economic gains over long-term measures through a combination of asset-based policies and de-regulation. China, instead, is trying something different. Its cross-cyclical strategy pledges to play the long game, improving financial stability, prioritising reforms, and restoring equality and sustainability.

In implementing the reforms, China is cracking down harshly on several sectors. Markets and investors are responding very negatively, including George Soros in a recent article. Yet these policies might be the micro-regulatory actions necessary to rebalance the economy – and could be more effective than the one-size-fits-all monetary policy hammer.

From Growth First to Common Prosperity

President Xi Jinping’s call on 17 August for increasing efforts to promote common prosperity was a more forceful embodiment of the policy direction he set four years ago. During the 19^th National Congress, Xi redefined the party’s principal contradiction to ‘the contradiction between unbalanced and inadequate development and the people’s ever-growing needs for a better life.’ This signalled China recognises its growth-first economic model supported by high investment and credit expansion over the past decades is no longer appropriate. Addressing the many economic imbalances and debt overhangs accumulated so far requires a fundamental shift.

Trend Growth – Time to Rebalance Towards the ‘Average Xi’

Notably, a weak middle class has started dragging on economic performance. China’s consumption share of GDP currently hovers around 40-55%, versus 65-75% in large developed markets such as the US or Germany (Chart 1). It was flat from 2012 and has fallen since 2000. Moreover, the growth in wealth and income has been unevenly distributed. The median income of the top 20% of households is 6.2x that of the bottom 20% (Chart 2). Great disparities also still exist across regions and between urban and rural households.

The lack of social development has become a serious macroeconomic issue. As the industrial infrastructure reached capacity after 30 years of catching up with the West and export-led investments, growth can only come from developing a healthy domestic market. Policymakers will focus on this.

Corporate Debt – Too Big or to Fail?

The other side of ‘corporate-led growth’ is dangerously high private debt. China’s nonfinancial corporate debt is 165% of GDP versus under 100% in most developed markets (Chart 3). Total debt is not higher than in developed market counterparts, but unlike those economies, it is concentrated in the private sector. High corporate debt is an inheritance of the strong banks and real estate deregulation that accompanied the boom of the early 2000s. Corporate leverage crowds out household debt, which in China is 20-30% lower versus mature markets, and constrains monetary policy. As such, corporate balance sheets are vulnerable to any ‘pro-consumer’ shifts from policymakers.

High corporate debt and a growth slowdown pose the question of how to manage monetary policy. In the past 20 years, the PBoC’s main problem was managing the yuan to help exports. Now, internal economics will matter more. So policy rates will gradually move to target onshore liquidity on top of offshore targets and the exchange rates. A natural trade-off between growth and reserves policy will emerge, and the PBoC will need to take a more marked stance.

Intensified Regulation Reflects a Stronger Push in the New Policy Direction

The regulatory tightening over past months is exactly targeted at the above issues to reflect the CCP’s new policy direction. The goal of common prosperity is more sustainable and equitable growth, while the cross-cyclical approach aims to be pre-emptive and anticipate systemic risks.

More specifically, tighter policy for the property market aims to control urban living costs and prevent further wealth polarization (Chart 4). Meanwhile, banning after-school tutoring attempts to reduce education costs and promote demographics. The antitrust campaign, crackdowns on big tech companies and shunning of the 9-9-6 work culture are efforts to curb corporate power and redistribute economic value to workers and consumers.

Pick Your Version of State Capitalism

‘Government is not the solution to our problem. Government is the problem.’

– Ronald Reagan, 1981.

Investors’ most important decision will be choosing which policy mix will succeed. The US and most Western economies remain stuck in various asset-based policies. These have failed to improve growth potential and inflation. Instead, they have supported large firms in capital markets, incentivising concentration, reducing competition, and boosting inequality. This correlates with high savings and persistent low interest rates. China, however, is using micro-policy and regulation to resolve the many overhangs accumulated during recent decades.

Xi’s recent policy actions negatively impacted almost all Chinese asset prices. Chinese stocks’ valuations have cheapened, but long-term risks persist. Xi’s new policies aim to address three concerns: anti-competitive/monopolistic practices, data security and inequality. Valuations are attractive, but prices will likely stay volatile, as it is unclear what sector Xi might target next.

Short term, Xi’s policy actions may slow China’s growth. Although the PBoC might start easing in the second half of the year, the slowdown is already a drag on global growth and will likely result in a dovish bias from DM central banks. But unlike in 2015, when China’s slowing growth caused a market crisis, global credit spreads and volatility will probably remain contained this time for the following reasons. Firstly, China’s growth is slowing but starting from a higher base; secondly, credit support is now embedded into DM central banks’ reaction functions, with even the Fed having bought credit in its Covid response. Over time, the use of monetary policy tools and fiscal deficits à la MMT is likely to undermine the dollar.

We stay selective on bond yields and credit spreads, which remain near record lows. Over the recent weeks of volatility, we have added upside through equity optionality in sectors linked to economic reopening and Chinese firms.

A more complete version of this report can be found here