China Economy Recovery And Rebalancing

T. ROWE PRICE INSIGHTSON EMERGING MARKETSChina’s Economy: Recoveryand RebalancingEmerging from the pandemic, an encouraging pathway forChina’s economy.March 2021KEY INSIGHTS China’s V‑shaped recovery from the coronavirus pandemic has been stark incomparison with many other economies. While this is encouraging, China’s long‑term strategy and track record are moreimportant indicators as it strives to become a more developed economy.Chris Kushlis, CFAAsia Sovereign Credit AnalystThe rise of technology and innovation represents a meaningful shift in directionfor China, a fact that is probably underappreciated by the market.China and its strong economicrecovery from the coronaviruspandemic have not goneunnoticed. Fourth‑quarter grossdomestic product (GDP) growth camein at 6.5% year over year, pushing theannual average growth to 2.3% for2020. China should be the only majoreconomy to record economic growthfor 2020. But what lies ahead for thesecond‑largest economy in the world,and what are the factors that we shouldwatch for as it continues to progress?China adopted stringent measures veryquickly to deal with the pandemic, withprevious experience of pandemics (e.g.,SARS) and the political structure allowingfor quicker control of the disease. Thishas allowed the economy to get back ontrack much quicker, with manufacturingthe first to bounce back and followed bya recovery in the services sector. Vehiclesales data provide one indicator of thenature of the V‑shaped recovery.Pandemic Response Has Alloweda Much Quicker RecoveryThe sharp recovery has not, however,been driven by major monetary or fiscalsupport. Unlike the unprecedentedaction taken by western central banks,China’s policy response to the pandemichas been more muted. This is primarilybecause its rapid recovery has enabledpolicy to taper relatively quickly.China’s V‑shaped recovery has beenprimarily attributed to a strong publichealth response. China successfullyimplemented what the IMF called“effective containment measures” toaggressively curb the spread of COVID-19,the disease caused by the coronavirus.The return to a more normal environmenthas been driven by three main factors—swift lockdowns, testing, and masks.China’s Central Bank Is Playingthe Long GameChina should bethe only majoreconomy to recordeconomic growthfor 2020.Compared with the stimulus measuresundertaken in 2009 and 2016, Chinesepolicymakers have been a lot more1

China’s V-Shaped RecoveryChinese vehicle sales indicate a strong rebound in consumer spendingand sentiment40Monthly YoY, Percent.we expecteconomic growth topotentially bounceback to around 8%to 9%, but afterthat, we expect it tohead back downto around previouslevels of 6%, withthe estimatedmedium‑termgrowth rate beingaround 5%.1CHINA RETAIL PASSENGER VEHICLE UNIT GROWTH 21As of January 31, 2021.Past performance is not a reliable indicator of future performance.Source: China Association of Automobile Manufacturers.YoY Year-over-Year.guarded because of less balance sheetspace but also because of not wishingto leave a legacy of higher debt. Whilecredit to GDP jumped by over 20% in2020, central bank policy for 2021 isfocused on that not going higher.The People’s Bank of China (PBoC) hasinitiated a number of policies, designedto prop up the economy in responseto the coronavirus outbreak. But it hasalso been very careful at the same timenot to increase the financial leverage inthe system with the country’s growingdebt burden. It has succeeded installing the pace of growth, but there isstill more to do, and the PBoC is likelyto tread carefully. What is important toremember is that the PBoC has manyweapons in its arsenal to help manageand ensure the stability of the economy.China has a strong record of achievingits objectives, and investors shouldremain focused on this.Strong Recovery Followed byManaged SlowdownIn the short term, we expect economicgrowth to potentially bounce backto around 8% to 9%, but after that,we expect it to head back down to1Jan-19around previous levels of 6%, with theestimated medium‑term growth ratebeing around 5%. Beyond that, wesee a further moderation to around4% to 5% levels.1 China has alreadyindicated that it would like to becomea more developed economy by 2035,and so an economic growth rate below5% would correspond.Driving that slowdown is thesimple fact that China’s workingage population has started to shrink,and it is increasingly more difficultto eke out further productivity andtechnology gains. China has alsobeen prioritizing the rebalancing ofits economy for some time, looking tobetter reflect the three core pillars ofgrowth—exports, fixed asset investment,and consumption.Until 2008, exports dominated interms of economic growth, while 2009saw a sharp increase in fixed‑assetinvestment to tackle the problemsthat the global financial crisis brought.Since then, policymakers have beenactively targeting domestic driversfor economic growth. And there areencouraging signs of success, asexport dependence has fallen in recentActual outcomes may differ materially from estimates. Estimates are subject to change.2

The rise oftechnologyand innovationrepresents ameaningful shiftin direction forChina’s economy.years. But with the services sector stillonly constituting around 60% of GDP,there is still some way to go to matchdeveloped economies.Shifting Priorities With a Focuson InnovationChina remains the major manufacturinghub of the world, but the compositionof what it manufactures is shiftingfrom pumping out cheap productsfor the western world to consume tohigher value‑added items. Rising laborcosts and the employment of artificialintelligence (AI) and robotics acrossswathes of industry have triggereda major change in the economy’sdirection—nudged by trade wars with theU.S. and other countries like Australia.We have seen significant investment inresearch and development (R&D) for thelast few years. Today, China is leading theway in many up‑and‑coming technologies,spanning artificial intelligence and digitalcurrencies to mobile banking, healthcare, robotics, and 5G technology.We expect that Chinese companieswill narrow the AI gap with their U.S.counterparts quite significantly in thenext few years. This is supported byabundant engineering talent, deep poolsof private sector investment, and largeamounts of digital data for deployingmachine‑learning techniques. Companiesalso have government support in terms ofregulation and research funding.The rise of technology and innovationrepresents a meaningful shift indirection for China’s economy thatis probably underappreciated by themarket. Some believe that China isjust mimicking U.S. companies, withAlibaba and Tencent as the eBay andFacebook of China. However, webelieve this does not reflect the reality,with these companies leading the wayin many fields.2 The top‑down drive topush innovation will continue, and wemay see some failures along the way,but the direction of travel is clear.China’s Economic Road MapChina is often accused of a lack oftransparency, but when it comes to theeconomy, it is a different story. Since1953, China has published a five‑yearplan that details economic developmentgoals for the next five years. The 14thChina’s Economic Road MapThe 14th five-year plan (2021–2025)—three key goalsEconomyKey Goals Become a “moderatelydeveloped” economyby 2035 Increased focus ondomestic demandEnvironmentKey Goals Move to low-carboneconomy/carbon neutralityby 2060 50% of vehicles electric orhybrid by 2035Dual CirculationKey GoalsInternal Circulation Upgrading of industrialsupply chains Innovation and technologyindependence Infrastructure spendingExternal Circulation Export growth Opening up economyFor illustrative purposes only.2The specific securities identified and described are for informational purposes only and do not represent recommendations.3

Five‑Year Plan (2021–2025) wasdrafted during the fifth plenum held inOctober 2020 and will be finalized at theNational People’s Congress in March2021. Guidelines for the plan focused onPresident Xi Jinping’s “dual circulation”theory, sustaining higher‑quality growththrough encouraging domestic markets,innovation, and reform.Beijing views boosting domesticdemand, upgrading supply chains,and seeking self‑sufficiency in keytechnologies as ways to hedge againstexternal uncertainties and challenges.Dual circulation also supports the needfor greater reliance on homegrowntechnology, and we expect a trend towardgreater spending on R&D within capitalexpenditure budgets in the coming years.Challenges Ahead, but RisingConsumerism Should Help Drive theEconomy in a Different DirectionIt is no secret that China faces a numberof headwinds, including slowing growth,a high debt‑to‑GDP ratio, an agingpopulation, U.S. trade war tariffs that arestill in place, and lower potential growthas resources shift into lower‑productivityservices. We may also see exportssuffer from improved work resumptionin other economies as the pandemic isgradually controlled.But the long‑term drivers remain.Urbanization, infrastructure, and arising middle class provide pillars forfuture growth. There also may be amisconception that urbanization islargely about people moving from ruralChina to towns and cities. Instead, webelieve its main feature is the upgradingof living space and amenities.Some commentators perceive,incorrectly, that urbanization is purelyabout expanding numbers. We see it asexpanding spending, as existing urbanhouseholds upgrade from dilapidatedstate apartments to modern and oftenmuch larger apartments or houses.The rise of the middle class shouldalso help power China in a differentdirection. That comes with a rise indisposable income with householdincome having grown around 10%annually for the last few years. Thislikelihood of increased income shouldengender greater spending andsubsequently help drive the domesticelement of economic growth upward.Long-Term Drivers for China’s EconomyUrbanization 1China has becomethe world’s largesturban nation with over843 million urban citizensas of the end of 2019,1a figure that is projectedto grow further.Every year, only about10 million people leavethe countryside, butanother 10 million areabsorbed by the simpleprocess of expanding thecity boundaries.Rising Middle Class(Consumer Power)Infrastructure From roads and rail tosubway systems, water,pipes, waste treatment,and pollution controls toports and airports, thedemand for infrastructureis much needed. China’s middle classhas grown from around65 million in January 2005to over 700 million in2020.Infrastructure is a keypart of China’s “dualcirculation” program.As of March 2021.Source: World Bank.4