China’s train of economy has taken on a new track
General Secretary Xi Jinping advocated a new development paradigm in a speech at a meeting of the Chinese Communist Party’s (CCP) Central Committee for Financial and Economic Affairs on 10 April 2020.
One of the dimensions of the new development paradigm is to make China more self-reliant, not only in food security and energy, but also in reducing the importance of exporting low-value added original equipment manufacturer (OEM) products and increasing import substitution and export of high-value added ‘killer technology’ manufactured products. Xi noted that China’s ‘factory of the world’ development model, which relies on labour-intensive manufacturing, importing materials and exporting to overseas markets, has reached its limit and become inadequate in the midst of the emerging international trend of deglobalisation. With low fertility rate and an aging population, China’s working-age population peaked in 2015 and labour costs have been rising. I add that the export-driven growth model has run its course after four decades of success.
A key concept of Xi’s new development paradigm is ‘dual circulation,’ which consists of domestic and international circulation. By boosting domestic demand and optimising production and the supply chain, domestic circulation is expected to become the primary driving force of the economy, while international circulation is supplementary.
In case of extreme adversity, the supply chain of key elements that are critical to national security shall be able to function in close-circuit domestic circulation. A Go (an Asian board game) player, Xi emphasises the benefit of making the first move (先手). In anticipation of the inevitable rolling back of globalisation, Xi apparently wants to start making moves to shape the decoupling on China’s terms as much as possible.
Other key dimensions of the new development paradigm include strengthening the position of state-owned enterprises and the ‘real economy,’ especially manufacturing and agriculture. China subsequently started cracking down on powerful private enterprises in the internet and platform economy sector, as well as over-leveraged property companies and speculative activities in properties in late 2020 and throughout 2021. Xi said in December 2021 that private capital was to shrink or grow in according to traffic light signals given by the CCP. In a study session of the CCP’s Politburo in April 2022, he reiterated the need to strengthen the supervision against monopolistic and anti-competition behaviours and work against the disorderly expansion of private capital.
China has cracked down on after-school private tutoring. This is partly due to the desire to make the playing field even for children from disadvantaged families to get to common prosperity, which is a tenet of the new development paradigm. It also aims to boost the affordability of raising children. Chinese parents living in metropolitan areas on average spent 12 percent of their income on private tutoring for their children.
The development of agriculture and rural areas and the promotion of the welfare of farmers are key dimensions of the new development paradigm. In Xi’s view, these will be instrumental to achieving food security, boosting domestic consumption and promoting common prosperity. The focus of urbanisation in the light of the new development paradigm will extend to county seats in the rural areas.
Travelling on rough terrain
The secular bull market in energy, industrial metals and grains is worsening China’s terms of trade. China imports 73 percent of its crude oil consumption, 41 percent of natural gas, 8 percent of coal, 20 percent of grains and many more industrial metals, while exporting mainly manufactured consumer goods. The potential further deterioration of its terms of trade is set to put negative pressures on China’s trade balance, GDP growth and companies’ operating margins.
Another risk lingering over the Chinese economy and business as well as investor confidence is China’s zero-Covid policy. The number of new locally transmitted cases has gone down and Shanghai has reopened from a two-month lockdown. As of this writing, there are six cities under partial or district-based lockdown, which account for only about 5 percent and 9 percent of China’s population and GDP, respectively. This is a substantial improvement on the 44 cities in lockdown, translating to 25 percent of population and 38 percent of GDP back in mid-April. However, as long as the Chinese authorities are unlikely to abandon the zero-Covid policy before the CCP’s 20th annual national congress (the Party Congress) this late October or early November, or even before the Chinese government’s Two Session meetings in March 2023, the terrain on which the train of economy is travelling on may remain bumpy.
Focus areas for stimulus to take the train running beyond zero-Covid speed limits
With the all-important Party Congress approaching in less than six months, maintaining stability is the top priority for Xi and the Chinese authorities. In this Party Congress, Xi will seek his third term for the top office of the CCP, which is unprecedented. The Covid outbreaks over the past few months and the resulting lockdowns and sharp slowdown of the economy have indeed come at an inconvenient time. Taking the success in 2020 in containing Covid to the level of demonstrating the superiority of Chinese public governance, the threshold at which China could abandon its zero-Covid policy is high.
Nonetheless, this does not necessarily mean that China will pull out all the stops to boost economic growth. Maintaining stability is in fact a coded phrase for retaining the legitimacy of the CCP’s one-party perennial rule over China. Common prosperity and fighting against corruption, poverty and pollution, among other things, are elements of maintaining stability in Xi’s taxonomy. The new development paradigm that was put in place in 2020 remains front and centre when it comes to Xi’s grand vision and thus in policy formulation.
Stimulus measures have been rolled out and will continue to come in monetary policies, fiscal policies, relaxation of crackdown on the property sector and better visibility of regulations over the internet sector, but their magnitudes and paces will be measured. The Chinese authorities are mindful not to trigger another round of excessive leverage and speculative bubbles with large-scale monetary easing or reflating of the property sector. Reconfiguration of the balance between state capital and private capital is a central tenet of the ideology of the CCP under General Sectary Xi. The Chinese authorities will probably bring about more visibility and guidelines and remove some uncertainties hanging over regulations on the internet and ecommerce giants. However, rolling back regulations in a meaningful sense will be quite unlikely.
The path of least resistance for China to take in order to stabilise its economy and keep unemployment in check is infrastructure spending. In April, Xi chaired a meeting of the Central Committee for Financial and Economic Affairs and called for increasing infrastructure construction, especially for transportation, energy, water conservancy, 5G, cloud computing and data centres, ultra-high voltage, artificial intelligence and industrial internet of things.
Potential outperformance in Q3 but still in a bear market
Policy divergence, light position and undemanding valuation may mean potentials for outperformance for Chinese equities in Q3 versus other major markets. There may be tradable rallies for traders to benefit from in the coming months. However, China is still in the process of transitioning to a new development paradigm, being hit by deteriorating terms of trade, increasingly tight global financial conditions and a slower global economy, and facing uncertain development in pandemic control. Chinese equities may still be in a bear market and long-term investors should be patient in accumulating positions.