China is well-positioned to meet the challenges that new technologies, climate change and a stagnant pool of labor pose.

For most of the past 40 years, investors, policymakers and interested observers have become used to the idea of China as a fast-growing, emergent economy, well on its way to achieving middle-income status, with every hope of continuing along a path of resounding economic success.

Recently, however, a different story has surfaced. This one portrays China as stumbling badly, weighed down by long-term challenges related to excess debt and investment, an aging population, the end of globalisation, and the adoption of policies inside and outside China that may frighten off investment and consumption.

In a new recent paper uncovering China, Christy Tan, Investment Strategist at the Franklin Templeton Institute says “In our view, the truth about China is neither as optimistic as some had earlier believed, nor as pessimistic as is currently fashionable. Rather, the central narrative is one of China in transition. China is shifting from an economy underpinned by extraordinarily high and probably unsustainable rates of savings, investment and debt accumulation to something else.

“Such a transition is not easy, but it is also not unusual. At similar stages of their development, other countries, including the United States, Japan and various successful East Asian economies, witnessed something similar.

“Whether investing in China directly or into themes that are linked to China’s economic prowess, the set of opportunities and risks related to China investment strategies is fundamentally shifting. What has worked in the past may not be so fruitful going forward. But fresh opportunities are also arising.

“In short, pessimism that China might get stuck in a middle-income debt trap appears exaggerated. China faces challenges but has extraordinary potential. It has a dynamic and innovative private sector, access to skilled labor, and is well established in the global trading and financial systems. Its odds of overcoming its challenges are greater than many think.

“During China’s rapid ascent into the world economy in the 1990s and early 2000s, the prevailing investment wisdom could be summed up as “buy what China buys, sell what China sells.” China’s voracious appetite for energy and raw materials, underpinned by rapid industrialisation and urbanisation, meant that investors could happily seek out opportunities in global mining and energy production.

“China’s increasing dominance of low value-added manufacturing meant that global investors shunned those same industries in the West on account of low-cost competition.

“Selling to the increasingly affluent Chinese urban middle class was another favored strategy. European and US consumer brands coveted brand-conscious Chinese consumers, with investors in hot pursuit.

“Going forward, the investment landscape will likely change, in our view. A China in transition away from investment encumbered by mounting loan losses is unlikely to see the rapid growth rates for basic materials, other commodities and energy.

“To be sure, China’s absolute levels of demand probably won’t fall off a cliff, but the period of rapid growth has already come to an end. Similarly, as Chinese consumers become more sophisticated and,  like higher income households worldwide, shift their preferences to services, brand buying habits will switch.

“As overall consumption rises as a share of GDP and as the consumption of services becomes more important, growth opportunities will become more apparent in sectors such as insurance, wealth and asset management, pension services, education, travel, personal care and new commerce.

“Similarly, business spending needs are shifting. Bricks, mortar, glass, steel, and heavy machinery will remain in demand, but are unlikely to be high growth areas. Instead, business services including consulting and financial advisory services, information technology, AI, big data analytics, and the design and implementation of robotics are areas where investors should anticipate higher growth. In short, there is every reason to believe that China remains an investment opportunity, both within China and with companies that offer products and services that address China’s shifting spending habits.

“China’s growth disappointments in the past five years have understandably raised questions about its long-term economic dynamism. Some of that is mere extrapolation of the recent past into the future.

“But it is also true that China is confronted with a multi-year adjustment to a misallocation of resources in property construction, with a corresponding increase in bad debt. Unwinding those excesses is apt to be a drawn-out process, one that may act as a drag on domestic growth for years. The slowing pace of globalisation and a backlash against China’s exports (as well as restrictions on high-tech exports to China) are further hindrances to growth

“A China in transition away from investment encumbered by mounting loan losses is unlikely to see the rapid growth rates for basic materials, other commodities and energy.

“But the underlying dynamism of China’s domestic economy remains intact. Gone are the days where Chinese entrepreneurs produce based on global demand and trends but are now trend leaders. It has and will continue to spur innovation and create new growth and investment opportunities.

“It is likely that government policy will aim to boost consumption’s meagre share in national income. Chinese consumer fundamentals, needs, and tastes continue to evolve. Accordingly, China is likely to offer astute investors fresh and exciting avenues for growth.

“Equally, investors must also adjust to new realities. Global investors are emphasising the importance of being on the ground with the right partners to navigate the rapid changes and identify the right opportunities.

“Owing to its sheer size, legacy imbalances, an aging population and slowing globalization, it’s unlikely China’s economy will return to its high growth era of past decades. Just as important, the sources of growth will shift away from what worked (construction, infrastructure, expansion of large-scale, low value-added manufacturing) into new areas of innovation, healthcare, renewable energy and industries that serve the local consumers.

“Given China’s considerable engineering skills, its access to global markets, finance and know-how, its dynamic domestic sectors economy, we believe it is well-positioned to meet the challenges that new technologies, climate change and a stagnant pool of labor pose.”

The Franklin Templeton paper considers the following scenarios in detail:

• The middle kingdom evolution: What’s shifting beneath the surface?
• Decoding China’s success
• China’s hurdles: unmasking major challenges
• Unleashing the dragon: Exploring opportunities
• How should investors judge opportunities and risks in China?

Read the paper.

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