After China’s Leadership Transition

China last month concluded its National Party Congress, the five-year leadership transition process that marks the start of a new presidential term and establishes the economic agenda for the next half-decade. Most notable from this 19th Party Congress was the decision made by the ruling Communist Party to include the governing philosophy of current President Xi Jinping in its revised charter, essentially securing his influence over the direction of China’s economy even beyond the completion of his second term in 2022. For investors, this only goes to underscore the shift in emphasis by the Chinese leadership away from high growth at all costs and toward a broader set of objectives that should add up to a more sustainable, if slower, pace of economic expansion over the medium- to longer-term. Maturing productivity and demographics mean that a declining rate of trend growth will now be a persistent feature of China’s economy over the years ahead. In this regard, it was instructive that President Xi’s opening speech did not contain any explicit targets for growth in gross domestic product (GDP). But a singular focus by the new Xi Jinping government on delivering higher-quality, more broad-based growth will have several implications for individual sectors and industries within the Chinese market. Xi’s Party Congress address covered a wide range of goals for the new term, from allowing greater market access for foreign firms, to controlling home prices, fighting corruption, deepening local capital markets and strengthening the military. Here, we identify seven major post-transition market themes for investors to watch over the period ahead.

1. The continuing rise of the service economy

The reorientation of China’s economy from domestic construction, low value-added goods manufacturing and expansion of physical infrastructure toward services and household consumption in areas such as healthcare, media, autos and air travel has been underway for years but is expected to progress further during the new Xi Jinping term. Service sector activity overtook industrial activity at the start of Xi’s first term in 2012, but the shift is still in its relatively early stages. At 52%, China’s service share of GDP has risen by seven percentage points over the past five years (see Exhibit 1), but it remains well behind other emerging economies of a similar per capita income level such as Malaysia (56%), Russia (63%) and Mexico (64%), and should have room to rise further over the coming years. Indeed, on the opening day of the 19th Party Congress, data released by China’s National Bureau of Statistics underlined this trend, revealing a 10.3% year-on-year increase for retail sales in September compared with just 6.6% for industrial production. Further deceleration in heavy industry will hold down China’s headline growth rate and its demand for traditional industrial materials such as iron ore, copper and cement. But continuing strength in services and consumption will benefit related sectors such as healthcare, technology and consumer discretionary, each of which have been equity market outperformers over the course of Xi Jinping’s first term and so far in 2017.

2. The shift from offline to online

Aggregate household demand for goods and services has become the largest contributor to China’s growth, but demand for online goods and services consumption is growing faster still. Over the past decade, the number of internet users in China as a share of the population has risen five-fold from just 11% in 2006 to 53% in 2016, making widespread online activity in China still a relatively recent development. By comparison, over the same period the U.S. share has risen only marginally, from 69% to 76%. To be sure, digital communications within China remain under tight Party control, with the government this year imposing new restrictions on foreign content streaming and increasing curbs on access to non-Chinese web domains. But an increasing share of China’s double digit growth in retail sales is now being conducted online. As recently as 2011, internet retail accounted for less than 5% of Chinese retail sales, but the share has more than tripled over the past five years, overtaking the U.S. in 2014 to stand at just under 15% by the end of last year. And similarly in media services, the online share of China’s total media consumption rose from roughly one-third in 2012 to more than 50% in 2016, with mobile internet alone accounting for 40%. Of the average 350 minutes spent daily on media consumption last year, 190 went to mobile or desktop internet, while just 160 were devoted to traditional sources such as newspapers, television and radio (see Exhibit 2). Internet software and services, communications equipment and electronic components have been standout performers within the Chinese equity market this year, and the ongoing shift from offline to online should continue to support these industry groups.

3. Indigenous innovation

While it moves away from lower-end manufacturing, China has made a shift in its industrial base toward higher-value output a top priority, and this is expected to continue under the next Xi Jinping administration. The Made in China 2025 initiative unveiled by the State Council in 2015 will be central to this goal of directing more resources toward higher value-added manufacturing, but the emphasis by policymakers on this industrial transition dates back to the start of Xi’s first term. Seven so-called “strategic emerging industries” – energy efficiency and environmental conservation, next generation information technology, biotechnology, highend equipment manufacturing, new energy, new materials and new-energy vehicles – were initially targeted in 2012 under China’s 12th five-year plan, with a broad range of segments such as desalination, semiconductor manufacturing, genomics and electric cars targeted under each. The government aim is for these seven industries to generate 15% of China’s GDP by 2020, up fivefold from 3% in 2010, and they are therefore likely to be among the fastest areas of growth in China’s economy over the medium-term. The Chinese authorities are using several tools to promote growth in these areas, including state subsidies, preferential tax treatment, more bank credit, easier capital market access and government procurement. Total research and development spending as a share of GDP in China should have room to rise further from levels that still lag the large developed economies (Exhibit 3). But in purchasing power parity terms, government spending on research and design has grown at an annualized rate of 11% over the past five years and overtook the U.S. in 2013. While much of the emphasis is typically placed on China’s demand-side shift to new industries, supply side innovation should provide further support for related sectors such as healthcare, consumer discretionary and technology.

4. The clean economy

Under a strengthened Xi Jinping, the Chinese government will continue to prioritize political stability alongside more sustainable growth. And tackling air pollution (which is now one of the leading causes of both mortality and mass demonstrations in China) will serve to address each of the aims. China’s economy still depends on coal for 62% of its primary energy consumption, compared to a U.S. share of just 16%. And alongside efforts to phase out the construction of new coal-fired power plants in a number of key industrial regions, China continues to grow its renewable energy capacity. As in other areas, China has become a world leader in wind and solar power over recent years, and in 2016 had a combined domestic installed capacity close to double that of the U.S. across these two energy sources (see Exhibit 4). Continuing efforts at energy switching toward renewables will further boost demand for related products such as solar modules, wind turbines and battery storage. And at the same time, moves toward greater energy efficiency should also support growth in fuel-efficient and electric vehicles, LED lighting and energy efficient appliances. At just 6% of its energy demand mix, natural gas is also likely to play a greater role in China’s power generation over the coming years, which should support demand for commodity imports from markets such as Australia and Russia.

5. More outward investment

With the U.S. government retreating from many of its international economic and political agreements, China will have a freer hand to pursue a more assertive foreign policy over the coming years. Xi Jinping in his Party Congress address repeatedly expressed an intention to turn China into a “leading global power” by 2050, which in economic terms should involve deepening trade and investment ties in the Asia-Pacific region and elsewhere. Indeed, last year was the first in which foreign direct investment (FDI) from China exceeded inward FDI into the country (see Exhibit 5). Further impetus for outward investment will come from Xi’s “One Belt, One Road” (OBOR) development initiative, a dual strategy that combines an economic belt of transportation, energy pipeline, power and telecommunications infrastructure from China to Western Europe, and a maritime network of ports, terminals and other marine facilities from the South China Sea across the Indian Ocean to Africa and the Middle East. This remains a long-term initiative that will build on China’s existing outward investment projects, such as the new 7,500-mile, 15-day railway freight route from Yiwu to London (now the 15th European city accessible by rail cargo from China), which opened earlier this year. Xi Jinping mentioned OBOR a total of five times during his Party Congress speech, and over time the plan should provide a new source of growth for local engineering and construction firms, industrial machinery producers and makers of capital goods equipment, while expanding the external market for China’s growing capacity in advanced manufacturing for telecommunications equipment, information technology and transportation systems.

6. Reform of state-owned enterprises

China’s state-owned enterprises (SOEs) continue to dominate traditional sectors such as oil and gas, steelmaking, banking and construction, and Party influence in these areas is unlikely to diminish over the coming years with limited competition from private firms. Indeed, the word competition was mentioned in Xi’s speech the fewest number of times for any Party Congress address going back to 1987. The government has however pledged to continue efforts to improve SOE profitability through mergers, efficiency targets, more government supervision and performance-related management incentives. According to a recent China Daily report, a total of 34 central government SOEs have been restructured since 2013, with the total number reduced from 117 to 98. And at the same time, support for private enterprises in non-strategic sectors will continue. Indeed the private sector now accounts for a greater share of China’s urban employment than state-owned firms (see Exhibit 6), suggesting that the Party has become less dependent than in the past on preserving government jobs to maintain social stability. Nonetheless, progress on SOE reform is likely to continue only gradually.

7. Exchange rate liberalization

Exchange rate policy will also have a role to play in China’s transition toward a more market-based system, but as with SOE reform, government influence is likely to remain high. Since abandoning the fixed dollar peg after the 2008 financial crisis, the People’s Bank of China has implemented several measures aimed at increasing exchange rate flexibility – twice widening the daily trading bands in 2012 and 2014; shifting toward a more market-driven daily fixing price in mid-2015; and introducing a new trade-weighted currency basket against which to manage the renminbi’s value at the end of 2015 (Exhibit 7). But following the sharp depreciation of the currency and steep decline in foreign exchange reserves between 2014 and 2016, the central bank has more recently tightened its control over the exchange rate, imposing stricter capital restrictions and this year introducing a so-called “counter-cyclical adjustment factor” in setting the daily reference price in order to prevent excessive one-way currency moves. These recent steps have succeeded in reversing market depreciation expectations, allowing the RMB/USD rate to recover most of its 2016 declines. In exchange rate policy and for the economy more broadly, this approach of pursuing gradual market-oriented reform without compromising stability is likely to remain the hallmark of economic policy in the new Xi Jinping term.

Ehiwario Efeyini, Senior Vice President & Senior Research Analyst
Global Wealth & Investment Management Chief Investment Office