Opportunities in new paradigms ahead for China

CHINA’S rise since its opening up in the 1980s has been characterised by unprecedented infrastructure spending. This has been in support of an industrialisation drive which, combined with the nation’s managed currency regimes, has underpinned an export sector that’s earned China the “manufacturer of the world” title over the past four decades.

As China gets ready to unveil its Fifteenth Five-Year Plan in the months ahead, it appears increasingly likely that its leadership may seek to create a new path forward.

The summer has already seen a new term – “anti-involution” – come into the mainstream lexicon. Such efforts will look to address the excessive competition that has led to overinvestment, destructive price wars and an overall lack of corporate profitability amid China’s multi-decade rise.

Indeed, since 2005, earnings per share at China’s A-share listed companies have grown a modest 5.5 per cent a year, in contrast to the 10.7 per cent nominal gross domestic product growth over the past two decades.

This highlights not only a comparative lack of corporate profitability amid rapid GDP growth, but also the inefficient deployment of the immense volume of capital mobilised in China’s industrialisation effort.

Anti-involution drive

China’s anti-involution drive seeks to streamline the planning and coordination of government investment, in an attempt to ensure the continued development of strategic sectors. Outside of these areas, it seeks to encourage private capital to play an increasing role in allocating capital within the economy.

On the former, despite considerable progress in electric vehicles and renewable energy, many objectives laid out in the 2015 “Made in China 2025” programme remain outstanding. This suggests China’s historical approach to supporting and subsidising advanced manufacturing technologies (including industrial robotics, software and machine tools), aerospace equipment and aircraft, as well as ships and ocean engineering equipment, will remain.

Implicit within the anti-involution drive in less strategic sectors should be the introduction of more market-based costs of capital and – as seen in the real estate sector in the past decade – an increased risk of business failure and bankruptcy, and the potential for associated unemployment.

While such an effort appears daunting, China’s East Asian neighbours have experimented with variations of such approaches since the 1990s. Recall, South Korea had such measures imposed on its corporate sector in the aftermath of the Asian financial crisis.

The pre-1997 Korean chaebol whose interests spanned from chemicals to retail to banking were forced to shed unproductive and unprofitable assets, incurring much economic pain amid the restructuring. However, over time, this allowed the nation’s leading companies to focus and helped establish the current Korean global leaders today in cars, chemicals and semiconductors. At the same time, this spurred development and catalysed growth in the country’s services sector.

Japan, seeking to avoid the painful restructuring following the bursting of its own bubble in 1989, took until the turn of the century, under then-prime minister Junichiro Koizumi to kick off structural reforms. However, former prime minister Shinzo Abe’s 2013 “Three Arrows” reforms truly accelerated these efforts to finally spur Japan corporates to focus on operating efficiency and capital discipline. This laid the groundwork to allow Japan corporate profits to grow 6 per cent, despite only 2 per cent growth in nominal GDP since 2013.

Undoubtedly, China will seek to avoid the economic, political and social damage that South Korea incurred to achieve its economic repositioning. Similarly, we expect China policymakers to draw lessons from Japan and avoid the prolonged approach taken in Japan in the 1990s that allowed deflation to embed itself in Japan’s economy through the turn of the century.

Indeed, once again, China can draw lessons from both the Japanese and South Korean experiences to cushion some of the pain that such economic transitions inevitably entail. While looking back at the last decade since Abe’s “Three Arrows” programme, much of these efforts were supported by government deficits, leaving Japan heavily indebted at a nearly 250 per cent debt-to-GDP ratio.

In contrast, South Korea, in the aftermath of its 1997-to-1998 crisis and at the behest of the International Monetary Fund, was unable to rely on an ever-expanding fiscal deficit. Instead, the country mobilised its then-nascent consumer sector to assist in the economic transition.

Though China’s household debt profile sits at nearly 65 per cent of GDP – above South Korea’s 25 per cent of GDP in the late 1990s – China’s households maintain a historic level of excess savings that were built during the Covid-19 pandemic.

Thus, measures to more durably address the property sector overhang and potentially create a broader social safety net may lay a foundation to begin to mobilise these savings. Such measures may also offer the economy an additional economic impetus, as real estate and external trade with the US ease in importance.

Beyond this, investors should also recognise that 2026 represents not only the start of the next Five-Year Plan for China, but also a window for the next foreign-exchange regime for the first time since 2015.

Foreign-exchange regimes

Since 1985, China has cycled through four previous foreign-exchange regimes roughly every 10 years, according to Carlos Casanova, UBP’s Asia economist.

Beginning with a dual exchange rate regime from 1985 to 1994, a proper foreign-exchange market gradually developed, shielding the national economy from rapid inflows and outflows that plagued emerging markets of the era.

Following a 1994 yuan devaluation, China moved to an overt US dollar peg which allowed the country to weather the foreign-exchange volatility that battered its Asian neighbours, amid the rapid 1995-to-1998 yen depreciation that many attribute as a trigger to the onset of the Asian financial crisis.

While the peg to the US dollar was useful during this decade of external instability, China’s ascension to the World Trade Organization (WTO) ushered in the catalyst for the next currency regime from 2005 to 2015.

With its WTO membership, export growth accelerated and foreign direct investment flowed in given China’s relatively undervalued exchange rate and cost advantages. This resulted in the revaluation of the yuan against the US dollar in 2005 and its steady appreciation through 2015 via a managed float, laying the groundwork for more meaningful current account liberalisation.

The past decade has seen China pivot once again, outlining the reference basket against which it manages its currency and promoting increased transparency, as it seeks to encourage the yuan’s increased use in cross-border transition.

With the 2018-to-2019 US-China trade war, 2022 Western sanctions on Russia, and increasing tension with the US under both the Biden and Trump administrations, pressure appears to be growing for China to take the next step in the evolution of its currency system as we enter 2026.

Overall, Casanova noted that the new growth model, following the Fifteenth Five-Year Plan and the next currency regime, should translate into slower growth for China’s economy, towards 4 to 4.5 per cent trend GDP growth, rather than the 5 per cent growth that has to date characterised the post-pandemic era on the mainland.

For investors, it suggests that while investing alongside government priorities in strategic sectors may still offer a useful guide going back to 1990, active stock selection strategies in China, such as those that have benefited investors in Japan, may likewise offer medium-term opportunities ahead.

Thus, expanding investor focus from government priority sectors towards efficient users of capital and corporate leaders who can consolidate growing segments of the economy can offer similarly attractive opportunities, as the new growth and foreign-exchange paradigms unfold in China.

The writer is group chief strategist at Union Bancaire Privee, a private bank and wealth management firm