Home > Insights > China Secular Risks: Deleveraging, Decoupling, and Technology Disruption
Viewpoints

China Secular Risks: Deleveraging, Decoupling, and Technology Disruption

The proximate risk is that China retreats from the successful template of market opening as it tries to insulate itself from geopolitical pressure.

China’s integration into the global economy has been accelerating. Among the most visible signs, Chinese A-shares equities became part of the MSCI Index in 2018, and they will see a further increase in their inclusion factor in 2019; bonds of Chinese government and policy banks joined the Bloomberg Barclays Global Aggregate Index earlier this year. For global investors, these developments hold the potential for diversification and scalable alpha opportunities. But they also make the Chinese economy more exposed to external shocks, and global markets more sensitive to Chinese market reverberations.

To be sure, our baseline remains that China’s economic expansion will slow gradually. We see this as natural, the result of the country having attained middle income status as well as deteriorating demographics. Nonetheless, as discussed in PIMCO’s latest Secular Outlook, we consider China a potential source of disruption.

In our view, China poses three key structural challenges to the status quo – all of which have potential investment implications for portfolios.

MANAGING INTERNAL GROWTH DECELERATION AMID DEBT DELEVERAGING

Avoiding disruptive deleveraging amid slowing growth is the main domestic challenge for Chinese policymakers. The country’s potential growth should remain relatively high by global standards – about 5% by our estimate. However, managing a smooth transition will not be easy.

Without doubt, China’s growth dynamics have been shifting to consumption from exports and investment, the traditional engines of growth over the past 40 years. That’s part of what’s necessary to escape the middle income trap.

But China also must create more innovative, higher tech products that can compete in global markets. That will be made more difficult by a rapidly aging population. Indeed, the Chinese labor force peaked in 2015. Urbanization still has some room to run but is also mature.

Debt leverage is another challenge. It has grown rapidly over the past 10 years – in firms, local governments and, more recently, households. Asset prices remain elevated, particularly in residential housing in major cities. Financial vulnerabilities are increasing in shadow banking credit, while loan quality at small- and medium-size regional banks is difficult to ascertain. Accordingly, potential growth rates will inevitably slow over the secular horizon.

In the event of a material shock to the Chinese economy, a key question is whether Chinese policymakers have internalized the lessons of balance sheet recessions in Japan and Europe. In contrast to most developed economies, where fiscal-monetary coordination is constrained by independent central banks and politicized budget processes, coordination between fiscal and monetary policies is inherent in China’s political reaction function. This offers the possibility of a more rapid and decisive response to any shock.

Nonetheless, as growth slows and the rivalry with the U.S. intensifies, China is likely to strengthen efforts to insulate itself economically and financially. Inevitably, China faces a trade-off between economic efficiency and political control. Years of public investment stimulus will affect the calculus: The marginal effects of additional fiscal stimulus and monetary easing may decline, while sustaining these pump-priming policies will likely create undesirable side effects – not least of which is implicit moral hazard, postponement of key structural reforms, and a crowding out of the private sector. In an adverse scenario, the Chinese authorities could be forced to accept significant currency depreciation, which would send a deflationary shockwave through the global economy.

DISRUPTIVE TECHNOLOGY INTERACTS WITH TECHNOLOGY DISRUPTION

Even in a relatively benign Chinese growth scenario, Chinese efforts to move up the ladder to higher value-added manufacturing will likely disrupt supply chains of producers in Europe, Japan, the U.S. and Southeast Asia.

Complicating the picture is the fact that for many Asian economies, China has become the biggest source of trade, investment and tourism. Yet many of these countries depend on the U.S. for their security. Singaporean Prime Minister Lee Hsien Loon aptly described the dilemma last year: “We do not want to end up with rival blocs forming or countries having to take one side or the other.”

However, the growing belief that China is rising at the expense of the U.S. has already spilled over into the technology arena. Washington’s policy response has shifted from forcing China to protect foreign intellectual property toward containment. For example, Chinese firms have built a commanding lead over competitors in 5G telecom technology. The U.S. ban on Huawei Technologies Co. Ltd. reflects deep-seated fears of Chinese technology controls. Chinese artificial intelligence and advanced robotics firms may face similar sanctions.

In response, China may retaliate by penalizing U.S. firms that comply with the ban, most likely by restricting access to China’s domestic market. Relative to other potential threats – such as reduced holdings of U.S. Treasuries, a ban on exports of rare earth metals or, indeed, a strategic currency devaluation – China’s strongest and most likely economic weapon is access to its domestic consumers.

Even if not yet fully realized, these concerns are disrupting global trade. At a minimum, a bifurcation of supply chains is likely. Given tariffs and other restrictions, multinational firms will experience higher operating costs due to reduced scale and specialization. While they may use existing manufacturing capacity in China to satisfy Chinese domestic demand, fresh investment outside China may be needed to supply U.S.-aligned export markets.

COMPETING FOR GLOBAL INFLUENCE

Most broadly, China’s growing economic power and ambition to establish a global sphere of influence could further disrupt the established geopolitical order dominated by the U.S. since the end of World War II.

As key regional powers, China and the U.S. are actively angling to gain regional influence via the Belt and Road Initiative and the Indo-Pacific Strategy, respectively. Beneficiary countries could be those along the belt and road that receive Chinese investment and low-cost funding, although debt dynamics and sustainability will need to be watched. Other low-cost manufacturing economies, such as Mexico, Vietnam and Bangladesh, may also benefit from revamped supply chains. In turn, countries and companies that are more integrated into Chinese growth- and export-oriented supply chains may require a higher risk premium.

We are keenly aware that these disruptive forces might not be limited to trade, technology and geopolitics. The line between commercial and military tension is thin – consider the coupling of advanced technology into both military hardware and telecommunications infrastructure. The hegemonic fight for global dominance could yet spill over to financial markets in the form of currency wars, financial sanctions and capital controls.

Yet, unlike the Soviet-U.S. nuclear arms race, there are no established rules, norms or forums that seek to prevent cyber warfare and state-sponsored hacking attacks from triggering a broader conflict. A central question is the extent to which the high degree of economic interdependence between the U.S. and China constrains the fight over security and influence.

As investors, we are mindful of this trade-off. Over the secular horizon, we are tilting toward Asian markets that are more immune to, or even beneficiaries of, Sino-U.S. strategic tensions. Domestic demand-driven economies with sizable populations, such as India and Indonesia, are likely to be more immune to volatility associated with this rivalry.

INVESTMENT IMPLICATIONS

The proximate risk is that China retreats from the successful template of market opening as it tries to insulate itself from geopolitical pressure. However, our baseline remains that the economic cost to all sides of disintegration is so high that a “great decoupling” is more likely to be avoided.

Over the secular horizon, given the current volatile political and economic dynamic, we anticipate this will be a bumpy path but one where flexible allocation and active portfolio management will have the opportunity to seek substantial alpha.

The Author

Stephen Chang

Portfolio Manager, Asia

Gene Frieda

Global Strategist

Related

Disclosures

London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Dublin
PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
Limited
3rd Floor, Harcourt Building 57B Harcourt Street
Dublin D02 F721, Ireland
+353 (0) 1592 2000

Munich
PIMCO Europe GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

Milan
PIMCO Europe GmbH - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

Zurich
PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. It is not possible to invest directly in an unmanaged index. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517) and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The Italy branch is additionally regulated by the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act. PIMCO Europe Ltd services are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Deutschland GmbH Italian Branch (Company No. 10005170963), PIMCO Deutschland GmbH Spanish Branch (N.I.F. W2765338E) and PIMCO Deutschland GmbH Swedish Branch (SCRO Reg. No. 516410-9190) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Spanish Branch and Swedish Branch are additionally supervised by the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act, the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008 and the Swedish Financial Supervisory Authority (Finansinspektionen) in accordance with Chapter 25 Sections 12-14 of the Swedish Securities Markets Act, respectively. The services provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services provided by PIMCO (Schweiz) GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia). This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. | PIMCO Japan Ltd, Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. All investments contain risk. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Taiwan Limited is managed and operated independently. The reference number of business license of the company approved by the competent authority is (107) FSC SICE Reg. No.001. 40F., No.68, Sec. 5, Zhongxiao E. Rd., Xinyi Dist., Taipei City 110, Taiwan (R.O.C.), Tel: +886 (02) 8729-5500. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Av. Brigadeiro Faria Lima 3477, Torre A, 5° andar São Paulo, Brazil 04538-133. | No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2019, PIMCO.