What China’s Odyssey Towards “Common Prosperity” Means for Portfolios
In February, China declared victory in lifting its entire population out of extreme poverty. Now it’s made distribution of income a priority.
The call for “common prosperity” is not new: Since the 19th National Congress of the Communist Party of China in 2017, the government has shifted focus from “growth first” to “quality first”, aiming to balance economic growth and sustainable development, with “social fairness” as a key focus. However, progress has been delayed by the U.S.-China trade dispute in 2018-2019, and then by the COVID-19 outbreak.
Now, with China’s growth recovery well on track, structural reforms and “risk prevention” have regained priority. This is driving the recent regulatory storm in China that has hit a broad range of sectors from tech to cosmetic surgery to private tutoring.
The string of crackdowns began on July 23 with a sweeping overhaul of China’s $100 billion U.S. education tech industry, banning companies that teach school curriculum from making profits, raising capital or going public. Other regulatory activity that followed include banning unfair online competition, protecting the rights of gig-economy workers, limiting gaming time of minors and taking action against “chaotic” online celebrity fan culture.
While there could be some short-term pain, such as financial market volatility and growth moderation, we believe these policy changes, if implemented well, could bring long-term gain. Potential benefits might include a properly regulated market environment, fewer speculative activities and policy loopholes, as well as a more inclusive and sustainable growth model.
Concerns over economic efficiency and private sector weakening could be overdone. Here are three reasons why.
1. Common prosperity is not about absolute equality, but inclusive growth
China is concerned about the income gap between its richest and poorest citizens. Official figures from the National Bureau of Statistics show that the richest 20% of Chinese had an average disposable income of more than 80,000 yuan ($12,000 U.S.) in 2020, over 10 times what the poorest 20% earned.
Widening income inequality is a global phenomenon, triggering waves of social unrest in recent years. Committed to social harmony, China’s goal is to develop a more “olive-shaped” income distribution by expanding the middle-income group. Policies will focus on improving the social welfare system (including pensions, healthcare and housing), ensuring fair access to education, and promoting upward mobility.
Recent regulatory changes aim to balance fairness and efficiency. For instance, the crackdown on private tutoring is complemented by increased resourcing for public schools and low-cost community childcare services, which could benefit low-income families and working parents.
The government has clarified that common prosperity is not about equal distribution of wealth, but rather affluence shared by everyone, both in material and cultural terms – a plan that will advance gradually. Growth still matters, with authorities pledging to double GDP by 2035. However, a reasonable adjustment of income distribution is needed to ensure growth is more inclusive and fewer people are left behind. This could help maintain social stability and ensure more sustainable growth in the long term.
2. The public sector is also subject to stronger regulations
The government has been working on breaking the implicit guarantee for state-owned enterprises (SOEs) and lowering SOEs’ leverage. The default ratio of SOEs, although still much lower than their private peers, has increased notably in recent years. Chinese companies' bond defaults amounted to 62.59 billion yuan ($9.67 billion U.S.) in the first half of 2021, the highest ever, according to Fitch Ratings. SOEs contributed to more than half of the defaults, totalling 36.65 billion yuan.
Since earlier this year, China has stepped up scrutiny and restrictions on lending to local government financing vehicles (LGFVs) to contain local governments’ implicit debt. The government has already capped the salary for SOE executives in recent years, and the anti-corruption campaign has kept public sector employees under close scrutiny.
Beijing’s top leadership has recently sent strong messages to reassure private firms of government support. They reaffirmed the importance of the private economy, which makes up more than 50% of total tax revenue, 60% of the country’s GDP, 70% of China’s technological innovation, 80% of urban employment and 90% of enterprises. Supporting small- and mid-sized enterprises (SMEs) has been a policy focus in recent years via monetary, fiscal and other administrative initiatives.
3. Most of the recent policy changes in China are consistent with global trends
Policy changes include strengthening anti-trust regulations, improving data protection, reducing income inequality and improving social class mobility, against the backdrop of explosive tech development and the rise of populism and protectionism across continents. China is experimenting with its own solution to these challenges.
We believe the implications of Beijing’s common prosperity drive will be far-reaching.
- Regulation will be strengthened where market expansion has outrun regulations and in sectors affecting social wellbeing. Deleveraging and housing market restrictions are unlikely to reverse course. Reform in sectors such as childcare, education, entertainment and healthcare will likely ramp up.
- Greater effort will be made to increase the share of labour income in GDP and improve income distribution. Labour protections will be further strengthened and a focus on education should help to improve productivity and income.
- Increased funding will be directed to healthcare, housing and education. Possible policy adjustments to increase funding could include tax reforms, policies to encourage charitable donations by firms and high-income individuals, and raising the proportion of profits from SOEs that goes to the government.
Implications for portfolios
The government’s regulatory actions could weigh on growth in the near term, but appropriate monetary and fiscal support, as well as resilient external demand, could keep growth at around 8% for 2021.
Policymakers also have ensured that liquidity remains strong by cutting Chinese banks’ reserve requirement ratio (RRR) by 50 basis points in July, releasing around 1 trillion yuan ($154 billion U.S.). We believe this acts a partial offset to the tightening policy for some key sectors and should be constructive for our ongoing overweight duration bias in China.
The direction of the Chinese yuan is less clear cut. The tailwind from robust export performance has led to the currency strengthening to a multi-year high against the China Foreign Exchange Trade System (CFETS) dollar basket, while monetary policy is now leaning towards a loosening of liquidity.
Foreign inflows to China’s bond market remain positive – with additional support from November’s inclusion of Chinese government bonds into the FTSE World Government Bond Index. This should offset weaker sentiment from equity price performance due to the regulatory headlines.
Further, while the push for common prosperity has intensified uncertainty in some sectors, we believe opportunities will emerge in other sectors, such as green energy and “hard technology”Footnote (like semiconductors, aerospace and biotechnology) , which are aligned with China’s national development goals. This is an environment that provides opportunities for active managers grounded in rigorous risk management.
In the long run, a properly regulated business environment likely will benefit all investors, by reducing vulnerabilities in the system and ensuring a sustainable growth path.
For insights into our views on China’s real estate sector, please read our recent blog, “Idiosyncratic Risk in China Real Estate: What Does it Mean for the Property Market and Banks? ”
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