Its bond market is the third-largest in the world. Two of its stock markets are among the global top seven. Yet chances are, you’re underexposed to the economy that continues to grow faster than the rest of the world.
Of course, we’re talking about China, which once again is subject to talk of a “hard landing” after a bond agency downgraded it this past spring. And while it’s important to understand the risks, it’s unwise to shun an economy that still accounts for more than 40% of global GDP growth each year. And if you dig into the shifting winds of the Chinese economy, and selectively choose the right ETFs, you can zero in on the nation’s virtues while sidestepping its potholes.
The era of nearly 10% yearly growth in China is a thing of the past. The Laws of Bigness have kicked in as the country’s growth has slowed to less than 7%, a figure that may slip further in coming years. China has come to rely on massive borrowing to stimulate investment. But with the Chinese government’s total debt now at 156% of GDP—up from 100% in 2008 according to Bloomberg Intelligence—most economists don’t think China can count on debt-fueled stimulus anymore.
That may not be a bad thing, however, since the returns on massive investments in infrastructure and industrial capacity are no longer yielding the high rates of return they did in the past, according to Michelle Borré, a portfolio manager at OppenheimerFunds. In recent years, “achieving the same GDP growth target has required increasing levels of investment and debt, ultimately resulting in an accelerating debt-to-GDP ratio,” Borré wrote in a recent note to clients.
She also said the banking system may have come to play too large a role, as China’s banks now control around $33 trillion in assets, or roughly three times the volume of GDP. In contrast, banking assets in the U.S. are smaller than GDP.
The Chinese government has begun addressing the issue, mainly by raising interbank lending rates, placing greater restrictions on loans made by the nation’s shadow banking sector and weeding out corrupt firms. Yet reforming the financial services sector won’t be easy. Some strategists express concern that Chinese finance ministers may remain too wedded to the maintenance of 6% annual GDP growth and lose their desire to rein in and reform the banking sector.
“If policymakers move quickly to tackle the debt buildup and resulting resource misallocation by allowing state firms to go bust, then growth could feasibly stabilize at around 4% to 5% during the coming decade,” writes Julian Evans-Pritchard at Capital Economics. Yet if the reform effort weakens, he sees growth slowing to just 2% per year in the coming decade.
Not everybody thinks that a slowdown in China’s current 6% growth rate is inevitable. Speaking at a recent investment conference, Helen Zhu, head of China equities at BlackRock, said “policy makers are using the current phase of strong cyclical growth to tackle the reforms that are needed.” Unlike strategists such as Evans-Pritchard, Zhu thinks China has been making clear strides in areas such as the environment, corruption and excess industrial capacity.
Still, you shouldn’t fully dismiss the implications of the recent Moody’s bond downgrade, which could make it harder for Chinese businesses and local government to roll over their debt at globally competitive rates. “It’s wise to steer clear of financials and other sectors seen at risk from instability,” Zhu said. Recall that our nation’s banking system was an Achilles’ heel for the economy once imbalances proved hard to correct.
That spells caution for ETFs with outsized exposure to China’s banks. The iShares China Large-Cap ETF (FXI), for example, has a 49.3% weighting in financial services. The fund, which carries a 0.74% expense ratio, has $3.2 billion in assets [as of June 30], which makes it the largest China-focused ETF.
The oversized exposure to the stressed banking sector helps explain why this popular fund has trailed the pack, delivering a 6.28% annualized return over the past three years, three percentage points below the average return of the 10 largest China ETFs.
Heady Growth, But Under-Owned
The fact that the top 10 China ETFs have less than $10 billion in combined assets is stunning when you consider that the top 10 Japan ETFs have around $28 billion in assets. The Chinese economy is nearly three times larger.
And while China now controls around 15% of the global economy (lagging the still-dominant U.S. economy), it’s on pace to win the global top spot by 2050 with a 20% controlling stake, according to PricewaterhouseCoopers. The World Bank believes that when adjusted into "international dollars" to account for the purchasing power of money locally, the Chinese economy is now already larger than the United States’.
According to PwC analysts, in a report entitled “The World in 2050,” other emerging markets such as Vietnam, the Philippines and Nigeria are all expected to crack the global top 20 by then. “But emerging economies need to enhance their institutions and their infrastructure significantly if they are to realize their long-term growth potential,” said the analysts.
And that’s where One Belt, One Road (OBOR) comes in.
OBOR is China’s grand plan to invest up to $500 billion in more than 60 emerging markets over the next five years, focusing mostly in Asia, the Middle East and Africa. Oxford Economics predicts that by 2050, the countries involved in OBOR are expected to contribute 80% of global GDP growth, up from 68% at the end of last year.
China’s aim is to refashion the historical Silk Road with new trade links and huge infrastructure projects including railroads, ports and highways. China compares OBOR to the Marshall Plan, in which the U.S. provided crucial capital to Europe after World War II. That effort, too, was seen as a way to help other nations boost their economies—and thus their appetite for imports.
OBOR may also aid China in its efforts to boost profits in bloated industries. While a series of mergers are shrinking capacity in steel-making and cement, for example, China still produces more than it consumes in many industries. OBOR should stimulate demand for construction and infrastructure firms, boosting profits and making such firms less of a default risk if the Chinese domestic demand weakens.