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By EV Forward

London - China faces headwinds — including demographic decline, high and rising debt, deglobalization — that have led to growth downshifting in the middle of 2010s as the economy reached middle income levels, a point where all Asian tigers have seen economic growth decline.

For four decades beginning in the 1980s, China enjoyed supercharged growth after opening to foreign trade and investment and implementing free-market reforms, becoming the world's #2 economy. In the past two decades, Chinese growth and markets were driven by manufacturing and exports in 2000s, moving to an internet and software-based economy in 2010s.

The technology revolution and digital transformation prevented a much bigger slowdown in the past 10 years, with the digital economy expanding from 5% of the economy then to 40% now. But the manufacturing and real estate sectors that propelled growth and lifted asset markets in the past will not be the future drivers for China, as President Xi Jinping has cracked down on internet giants and pushed to make state-owned enterprises bigger and stronger, amid a partial decoupling from the U.S.

Recent convergence in the growth of the private and state-owned sectors signals that the government is playing a bigger role in the economy, leading to lower productivity and growth as the role of state capitalism increases in the coming years. Growth in the rest of this decade will likely come from hard tech, science-based industries, which the government should support to increase productivity in the economy.

China's geopolitical aspirations and challenges

Until recently, Chinese leaders had emphasized the country's peaceful rise. Under Xi, China has adopted a more muscular approach to foreign policy, extending its economic influence abroad through the Belt and Road Initiative while engaging in territorial disputes and military threats against neighbors — and more recently trying to expand the role of its currency. Russia's invasion of Ukraine has reinforced Moscow-Beijing relationship, but China will be reluctant to cross U.S. red lines given its economic interlinkages with the West.

China benefits from discounted Russian oil and minerals, but trade with Russia accounts for only 3% of its total trade. China means more to Russia, while the West means more to China. The war in Ukraine has focused attention on the future of Taiwan. China has sought after the island since 1949, vowing to "unify" Taiwan with the mainland—using force if necessary. The costs would be catastrophic, however, given the high degree of economic interdependence with the U.S. and Europe; we believe peaceful unification rather than a military invasion is the most plausible scenario.

Beijing is vulnerable financially. China is the world's biggest exporter and one of the strongest contributors to global growth but the yuan has several limitations and cannot displace the U.S. dollar (USD) as the top reserve currency. While Beijing will continue to leverage its financial power by forming currency blocs and creating mechanisms to facilitate trading in yuan — such as the Cross-Border Interbank Payment System (CIPS) and the digital yuan (e-CNY) — chipping away at the USD will not be easy. China will counter U.S. financial dominance through dual currency payment systems and regional economic alliances, but diversification from the dollar will be slow moving.

China and U.S. technology race

The technology race is at the heart of the U.S.-China rivalry. The Pentagon has warned that China is developing technologies to conduct long-range precision strikes as well as space and cyber capabilities to counter U.S. dominance. China leads in telecommunications such as developing and installing 5G and Green Tech solar panels and wind turbines, while the U.S. leads in artificial intelligence, semiconductors and online gaming.

The Biden administration's new controls on China-bound technologies intend to constrain the development of China's semiconductor industry and keep cutting-edge chips out of China's hands. The restrictions could be tightened over time to steer firms away from China, thwarting attempts by Beijing to innovate its way around the constraint.

China trails South Korea and Taiwan in semiconductor manufacturing, but Chinese wafer fabrication facilities lack the technology required to make advanced chips. Since Beijing will not be able to retaliate against Washington, the state will instead turn inwards to focus on domestic technological development and growth.

Key takeaways

The market drivers of the last two decades — such as real estate or consumer-focused internet companies — will not be the drivers of this decade. Instead, China 3.0 themes for the 2020s include upgrading consumption, renewable energy and indigenous technology advancements that will be the drivers of growth and productivity, and markets. Further risks include a real estate driven financial accident, a more aggressive technological decoupling from the U.S., increased government involvement in the economy and a geopolitical miscalculation.

Bottom line: The risk premium in Chinese assets has increased significantly. China has economic, geopolitical and technological aspirations, but faces challenges to meet its goals.

Jitania Kandhari
Deputy CIO of the Solutions and Multi-Asset Group
Co-Lead Portfolio Manager for Active International Allocation
Head of Macro and Thematic Research for Emerging Markets Equity