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China: From Smokestack to Labtech

February 5, 2018 | Global/Emerging Markets

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China is commonly characterized as a smokestack economy, focused on infrastructure investment, cheap manual labor, and polluting industries. But that is changing, as China's 2017 equity-market return of 50% suggests.

The challenge: Can China justify those returns and make the aggressive leap into an innovative, digitally led economy?

Growth in the country's population and change in its demographics are often discussed, but China is also dominating the world in internet usage, with 731 million users in 2017 versus just 434 million in the European Union, 432 million in India, and 237 million in the United States. And Tencent's WeChat, the popular Chinese chat app, has surpassed 700 million users, quickly catching up to Facebook's Messenger and WhatsApp.

Scaling across a user base of hundreds of millions has led to innovation in business models.

Consider, for example, that online payment companies Tenpay and Alipay are now encroaching on (even surpassing) the number of online payments seen by Visa and MasterCard, as the chart below illustrates.

The opportunity to gain exposure to these companies, which we see as both self-funding and self-growing, is important to us as investors. The story is no longer about “Made in China” but rather “Invented in China.”

The number of science, technology, engineering, and mathematics (STEM) graduates in China will likely support this transformation: 4.7 million in 2016, according to McKinsey Global Institute, versus 2.6 million for India and 568,000 for the United States.

Ample funding is available to Chinese companies that want to innovate. Although the United States still received the most venture capital in 2016 in virtual reality, autonomous driving, artificial intelligence, and robotics, China was not far behind—and it received the most venture capital funding in financial technology.

The story is no longer about “Made in China” but rather “Invented in China.”

Also supporting Chinese innovation are tax credits. Certified high-technology and new-technology companies could receive a preferential income tax rate of 15%, 10 percentage points lower than the statutory rate of 25%. There is also a 150% tax deduction for eligible research-and-development expenditures.

Lastly, China has one of the largest, most liquid, and fastest-growing equity markets in the world . The Shanghai and Shenzhen stock exchanges list 3,500 companies with an aggregate market capitalization of $7.5 trillion. 1

That is second only to the New York Stock Exchange and Nasdaq, and multiple times larger than other major emerging markets, such as Korea and Taiwan.

Yet China is under-represented in global equity indices relative to its economic influence. China accounts for a substantial part of the world: 15% of global gross domestic product, 11% of global trade, and 11% of global consumption.

China composes just 3% of the MSCI AC World Index. When MSCI includes China A-Shares in its indices in June 2018, they will represent just 1% of the MSCI Emerging Markets Index and 0.1% of the MSCI AC World Index.

We believe that China's weight in global benchmarks—and thus its relevance to investors—will increase materially over the next decade.

This leads us to believe that China's weight in global benchmarks—and thus its relevance to investors—will increase materially over the next decade.

We see two major risks to the China story.

The first is that the country opens up its capital and financial markets too quickly. When financial markets are liberalized, a period of learning and massive misallocation of capital typically ensues.

Second, after the National Party Congress, President Xi Jinping moved to more dominant political position. If he is reaches the level of power of Mao Zedong, he could be perceived as political threat–and if he loses power, that could have an impact on the innovation China has recently seen, because Xi is so closely aligned with it.

1 Source: Goldman Sachs, as of July 17, 2017.

The MSCI AC World Index represents mid- and large-cap equity performance across developed and emerging markets. The MSCI Emerging Markets Index represents mid- and large-cap equity performance across 24 emerging markets countries.