Year of the Dragon

February marked the beginning of a new year – the Year of the Dragon – on the traditional lunar Chinese calendar. More specifically, the coming twelve months fall under the heavenly branch of the “Wood Dragon”, promising growth and abundance to those lucky enough to be born in the period. 

Indeed, China’s economy could do with some supernatural support. Over the past three decades, the Chinese Communist Party (CCP) oversaw a period of tremendous economic expansion¹. It was enabled by massive investment in infrastructure and real estate, financed largely by state-owned financial institutions. The strategy was immensely successful. Large swaths of the population were propelled into the middle class. Life expectancy, education, and private wealth improved; and with it the capabilities for higher-quality manufacturing and services, and the spending power to consume them. International investors took note, channelling foreign capital into the country. For a long time, a virtuous cycle reigned.

Now, China’s real estate sector, the economy’s trusty engine for growth, is sputtering. Such investment can only be sustainable if it creates value that outpaces its costs. Building a house only pays off if tenants move in to pay the rent. Financing a road only pays off if there is a factory at its end that generates sufficient profit to cover its construction. At the apex of China’s tremendous growth story, its economy is running out of steam: analysts report ghost towns of half-finished homes; roads built to nowhere. To avoid a painful collapse, the economy must change tack.


A new hope

Economists around the world generally agree that China must wean its economy off debt-fuelled infrastructure construction and instead funnel resources into segments that promise sustainable expansion. Indeed, the CCP has taken note and not been sat idle.

Government strategists have established a list of economic “policy favourites”, aiming to position the country for the economy of the future. Sustainable energy infrastructure is one of them: in early 2023, the country’s capacity for solar power production reached 228 gigawatts, as much as the rest of the world combined. It is now producing ten times as many electric vehicles as Germany, and controls two-thirds of global lithium mining, a vital ingredient for battery production². In the effort to move to Net Zero, the Western world will have little choice but to collaborate with the renewables superpower that China has become.

The transition is perilous but possible. For now, both local and foreign investors remain spooked by the collapse of the biggest real estate developers in the country, and sentiment is at an all-time low. Whilst a 2007 Lehmann-Brothers-style fall-out remains possible, it’s largely already factored into Chinese asset prices; the Hang Seng index of Chinese equities is down 52% since its peak in 2018³.


A golden opportunity?

From a contrarian perspective, the Chinese market may look like an attractive “value” play, with shares appearing so cheap they’re unlikely to weaken much further. Yet this thinking is likely premature. Yes, China’s “policy favourites” should position the country well for the long term and have the potential to offset the headwinds of a rapidly ageing population. In the short term however, the government has not done enough to assure investors that the unfolding property crisis is under control. As a result, we prefer a prudent stance on Chinese equities until momentum turns sustainably positive. In our view, it is preferrable to miss the initial leg of an elusive recovery rather than suffer a prolonged sell-off.

Still, the long arc of progress and development are in China's favour. Improving levels of health, education and technological prowess should continue to pay dividends in the form of further economic growth ahead, especially should the CCP succeed with its ongoing strategic repositioning. If the Year of the Dragon does not bring the recovery, the Year of the Snake just might.

Sources

¹ Bloomberg

² Bloomberg, Global Energy Monitor

³ Bloomberg

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CA28/Feb/24