China: Tech titan or ticking economic time bomb?

No other country evokes such mixed feelings in the West as China. While geopolitical strategists predict it will surpass the United States as the dominant global power this century, investors see a nation increasingly constrained by state control. As a result, the dynamism of private enterprise is weakening. This has led ING and GaveKal to adopt a more cautious, wait-and-see approach.

Geopolitics and investing
This is the final article in a seven-part series by Investment Officer on the impact of geopolitics on investments. The topic will also be discussed (in Dutch and English) at the Investment Officer Fund Event on Monday, 30 September in Bussum, the Netherlands, titled Europe Under Pressure.

Arthur Kroeber, China expert and head of research at Gavekal, argues that Beijing is under significant pressure from U.S. criticism and sanctions, particularly concerning tariffs, state subsidies, and the undermining of WTO rules. In response, President Xi Jinping has intensified efforts to bolster China’s resilience and strategic autonomy, aiming to climb higher in the global value chain by strengthening its position in key technologies. According to the Technology Tracker database of the Australian Strategic Policy Institute, China now leads in 37 out of 44 technologies, leaving the U.S. behind.

However, this approach cannot mask the fact that economic recovery following the pandemic has not materialised. The real estate crisis persists, consumer spending continues to decline, and the financial health of local governments has worsened. Most notably, sentiment in the private sector has plummeted, exacerbated by the government’s tightening grip on tech giants like the near-monopolistic e-commerce platform Alibaba.

Listen to Arthur Kroeber, China expert at Gavekal, 
as he discusses the conditions for investors to return to China:

Since 2015, Xi Jinping has consistently supported state-owned enterprises, which had nearly been overshadowed by innovative private initiatives. He introduced a policy that prioritised state companies over private ones, with the Communist Party aiming to curb the instability it associates with a free market economy.

The cost of an overcontrolled strategy

However, Kroeber of Gavekal warns in a conversation with Investment Officer that the costs of this “overcontrolled strategy” are becoming increasingly apparent. He doubts whether the government can maintain this approach over the next decade or two as new waves of innovative companies and sectors emerge.

Chinese private investments decline 

The country carries a significant debt burden. “Much of this debt has been used to finance relatively low-productivity infrastructure investments, often through financing vehicles of local governments, which lack the revenue to repay the loans,” says Kroeber. “Now they are forcibly redirecting capital from infrastructure and real estate to technology-intensive production. The theory is that this will improve returns on capital and that productivity growth will drive more economic growth.”

Arthur Kroeber on the sustainability of technological advancement in China.

Kroeber’s concerns are echoed by economist Noah Smith, who, in his recent Substack analysis “Xi Jinping vs macroeconomics,” argues that Xi’s push for self-sufficiency through high-tech industry is failing. With falling incomes, weak consumer confidence, and a real estate crisis, China faces deflation that threatens its broader economic stability.

Also read: Xi-Jinping vs. macroeconomics, door Noah Smith

“Decoupling” is the theme in China and the U.S. Both nations, along with the EU, aim for self-sufficiency to shield against external shocks. Biden’s Inflation Reduction Act and the EU’s Chips Act reflect this shift.

“At the moment, you have both political risk and a very mediocre economy with weak nominal growth. That doesn’t offer good returns in any asset class.”

Arthur Kroeber, Gavekal.

Notably, both China and the U.S. are working to reduce their dependence on capital goods from other countries. Bilateral trade between the two nations decreased from 2018 to 2023, whereas it had been increasing in the five years prior. Interestingly, despite rising tensions, bilateral trade between China and Europe is growing, which could spark national security concerns between the U.S. and the EU.

The EU is becoming increasingly dependent on China

Source: Peterson Institute of International Economics.

‘Decoupling is not happening’

Kroeber adds nuance to the debate: The U.S. cannot function without China either. American companies rely on critical minerals like graphite, essential for semiconductor production, with China controlling about 95 percent of the global market. “There are other rare earth metals the U.S. would like to eliminate from China’s supply chain, but that’s difficult. When you dig deeper, it becomes clear that China remains deeply embedded in the supply chains that end up in the U.S.,” says Kroeber.

Also see:  ‘Numbers Matter: Defense Acquisition, U.S. Production Capacity, and Deterring China’

Despite moves toward decoupling, the major global trading blocs remain dependent on one another. However, many investors have withdrawn from Chinese assets due to weak nominal growth in recent years. Kroeber believes that if China adopts a more prudent set of macroeconomic policies and accelerates nominal economic growth, investors would likely return.

MSCI ALL Countries index

Bron: MSCI.

China in asset allocation

Bob Homan, head of the investment office at ING, shares a similar view. “At the moment, we are neutral on China because we see all the cyclical issues. However, it is extremely cheap in terms of valuations, so a neutral stance suits us. I believe we will eventually shift to overweight rather than underweight, as these cyclical problems will eventually be resolved. Additionally, due to some degree of deglobalisation, economic cycles are no longer fully synchronised. This provides a nice diversifier in the portfolio, also known as decorrelation. Of course, the correlation between stocks and markets remains significant, but that cycle continues globally. That might decrease, which is beneficial from a portfolio management perspective.”

“I see many strategists and investors saying, ‘we are very focused on geopolitical developments.’ But they don’t act on it. That frustrates me because it gives their clients a false sense of security.”

Bob Homan, ING

When asked about the impact of global geopolitical unrest on the bank’s strategic asset allocation, Homan—drawing on 25 years of professional experience—responds almost laconically: “Well, I see many strategists and investors saying, ‘we are very focused on geopolitical developments. And we are very attentive to them.’ But they don’t actually do anything with it. That frustrates me because it gives their clients a false sense of security. I believe that, with most major geopolitical events, which tend to happen rather unexpectedly—like the war in Ukraine—you can’t really be prepared for them. Unless you hedge,” Homan adds, “but that costs you returns.”

ING’s strategic asset allocation includes an overweight position in the U.S., an underweight in Europe, and a neutral stance on China. Despite rising geopolitical tensions, Homan sees no benefit in import tariffs or boycotts of Chinese goods, such as electric cars in the EU.

Bob Homan, ING, on European import tariffs as compensation for China’s export subsidies:

Cees van Lotringen is a writer, journalist, and entrepreneur. He is the former editor-in-chief of Investment Officer. The original and full version of this article appeared in Dutch on innvestmentofficer.nl.

Further reading in this series:

• The AI revolution is separating the wheat from the chaff (2 September)
• Energy transition ushers in biggest bull market ever (12 August)
• ‘Dancing on the volcano - as long as it lasts’ (22 July)
• China’s sudden electric car boom stirs strategic concerns (1 July)
• An autonomous EU would create a new framework for investors (7 June)
• Europe’s rude awakening: Geopolitics is back (21 May)