The battered Chinese economy is on the verge of getting back on track

The Chinese market has rebounded sharply since early November, fueled by hopes that the government would reverse the country’s harmful zero-Covid policy. But do investors have to be careful what they wish for? On the one hand, an easing could trigger a crisis for the country’s immature healthcare system. On the other hand, a revival in Chinese growth could exacerbate the inflation crisis for the rest of the world.

The SSE Composite Index, which tracks stocks traded on the domestic Shanghai Index, is up 10% since early November. Hong Kong-based Hang Seng’s recovery was even more remarkable, with the index up over 30%. The rebound comes after a miserable year for Chinese investors, in which a sluggish economy and a vulnerable real estate sector weighed on sentiment and dragged stock prices lower.

The catalyst was an apparent softening of the Chinese government’s stance on its zero-Covid policy. Some easing of quarantine restrictions and contact tracing rules have been introduced alongside some clear indications from the government that it wants to open up the economy. With protests erupting in the streets and weaker economic data, it has also become increasingly clear that the costs of the ‘go slow’ policy are rising.

Investors are clearly optimistic that this stance will ease further, leading to a recovery in the Chinese economy. This would be welcome for the global economy, as many other major economies are expected to fall into recession in 2023, and also for the regional economy, much of which still depends on China to drive growth.

However, the equation is not simple. China’s zero-Covid policy was not simply the whim of an authoritarian government, it was put in place because the healthcare system was not equipped to deal with significant numbers of cases, vaccination rates were low and the vaccine itself was not particularly effective against new strains of Covid. Only about 40% of those over 80 in China have received the full two shots and one booster shot. This is around half the rate for people in the UK and poses a fundamental risk of reopening.

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Sharukh Malik, portfolio manager for Asia and emerging markets at Guinness Global Investors, says that if China were to open up fully at once, a worst-case scenario could mean up to three million deaths: “That’s why China has stuck with zero-Covid. Not enough older people are taking the vaccine.” There are a number of contributing factors to this – reliance on traditional medicine, a lack of education from doctors and perhaps a sense of relative safety because Covid rates have been low. Malik says any progress on vaccinations, even with a weaker vaccine, would allow for some reopening.

Vaccination requirements are one solution, but the government has been surprisingly reluctant. Still, he believes the government is likely to fully open up by 2023 given the rising financial and social costs of the policy. The economic recovery, if it comes, could be significant. He adds: “A lot of savings have been accumulated in recent years, as we have seen in the UK. There could be a significant increase in consumption as the economy opens up. With interest rates rising in developed markets, if China opens up next year, China could be the only major economy to grow. From an asset allocation perspective, China could be the bright spot.”

The mood could also change quite quickly, as the strong recovery since the beginning of November shows. Valuations in Chinese equity markets look very cheap and the region is almost universally unpopular with investors. Therefore, even a small shift in sentiment could result in significant movement in the markets.

But will a Chinese revival be good for the global economy? Gerrit Smit, manager of the Stonehage Fleming Global Best Ideas Equity fund, says: “It is clearly in everyone’s interest that China manages its restrictions better and the signs are that they are starting to do so. Otherwise it will hurt their economy so badly and we all know how dependent the rest of the world is on their exports. Their exports are currently collapsing while the rest of the world’s imports are still growing. In 2023, in relation to these issues, we have reason to believe it will be better.”

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Nonetheless, there is a risk that it could contribute to global inflationary pressures. Mark Preskett, Senior Portfolio Manager at Morningstar Investment Management, says: “The main drivers of global inflation have been energy-related. China is the largest consumer of natural gas, the largest importer of natural gas. Its natural gas consumption has fallen this year for the first time in 20 years as the country went into lockdown and demand slacked, but we had situations in 2020 where they tried to outbid the Europeans for gas. We see a significant drop in gas prices this year, but a strong China would need more gas.” He adds that the country could buy Russian gas, but that has historically provided only about 10% of its supplies.

In return, the supply chains would relax, he says. This was also inflationary as supply could not keep up with demand. Preskett adds, “China’s lockdown has added to the pressure on the supply chain.”

Much will depend on the relative weakness of Western economies. A Chinese revival, if it happens, could provide important ballast against recessions in the UK, Europe and the US and may not contribute to inflation if demand elsewhere is sufficiently weak. However, as it has been for much of 2022, the global economy is walking a tightrope.

This story first appeared in our sister publication, Portfolio Advisor.

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