China is the second largest economy in the world. Despite its many challenges, it is set to overtake the United States over the next decade. We analyze the opportunities and risks of investing in China.
- How to Invest in China
- Opportunities of Investing in China
- Risks of Investing in China
The growth experienced by China since the late 1980s is, without a doubt, the greatest economic success of the last half a century. In less than two generations, China has gone from being one of the poorest countries on the planet to becoming the second largest economy in the world.
This has led to a dramatic increase in average per capita income. Consequently, the standard of living of the Chinese population has improved in a vert significant manner. While it is still below that of Western economies, the trend continues to be positive.
Another consequence of that economic growth is that the Chinese stock market is already the second largest in the world by total market capitalization, ahead of Japan, and only behind the United States.
China nowadays has many large and powerful corporations, making it possible for the country to increase its economic and political influence. That may also translate into higher returns for those who have invested in China.
The world can no longer ignore China. Whether it is manufacturing, finance, trade, energy policy, or geopolitics, the Asian giant will play a major role in the future.
For all these reasons, it is essential to make an analysis of the opportunities and risks involved in investing in China.
How to Invest in China
There are three main ways to invest in Chinese stocks: selecting individual stocks, buying a passive ETF, or investing our money in an active investment fund.
This post will be useful to you regardless of which option you prefer. We will focus on investing in China. You can first decide if you are interested, and then decide how to do it.
However, I will mention a couple of things.
If you want to invest in individual companies, keep in mind that there are different types of shares in China. This means the same company will have different share classes depending on where a stock is listed, in what currency it is traded, and who can invest in it. For additional information on the different share classes in China, visit this link.
Another thing you should keep in mind when analyzing the financial statements of Chinese companies is that accounting regulations differ significantly with those of the West. Therefore, I would suggest caution before comparing Chinese and Western companies.
If you want to passively invest in China through an ETF, you will first need to be familiar with its main stock market indices to decide which one you would like your investment to track. For details on the subject, visit this post:
Chinese Stock Market Indices
Opportunities of Investing in China
Let us start our analysis by discussing the arguments in favor of investing in China and Chinese stocks:
Strong Economic Growth
China has been one of the countries with the highest rate of economic growth for several decades. In fact, those who knew China before the 1980s can attest to the great transformation that has taken place in just four decades.
Between 1980 and the 2020s, China has achieved an average annual growth rate of 9.4%. While it is true that the growth rates of the last decade have ranged between 6-8%, that is still much higher than the growth experienced in both developed countries and most emerging economies.
Hence, investing in China makes it possible to benefit from very high growth rates. A larger economy tends to lead to larger corporate profits. After all, the bigger a country’s economy, the more there will be for both businesses and workers.
First Economic Power of the Future
China is the most populous country in the world with about 1.4 billion people. The logical consequence of pairing such large population with its tremendous economic growth is that China is set to become the first economic superpower.
The following graph shows the historical GDP of the three largest economies on the planet: the United States, China, and Japan:
As we can see, just half a century ago, the Chinese economy was simply negligible. Even a couple of decades ago, it still represented only a fraction of the economies of both the US and Japan.
However, in 2010 China overtook Japan in terms of GDP. Just a decade later, its economy was almost three times that of Japan. And in a few years China is likely to overtake the United States. According to CBRE, an economic analysis center based out of the United Kingdom, the Chinese economy will overtake the US economy by 2028.
Apart from the incredible economic growth experienced by China as a whole, we must also consider which sectors are leading that progress.
China knows very well that topics related to technology, software and advanced manufacturing methods will be key in the future. As a result, the Chinese government incentivizes companies in certain sectors through lower taxes.
One of the consequences of such policies is that, as of 2020, there were more Chinese than US companies among the 500 largest in the world, a list known as Fortune 500. And if we look at the sectors in which these companies operate, we will realize that China is a good position to dominate certain industries in the future.
Keep in mind that technology companies tend to enjoy higher growth rates and commercial margins than companies in more traditional sectors.
Integration with other Asian economies
It is often said that China is highly dependent on exports to the United States and could be severely affected if the trade relationship between the two superpowers is broken in the future.
Frankly, such statements are very misleading. While it is true that China would suffer under such a scenario, the United States receives much more from China than the other way around. The United States receives a lot of goods from China and would be severely affected if that were to change suddenly.
At the same time, China is reorienting its trade priorities. This leads to closer economic ties between China and its neighbors in the Asia-Pacific region.
In November 2020, several countries in the region, including China, Japan, Australia, South Korea, the Philippines, Vietnam, Thailand, New Zealand, Indonesia, and Singapore, signed the Regional Comprehensive Economic Partnership, an agreement to trade freely with each other.
This group of countries accounts for more than 30% of global GDP. A percentage that will increase in the coming decades.
Belt and Road Initiative (Silk Road)
Apart from the agreement signed with its Asia-Pacific neighbors, China is also leading a large-scale project known as the Silk Road, whose official name is the Belt and Road Initiative.
It consists of a massive plan to develop maritime and railway infrastructure. China intends to facilitate and boost its trade relationships with Europe, Africa and the Middle East. The end goal is to rebuild the ancient Silk Road.
This project is extremely ambitious and will serve to strengthen China’s dominant position in global trade. It will ensure access to export markets, as well as the import of necessary resources, such as energy and metals.
Leaving political considerations aside, the Chinese government pursues a pro-growth economic agenda. The objective is to improve the standard of living of the population, in order to advance its more selfish interests.
It is for this reason that China encourages its entrepreneurs, especially in those sectors considered strategic for the economy of the future, facilitates investment, taxes capital income favorably, and considers free trade and infrastructure development as top priorities.
This contrasts with the economic policies that are being promoted in the West, as these are not aimed at boosting economic growth. The West’s priorities are very much ideological and anti-growth.
In this sense, investing in China can make it possible for us to benefit from the greater economic growth that will take place.
While most Western economies face a dire macroeconomic situation, with very high public deficits, record levels of public debt, few or no foreign reserves and, in many cases, large trade deficits, China seems to be in a healthier position.
It is true that many regional governments in China are highly indebted, so the situation is far from ideal. However, China enjoys a very high level of foreign reserves, as well as a gigantic trade surplus.
This surplus has led to a high level of domestic savings, and the accumulation of many foreign assets.
According to the IMF, China is the country with the largest net international investment position. This means that Chinese companies and citizens own far more assets abroad than Chinese assets are owned by foreigners.
The countries behind China are, in order, Japan, Germany and Taiwan. All of these countries have one thing in common: they tend to export a lot more than they import.
By contrast, the United States is by far the country with the worst international investment position. Spain, the United Kingdom and France are other countries with very poor international investment positions.
We have already discussed that China has a very high level of foreign reserves. However, it is worth noting that much of these reserves are in the form of physical gold.
According to Gold Hub, China has been accumulating gold for years. Official data indicate that it has about 2,000 tons of gold. But unofficial data indicate that the true figure could be much higher. For example, China is the largest gold producer in the world.
For those who are interested, according to official data, the United States has about 8,000 tons of gold. However, that figure has not changed for over half a century. And its gold reserves have not been audited since the early 1970s.
Proximity to India
Finally, we must bear in mind that, although China will be the world’s leading economic power by the end of this decade, it will not be so by the end of the 21st century.
All projections indicate that, in 50 or 60 years, India will overtake China as the largest economy in the world. In terms of population size, it is expected that India will be the most populous country before 2030.
The growth experienced by India will create more opportunities to trade and invest. This will translate into higher sales volumes and profits for many Chinese corporations.
Risks of Investing in China
Next, we analyze the biggest risks to consider when investing in China:
One of the things that puts off a lot of international investors is the way regulation and politics work in China. The rules of the game are usually more opaque and less predictable than in Western economies.
Additionally, it is said that many Chinese companies do not have the same standards as Western companies when it comes to preparing their financial statements in a way that accurately reflects reality. This increases the risk of accounting scandals in the future.
In addition, Chinese authorities can change their mind about anything they deem important for the country, without offering any recourse to domestic or foreign investors. And while those situations can happen anywhere, they are more likely to occur in China.
Although China is considered the best emerging economy in some respects, it lacks one of the most important characteristics of an emerging country: a young and growing population.
China already has the demographic profile of a developed country, with an aging and declining population. While the situation is not as dramatic as in Japan or many European countries, China will experience the same fate in the next couple of decades.
This is the consequence of China’s long-standing one-child policy, which prevented many families from having more than one child.
The one-child policy was abolished a few years ago with the aim of boosting the birth rate of the country. But the results have been quite disappointing. Therefore, unless things change dramatically in the future, the working population in China will eventually drop considerably compared to the number of retirees in the country.
This means that the country will have fewer resources to develop and grow its economy, while the burden on public resources increases.
Commercial and Geopolitical Risks
While we have previously commented that China is reducing its commercial dependence on the United States, strengthening economic ties with its Asia-Pacific neighbors, and developing infrastructure to be better connected to Europe, Africa and the Middle East, the truth is that China is not immune to trade or geopolitical conflicts. Especially in the short term.
Investors in China should be aware that geopolitical tensions with countries such as the United States or Taiwan may worsen the economic situation in the future.
While it is important to remain positive, the risks of investing in China from a geopolitical perspective are considerable and can show up in many different forms.
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