Active Thinking: China – the simmering transformation

GAM Investments’ Jian Shi Cortesi, Investment Director, Asia/China Growth Equities, discusses the simmering transformation of China's economy. She analyses China's pivot to digital and green growth, exemplified by BYD's innovative impact in the electric vehicle sector.

21 August 2024

The MSCI China Index saw lacklustre performance year to date. Volatility picked up recently after the rally in the spring and early summer. The equity risk premium of the Chinese market offers insights into the level of risk priced into valuations. A higher equity risk premium indicates more risk factored in, correlating with lower valuations. Currently, the implied equity risk premium in China is comparable to levels seen during the global financial crisis¹, suggesting the market has accounted for considerable risk already.

Despite enduring a bearish trend for approximately three years, we believe the potential for further decline for China is relatively limited. The market is ripe with latent upside potential; however, the realisation of this potential hinges on the emergence of a catalyst to propel the market upwards. The anticipation is for a trigger that will unlock the inherent value and drive a positive shift in the market trajectory. We believe the market is already simmering, but needs continuous addition of fuel to reach a full boil.

Property market stabilisation

The shadow cast by the Evergrande default has lingered for several years, creating an overhang that continues to affect investor sentiment. Despite the minimal exposure of many Chinese companies to the real estate market, the sector's troubles have broadly impacted perceptions of Chinese equities.

In an effort to stabilise the property market, China has implemented a series of measures over the past two years. These initiatives include reducing mortgage rates to facilitate home buying, relaxing restrictions on home ownership, allowing households in some cities to purchase a second apartment and providing more lenient financing options for developers with robust balance sheets. Additionally, local governments have begun to address housing inventory by purchasing properties from developers to use as social housing, which aids in alleviating excess inventory. The government's ongoing efforts to support the real estate market are yielding incremental positives, though progress appears gradual. The issue remains a common topic among investors when discussing Chinese markets.

However, it is important to differentiate the current situation from the 2008 US financial crisis. The Chinese banking system has shown resilience, with the challenges primarily concentrated among developers rather than stemming from mortgage defaults. The defaulted loans represent a minor portion of the banks' total loan portfolios and are generally secured by significant collateral, providing a safeguard for the financial institutions.

While the property market may not be heading towards a crisis similar to the 2008 meltdown, it is evident that transactions and construction levels are expected to be lower, potentially impacting GDP growth. Nonetheless, the measures implemented have effectively reduced the financial system's risk exposure. The government's strategic actions mentioned above have collectively contributed to the stabilisation efforts. These steps have been incremental, reflecting a cautious yet proactive approach to managing the property market's health and ensuring the stability of the broader financial system.

Transition in the composition of China’s GDP growth

In a previous article, ‘China’s economic revolution beyond stereotypes’, we delved into China’s emergence as a global innovator and economic powerhouse. Echoing insights from KKR’s April 2024 report ‘Thoughts from the road’, we discern a multifaceted shift in China's GDP growth for 2024. Digitalisation emerges as a pivotal force, anticipated to bolster GDP by an estimated 3.3%. The pivot to eco-friendly energy sources, encompassing solar, wind and electric vehicles, is forecasted to yield an additional 1.7%. Meanwhile, consumer spending, notably in the realms of travel and dining, is expected to contribute 0.4%, with other sectors collectively adding another 0.7%. In stark contrast, the real estate domain and its associated industries are currently exerting a 1.4% drag on GDP growth.²

When these elements are combined, the total GDP growth for China in 2024 is estimated to be approximately 4.7%. However, projections for 2025 indicate a potential decrease to 4.5%.³ This anticipated deceleration can be attributed to the 'law of large numbers' which suggests that as the base of the economy grows larger, the rate of growth naturally slows down.

BYD is revolutionising the EV space

BYD stands out as a revolutionary force in the electric vehicle (EV) industry, not only within China but also on a global scale. As the world's largest EV seller by volume⁴, BYD offers a diverse range of vehicles, from basic models starting at USD 9,000 to premium options priced at USD 300,000.⁵ Its product lineup includes both pure electric and hybrid cars, providing consumers with the flexibility to choose according to their preferences.

What sets BYD apart is its commitment to continuous improvement in vehicle quality and performance while simultaneously reducing costs. This year it introduced an innovative hybrid car which can travel up to 2,000 kilometres on a single tank of petrol, equivalent to the distance from New York to Miami, with a starting price of just USD 14,000. This pricing strategy positions BYD's hybrid and pure electric cars as more affordable alternatives to traditional fuel-powered vehicles, which is likely to further drive EV adoption in the Chinese market.

BYD's significant sales volume, with nearly three million EVs sold last year, provides the company with a substantial scale advantage. This scale benefits not only research and development (R&D), particularly in battery technology, but also marketing efforts, allowing for economies of scale that contribute to the affordability of its products. Contrary to the common perception that low labour costs are the primary driver of Chinese products' competitiveness, it is actually the scale of production that plays a more critical role in reducing costs. The scale advantage is a key factor in the affordability of many Chinese products, as it enables companies to deliver at lower costs due to the immense domestic market.

BYD's remarkable 43% increase in sales volume in China last year, at the expense of major competitors like Volkswagen, Toyota, Honda and Changan⁶, underscores the shifting dynamics in the automotive industry. The rise of local brands with technological advantages in EVs is reshaping market shares, particularly in the crucial Chinese car market, which accounts for a third of global car sales annually.⁷ BYD's scale in China not only solidifies its domestic market share but also provides a springboard for international expansion. The company's scale advantage facilitates its entry into export markets, especially in regions without strong domestic car brands, such as Australia, Israel, Russia, the Middle East, Latin America and Southeast Asia.

The simmering transformation

BYD's trajectory in the EV industry is a testament to China's broader policy goals. As common wisdom advises 'don't fight the Fed', a similar approach should be taken with Chinese policies. The government's broader policy is steering away from an overreliance on real estate, a sector that is not viable for indefinite growth, and is instead directing efforts towards the development of clean energy and digitalisation. There is a substantial domestic drive for technological innovation, particularly in digitalisation, artificial intelligence and autonomous driving, all of which are strongly supported by the government.

Although it is difficult to predict an exact timeline for the transformation underway in China, we believe it is building a foundation for future economic growth, and the impact will manifest in the coming years.

Jian Shi Cortesi manages China and Asia equity strategies at GAM.