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China
New rules add risk, but China still offers rewards

“It doesn’t matter if a cat is black or white,” China’s former paramount leader Deng Xiaoping once said of his country’s economic system. “As long as it catches mice.”


In the decades since, China has indeed caught many mice. Its economy has grown by leaps and bounds since Deng spearheaded efforts to open its doors to the rest of the world. Its rapid modernization nurtured some of the world’s largest companies, such as Alibaba, Huawei, Tencent and Ping An. China has also been a boon for the investors and businesses that have benefited from inexpensive labor, massive consumer markets and the impressive share-price growth of some of China’s homegrown companies.


However, China is still its own country. It may have embraced some aspects of capitalism — private enterprise is as much a byword there as it is in the West — but it has not adopted the sometimes-complicated pluralism of liberalized representative government. The Chinese Communist Party has sole control over the apparatus of the state, and it isn’t afraid to flex its muscles on social and economic issues.


That resolve has been on display in recent months. In February, President Xi Jinping announced that China had succeeded in ending extreme poverty and would pivot to addressing wealth inequality. The subsequent waves of new rules have been wide ranging, including strict limits on the consumer data that companies can gather and restrictions on how often minors can play online games. 


Some of the regulations have specifically targeted industries and even companies with crushing precision. Mobile storefronts were ordered to drop apps produced by ride-hailing giant DiDi. Large-scale cryptocurrency miners were forcibly shut down. The private-tutoring industry was essentially shuttered.


This chart summarizes some of the key regulatory events in China this year. On Feb. 23, President Xi Jinping announced that China had eradicated extreme poverty (defined as income of $620 or less a year). On June 30, Ride-hailing company DiDi filed an initial public offering on the New York Stock Exchange in defiance of government guidance. On July 2, China orders DiDi to stop signing up new customers. On July 23, for-profit tutoring for core school subjects is banned. On Aug. 17, Xi reiterates China's dedication to "common prosperity." On Aug. 20, the Personal Information Protection Law, which limits data gathering by companies, is passed. On Aug. 30, minors are limited to three hours a week of online games. On Sept. 8, online tutoring is banned.

“An associate of mine quipped that we now know the color of the cat,” says equity portfolio manager Steve Watson. “The cat is red.”


Foreign investors have taken note. In August, their share of ownership in domestic Chinese companies was at its lowest point since 2014. It’s an understandable response — why invest in China when the government can upend a company or even a whole industry? Compounding the issue have been recent worries around deep leveraging by some Chinese companies, as highlighted by the plight of real estate development firm Evergrande.


Those fears are already reflected in Chinese share prices.


“There’s a very high risk premium for China,” says equity analyst Ben Lin. “Capital markets don’t like uncertainty and chaos, as they’re very difficult to price. That’s weighed on the entire market, even those stocks not in the direct line of fire of the regulations.”


Some such high-level considerations are only a starting place for investors. Despite its unique blend of risks, China also comes with tantalizing opportunities — rapid economic growth, a strong industrial base and a massive and growing consumer class that’s hungry for modern luxuries and conveniences.


Additionally, regulation has not been evenly applied, with some industries and companies seemingly out of the government’s crosshairs. And while old economic ties have been taxed by political squabbles and the COVID-19 pandemic, China is still deeply enmeshed in the world economy — it needs foreign capital as deeply as other countries need its manufacturing capacity and inexpensive labor. The bottom line is that China still offers great promise for investors. But understanding and parsing these risks and opportunities requires thorough, on-the-ground research.


“What Capital’s analysts and portfolio managers do in China as investors is what we do everywhere else. We don’t invest based solely on a nation’s characteristics or an industry’s characteristics; we talk to companies, we analyze the numbers and we build a vision of the company’s future,” Watson says.


The new regulations are sweeping but not universal.


This new emphasis on reducing income inequality has focused on a few areas. Xi has cited the “three mountains” of health care, education and housing costs. That second peak offered the justification for dismantling the private-tutor industry.


“The government’s argument is that if you hire teachers out of schools as private tutors, that just lessens educational opportunity for the poor,” Watson explains.


Additionally, the government has focused more of its regulatory energy on “soft” industries that lack a physical end product, such as cryptocurrency mining and online services. China wants to shift away from an export economy, utilizing its industrial capacity to produce specialized technical items and address growing domestic demand, says Lin, who covers Asian insurers and the machinery, construction, engineering and electrical equipment sectors in Asia.


Chinese exports are a critical part of the global economy


This chart compares various countries and political units by the value of their merchandise exports in 2020, in U.S. dollars. China is a critical part of the global economy, having exported goods worth $2.59 trillion — more than any other entity. The European Union exported $2.21 trillion and the U.S. exported $1.43 trillion. Japan, Hong Kong (as a portion of China), South Korea, Mexico and the United Kingdom each exported less than than $1 trillion worth of goods. Source: Statista. European Union export figure did not include intrabloc trade. As of July 2021.
Source: Statista. European Union figures do not include intrabloc trade. As of July 2021.

“I think we’re at a juncture where the Chinese leadership wants to avoid the middle-income trap,” he adds. “Going forward, they’re going to want a strong domestic economy that’s more driven by domestic consumption. And they want to move further into high-end, high-tech manufacturing.”


That’s been matched by Chinese efforts to insulate themselves from international sanctions. The Trump administration’s ban on Huawei was instructive, Lin says, because it demonstrated that China may not always have access to some markets — meaning it would need to create more of its own critical technology.


“There is a conscious effort to develop domestic champions that could replace the foreign imports that China relies on,” Lin explains. “Components and semiconductors are an example, but it goes beyond that. They want to make more than a semiconductor — they want to make the whole machine.” 


Similarly, China will likely want to beef up industries in which it’s already a world leader, like solar panels, he adds. “There’s a huge focus now on electric vehicles, batteries, solar and the like. They recognize that the world wants to be more green, and whoever can produce the most green products is going to dominate that space.”


Add all that up, Lin says, and it appears that China’s likely to pour resources into its industrial capacity rather than restrict it with new rules. And tapping into China’s domestic demand could help pave the road for broad, long-term growth for the country’s high-end manufacturers.


Even some industries among the “three mountains” could avoid further scrutiny.


Not every company in the health care, education or housing fields will necessarily be targeted, says Emily Chen, a China industry specialist.


“In the health care service sector, hospitals are dominated by government-backed public institutions. Private providers serve as supplementary roles, so they’re not the priority for regulatory actions,” she explains.


That could be true for drug companies, as well. “The pharma and biotech industries have gone through some drastic regulatory reforms since 2015,” Chen adds. “That resulted in cheaper and better-quality generic drugs. I think the public is happier with those outcomes, and another regulatory crackdown is unlikely.”


Pharmaceuticals could also benefit from the same trade winds supporting technology and manufacturing, such as economic growth and self-sufficiency. They also get a boost from another significant factor: demographics. The world is growing older, and that’s driving demand for all manner of drugs, treatments and medical devices. That trend is especially acute in China, where the median age has doubled in the last 50 years.


China’s already seeing success in the biopharmaceutical field, for example: Beijing-based BeiGene, founded in 2010, has already developed several anti-cancer treatments, and it has several more drugs in its testing pipeline.


Social stability appears to be a significant factor behind the new rules.


Some commenters have suggested that the justifications for these regulatory actions are simply a fig leaf for the Chinese government’s true aim: knocking big companies down a peg. DiDi, for example, was targeted ostensibly on data-privacy grounds, but many China watchers noted that it had launched an initial public offering on the New York Stock Exchange months earlier, in defiance of government guidance.


Whether or not there is truth to that claim, Watson says the broader sweep of the actions seems to spring from a genuine regulatory concern.


“I’ve spoken to many of our associates in China, and they don’t believe that these actions are simply about control or an anti-business sentiment,” he says. “There is a true concern by many officials that these companies are operating in a way that doesn’t benefit the masses, that the government is trying to ensure social stability.”


China still needs foreign capital, and it’s still deeply enmeshed in the world economy.


The last few years have posed many tests for the globally interconnected economy. There’s the damage that the COVID-19 pandemic has wrought on supply chains. Before the outbreak, China was trading blows with the U.S. and other countries over trade, with countries instituting protectionist policies targeting electronics, steel, soybeans, beef and even wine.


“The relationship with China has been fundamentally altered,” Watson explains. “We’re no longer in the happy clappy Deng Xiaoping phase, where our companies were invited to teach China how to do things. Today, China’s saying, ‘We’re going to do things our way. If you don’t sell us technology, we’ll make our own.’”


However, the global economy did not spring into life overnight and much of the progress over the past several decades is likely to remain in place. It’s not as though any nation can flip a switch and disentangle itself from the deep supply chains that run in and out of China. “Most of the goods the rest of the world consumes come from China,” Lin says. “It took 30 years for China to become a global factory, and it would take other countries at least as long to reclaim that production capacity.”


And the drivers that created today’s conditions are still going strong. Western countries still want inexpensive goods, and China is still a developing economy, even with its billionaires. By per capita GDP, it still ranks closer to Cuba or Malaysia than to Japan or the U.S.


“China still needs us for a lot of things. They need us for capital. They need us as a market for their goods. They need us to educate their kids. They need us for all kinds of expertise in many in many domains,” Watson says. “And this may be a bold statement, but what Fortune 500 company CEO doesn’t want to do more business in China? We’re still deeply intertwined, and I’m cautiously optimistic that we can continue to work together.”



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