A bear in a China shop? Four threats to China's economic rise

Meeting fund managers is an important part of our analysis. But to broaden our research and view of the world, we also attend investment conferences and talks by high-profile economists, strategists and other commentators.

Last month, we went to an event hosted by George Magnus. He's most widely known for predicting the US sub-prime mortgage crisis would trigger a global economic recession (which, as we know, followed in 2008 – the hangover of which continues to this day).

He's still closely followed for his views on the global economy. But he also has a keen interest in China and has researched the world's second-largest economy for many years. This was the focus of his latest talk, specifically the potential threats to its economic rise.

This article is not personal advice. We may not share the views of George Magnus. If unsure, please seek advice. All investments fall and rise in value, so you could get back less than you invest.

China's four red flags

Magnus believes there are four traps China must confront and overcome in order to thrive:

1. Debt – China's reliance on debt is huge. It's not unusual for governments to borrow and create debt in order to finance its growth. But China's appetite for debt has become almost insatiable, especially as it tries to maintain the enviable levels of economic growth it's become accustomed to.

   The worry is this debt pile is simply unsustainable. China needs to wean itself off borrowed money otherwise it's at risk of a full-blown financial crisis. This could ultimately lead to lower rates of economic growth, though this isn't wholly unusual for economies going through a period of maturity.

   It's a fairly commonly held view that China will one day succumb to a banking crisis, but this could be years ahead. Magnus doesn’t think it's in imminent risk of collapse. China's central bank is known for implementing policies to help support its banks and stabilise the economy, and this is unlikely to change in the near term.

2. Middle income – As countries develop and incomes rise, many gradually grow out of poverty. But some fall into what's known as the middle income trap. This has tended to happen once a country has exhausted the potential from lower-value activities, such as exports and industrialisation, but its wages stagnated and it struggled to prosper further.

   Outside of the UK, US and Japan, few economies have transitioned to high-income status (Hong Kong and Singapore are a couple of the more recent exceptions). China needs to work hard not to lapse at this hurdle.

3. Currency – Earlier this year, China allowed its currency, the renminbi, to fall below the symbolic level of seven to the dollar. While it now sits just above this level, the move was seen as a retaliation against the latest round of US tariff threats. It wasn't the first time China has been accused of manipulating its currency in order to improve its competitiveness.

   A weaker currency could help boost China's economy by making its exports cheaper for, and more attractive to, overseas buyers. That said, this is offset to a degree by the higher price paid for imported goods.

   Magnus thinks it's important for China to maintain at least some stability in its currency. This could help to avoid significant capital outflows and a debt crisis (a weaker currency makes it more expensive to pay off foreign debts, for example), and to help rebalance the economy from one reliant on exports to consumption. China risks stunting its growth potential if its currency devalues too far.

4. Ageing population – This isn't a problem exclusive to China. But its population is ageing rapidly, and quicker than some other economies. Its birth rate also remains relatively low, even though its one-child policy was removed in 2016.

   Over time an ageing population will become more reliant on things such as welfare, social care and medical treatment. But as the younger, working age population shrinks, there are fewer people to help fund these services. This issue is exacerbated in countries such as China, where incomes per head tend to be lower than developed economies.

Our view

Like all economies, large or small, developed or emerging, China has challenges to deal with. Its old economic model – one that focused on low-value manufacturing – has run its course. China must now look forward to its new model, focused on high-value technology and domestic consumption, in order to succeed.

China is also undergoing significant reform. It's focused on improving governance and, while it has historically been difficult for businesses to operate there and for foreigners to invest in its markets, things are changing.

China's markets have evolved significantly over the years and, importantly for investors, this includes both the quantity and quality of companies based there. Its markets are almost too big to overlook, especially if the country continues to prosper, make investor-friendly reform and improve corporate governance.

We think there's a lot of potential in China. In our view, a good place to start for those looking to dip a toe in the water is a broader Asian or emerging markets fund – our favourites can be found on the Wealth 50. That said, China still has a long way to go and investors should be aware it’s a high-risk place to invest, especially as periods of economic and political instability are likely to persist.