A Year in Review and What to Expect in 2023
The year 2022 was a roller coaster ride for those living or doing business in China. Having started out in a way reminiscent of 2021, in the course of fewer than 12 months China witnessed enhanced anti-COVID lockdowns across dozens of major cities, including Shanghai, the convening of the 20th Congress of the Communist Party of China (the “20th Party Congress”) which saw General Secretary Xi Jinping elected to a third five-year term, the rapid easing of anti-COVID regulations starting from late November, a major government conference on macroeconomic policies showing signs of economic liberalization, and complete access to working papers relating to China-based US listed companies by the Public Company Accounting Oversight Board (PCAOB) by December.
All of these happened at such a neck breaking pace that China watchers can be forgiven for feeling dazzled at first sight. This piece seeks to explain some of the underlying macroeconomic and political underpinnings and implications of such developments and to offer a few pointers about what to expect in future.
Fundamentals: How “Macro with Chinese Characteristics” Differs from “General Macroeconomics”
Macroeconomics ( “Macro” for short) is usually taken to mean the use of fiscal and monetary tools by governments to affect society’s economic performances. Depending on the size of the government’s role in a society, macroeconomic policies can have greater or lesser implications in any given society. In China, “macro” means not only fiscal and monetary policy tools, but a whole host of tools, often political in nature and often not available to western governments. These include the banning or shutting down of an entire sector, such as cryptocurrency or private academic tutoring, or aggressive intervention in others, such as the dampening of the real estate market in recent years through imposition of strict limitation on mortgage borrowings. Thus, compared to western economics, to understand the trends of the Chinese economy, one must pay even greater attention to government policy initiatives.
In the past decades, western China watchers have often regarded the Chinese system as “state capitalism”. This is a misnomer. The Chinese system is, and has always been regarded by its government as a socialist system where the driving force behind economic growth is state policies as implemented by the state and the state owned sectors. This basic premise was embodied in China’s “Four Cardinal Principles”, announced by Deng Xiaoping at the beginning of the Reform and Opening Movement in March 1979. 1The Four Cardinal Principles, together with the Reform and Opening Up principle, constitutes the Two Basic Points of Deng Xiaoping Theory and thus it is the state’s primary role coupled with reform and opening up that form the foundations of contemporary Chinese politics and macroeconomics. It would thus be critically wrong to try to understand Chinese economic development without first understanding the CPC’s foundational role in it, and it would not be possible to see where the future lays without first trying to understand what the CPC’s stated goal is regarding the future. Given the CPC has just concluded its 20th Congress this fall, this provides an excellent opportunity for observers to understand the CPC’s vision for the future, which should be the starting point of all China macro analysis.
Keywords from the 20th Congress – “High-Quality Development”
If there is one key takeaway from the 20th Congress it would be the Congress’ emphasis on “high-quality development” (高质量发展). While not made explicit in the Congress’ political report, high-quality development reminds one of “Made in China 2025”, an earlier initiative released by the Chinese government in 2015 to rapidly develop advanced manufacturing capabilities in ten high technology industries. These ten industries are: information technology, robotics, green energy, aerospace technology, ocean engineering and high end shipbuilding, railway, power, new materials, healthcare and life sciences, and agricultural technology. By pursuing high quality growth, the Chinese government will encourage innovation and R&D in these high tech sectors. This will be in contrast to the old growth model, followed between 1979 and present, which could be termed “export-led growth”, where China has provided low cost labor and functions as a “workshop of the world”. The contrast could not have been sharper. Under the new model, the focus will be on the development of domestic intellectual property, and the mode of production will be capital and human capital intensive, whereas under the original model, intellectual property would be provided by firms from advanced economies through licensing, and the mode of production would be labor intensive. The CPC is pursuing high-quality development in part to make China more self-sustaining in terms of high technologies, but also in part as a reaction to the population growth slowdown seen in recent years.
Given that high tech sectors will require time to develop, the immediate implication of this move away from export-led growth would be a gradual dampening of international trade between China and the advanced economies. The 20th Congress’ political report thus referred to the “positive interplay between domestic and international economic flows”. In the original Chinese text, this literally means “dual (trade) cycles” （双循环）, with a domestic trade cycle within China and an international trade cycle between China and the outside world. It is clear that careful cultivation of domestic demand would replace a portion of foreign demands （以内循环为主）. This will require the government to take positive measures to stimulate domestic demands, and likely provides one key explanation as to why the government, after so many months of stringent anti-COVID measures has lifted many restrictions in recent weeks.
Impact: “High-Quality Deal Making” on the Rise and Domestic Markets Stimulated
To facilitate “high-quality development”, the government will encourage both domestic R&D activities in the above-mentioned select sectors, such as advanced manufacturing, telecommunications, and military related industries, and the overseas acquisition of target businesses and intellectual properties in these sectors by Chinese buyers. We thus expect to witness increasing attempts by Chinese buyers to acquire targets and assets in these sectors. Such endeavors however will be subject to the national security review regime of advanced economies, which have been strengthened in recent months. Nations that previously did not have CFIUS-like regimes have now either adopted similar regimes (e.g., the United Kingdom) or are in the process of adopting them (e.g., the Netherlands). We therefore anticipate increased hurdles for Chinese companies to acquire targets in these advanced sectors. However, given the CPC’s determination, we do not think enhanced regulatory scrutiny will necessarily stop or even dampen Chinese buyers’ enthusiasm in the space. The recent easing of COVID-related travel restrictions will help Chinese potential buyers as they are now freer to travel to other countries to conduct due diligence investigations and engage in face-to-face communications with their foreign counterparts. We expect to see increased outbound M&A activities from China over the next 12-18 months.
Similarly, the Chinese government will further open up domestic markets for foreign businesses to acquire footholds, with the hope that these foreign businesses will import some of their advanced technologies into China. The Congress’ political report specifically stated that the CPC “will make appropriate reductions to the negative list for foreign investment, protect the rights and interests of foreign investors in accordance with the law, and foster a world-class business environment that is market-oriented, law-based, and internationalized.” We have witnessed on multiple occasions the eagerness of provincial and municipal governments in attracting foreign investments. Such an opening up initiative however runs counter to recent trends among western governments to apply more stringent controls over the export of technology into China, and we expect more legal and regulatory problems may appear for multinationals setting up businesses or conducting foreign direct investments in China. Depending on different assessments of the geopolitical risks posed by China, different multinationals may reach different conclusions about whether to take advantage of the Chinese government’s FDI drive. Some may move away from having a physical presence within China and turn to a franchise-based model where they will license local Chinese businesses to continue their brand’s presence in the country. Others may still wish to take advantage of the Chinese government’s increasingly encouraging attitude towards international businesses. They may benefit from certain Chinese business owners’ desire to geographically diversify their investment portfolios.
In other words, for both outbound and inbound acquisitions, we envisage an increase in “high-quality deal making”, i.e., M&A and other deal making activities involving businesses and assets relating to the advanced technology sectors regarded by the CPC as “high-quality” sectors.
Separately, to stimulate domestic demands and reduce the nation’s reliance on export-led growth, the government will need to restore the Chinese population’s faith in the economy. In order to do this, the government held the Central Economic Work Conference (中央经济工作会议) on December 15 -16 during which it explicitly recognized e-commerce platforms as an important core component of the economy and pledged to support the continuing development of the real estate sector. These were sectors that had previously been subject to government criticism or disfavor, and the government’s now positive attitude about them demonstrate its desire to create a more liberal economic environment for its domestic audience. This is intended to restore the public’s faith in the domestic economy and help stimulate domestic spending. Coupled with the continuing reduction of the negative list for foreign investments, we think e-commerce, TMT more generally, and real estate will remain important sectors for foreign investors to look at.
Renewed Pledge of ESG
“High-quality development” also means economic development that does not come with environmental degradation or other externalities. A growth model based on “export-led growth” often comes with externalities. The labor-intensive nature of export-led growth often leads to workplace hazards, workers being under-compensated, and worker abuse problems. The low(er) tech nature of mass manufacturing activities in turn contributed to air, water and land pollution. Corruption is also a side product. Within this context “high-quality development” can also mean development with an emphasis on “environment, sustainability and governance.” This is in line with the CPC’s basic policy initiatives since Xi Jinping was elected general secretary in 2012. With the 20th Congress’ political report making the same emphases, we can safely assume that regular features over the last decade, such as periodic anti-corruption drives, will be here to stay as a regular feature in the long term. While it will be applied across the board, business sectors that are not within the favored “high-quality sectors”, like traditional manufacturing, will likely bear the brunt. Similarly, the government will encourage domestic and cross-border investments in sectors such as new materials, renewable energy and advanced manufacturing, leading to more deal flow in these sectors. One key feature to note is that as part of the discussion about China’s further opening up, the Congress’ political report specifically singled out the “Belt and Road Initiative” as a success story. We can therefore expect to see more investments in the “high-quality development” and “ESG” sectors along the Silk Road Economic Belt and Maritime Silk Road, including the renewable energy, telecommunications and power infrastructure, railway and transportation infrastructure sectors. The purpose will be to encourage “high-quality interaction” between China and countries along the Belt and Road Initiative, allowing some degree of spillover of China’s “high-quality development” into these societies.
The Future of Chinese Companies in Overseas Capital Markets
On December 16, the PCAOB confirmed that it has been granted full access to Chinese auditors’ work papers relating to Chinese businesses listed on the US stock markets. This is a critical development, as such a move allows Chinese companies listed in the US to avoid mandatory delisting due to the PCAOB not having access to the work papers. Allowing Chinese companies to stay listed in the US puts a break on the decoupling between the two nations and will have a stabilizing impact from a geopolitical perspective. It also enables Chinese companies in the technology sectors to continue to draw on US capital for future growth. The latter is an important feature due to the lack of a comparable, deep bench of institutional investors experienced in value investing in the technology space in Asia compared to the US. The Chinese regulators’ accommodation of the PCAOB can be seen also as a move to safeguard the 20th Congress’ stated goal of “high-quality development”. With Chinese companies tapping into the US stock markets now becoming a continuing reality, we expect to see US institutional investors returning to Chinese target companies for their investments. We also anticipate a rebound in US IPOs by Chinese issuers as well as M&A activities by such companies.
1 The Four Cardinal Principles are: (1) socialist path; (2) people’s democratic dictatorship; (3) leadership of the Communist Party of China (CPC); and (4) Marxism-Leninism Mao Zedong Thought.