Will China’s Next ‘Four Modernizations’ Bring Good Fortune?

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China’s Year of the Rooster officially began on 28 January 2017, and investors should be happy to hear this proud creature crow out a new dawn – especially given China’s tough start to the Year of the Monkey in 2016. Fortunately, determined policy makers at the time were able to focus their efforts on continuing reforms and restoring economic growth, which boosted commodities prices globally in the second half.

We believe President Xi Jinping will use 2017 to keep up his reform efforts and project stability as he readies his Five Year Plan for the Communist Party congress in November – but we also wouldn’t be surprised to see a little rooster-like showmanship on China’s "One Belt, One Road" initiative and other prestige projects. President Xi, who is already the most powerful Chinese leader for a generation, is determined to fashion a more modern, dynamic and economically prosperous China than his predecessors did – albeit one that is still under party control.

Four Modernizations 2.0
In fact, Xi’s ambitions for the next five to 10 years could be called the “Four Modernizations 2.0”, after the efforts of former Premier Zhou Enlai to reform China in four key areas: agriculture, science and technology, defence and industry. Today, these same economic lenses can show us where President Xi may focus China’s efforts in the coming years.

1. Agriculture
China’s agriculture industry is woefully undeveloped, and it still employs too many people compared with more prosperous nations: China’s agriculture employment share has come down significantly but is still around 30 per cent, compared with the US at 3 per cent. China must continue moving along this path as it focuses on urbanization, industrialization and higher consumption. Despite its significant economic progress over the last 25 years, China still suffers from huge wealth inequality between its developed coastal provinces and its rural interior regions. Improving water quality and reducing pollution should help China improve farming productivity, and its recent acquisition of a farming chemicals and seeds giant could wring more food from less land.

This strategic transition away from agriculture could also force China to substantially reform its "hukou" system, which markedly limits the ability of China’s people to migrate to where the economic opportunities lie. With noticeable differences in living standards and property prices, China will need to share its future economic success with both urbanites and the rural hukou citizens who have contributed to building the provincial economies.

2. Science and technology
China became a great manufacturing economy in the last 25 years, but it has lagged somewhat in innovation and in research and development (R&D). That is beginning to change, however, as China breaks new ground with social media and the consumerization of its economy. China’s BATs (Baidu, Alibaba and Tencent) are as fast-paced – although arguably not as innovative – as Google, Amazon and Facebook, driving China toward greater economic integration within the region with new financial services such as Alipay. China is also filing more patents than any other nation, creating new global forces in telecommunications and technology, boosting defence R&D and tackling new initiatives in space – although the gap between China and the “best of the west” remains wide for now. Of course, China must invest more in its health-care system and focus on building related skills, since the country still offers lower standards of health care than many others. Nevertheless, Chinese companies are moving away from commodity investments toward higher-tech and R&D-intensive acquisitions – particularly in the agriculture sector.

3. Defense
China has always had a significant army defending the walls to its north, the deserts to its west and the jungles to its south, but for several centuries it has not devoted enough attention to its naval powers. China is now treating its air and sea defences more earnestly – fortifying disputed island territories and expanding its aircraft carrier and submarine fleets – but this is raising geopolitical temperatures in the South China Sea. Many nations – particularly the United States – are concerned about China’s maritime expansion, yet it is not without precedent. After the Civil War, the US expanded its maritime boundaries from the Philippines to Bermuda, which went relatively unremarked at the time, but which now helps China justify its efforts to reclaim its former hegemony.

China’s geopolitical relationships with other nations could also change in other significant ways. The diplomatic myopia of the new US president may enable China to pursue its current geographical expansion undeterred, and to use its "One Belt, One Road" initiative to fill the economic void left by the US. At the same time, an irrational North Korea could create the kind of tension that might force China to respond to external pressures and change its approach to controlling its sea routes. It is also possible that China’s ever-closer relationship with the Philippines could pave the way for the US to withdraw its forces from those islands, which would help China feel less boxed-in on its Pacific side.

4. Industry
China already has some of the world's most significant industrial capabilities, although it does need to reduce its emphasis on past successes such as coal and steel. The country is rapidly moving up the value chain with its expertise in robotics, automation and new technologies such as electric vehicles and EV and hydrogen buses – which are underpinning its “One Belt, One Road” plans. With strong franchises and more engineers being trained than the rest of the world combined, China is seeking to leap several decades of industrial progress in a single bound; along the way, China hopes it can rectify the enormous environmental damage it has wrought over the last 25 years and become more of an innovator than a fast follower. The corporate confidence of the BATs and new mobile-computing technology from Chinese firms should help form a base of accelerated consumption and services, which should help China rebalance even further away from exports and cheap, low-value-added manufacturing.

Key considerations for investors
As we wrote late last year in our annual outlook, we see China as the big investment story of 2017, and our overall optimism continues as China enters the Year of the Rooster. Here are some important factors for investors to keep in mind as they consider investing in this dynamic region:

  • As China urbanizes rapidly, it may require fewer industrial commodities and more oil and softs, which may shift the outlook for commodities.
  • With China rebalancing toward a consumption-based economy, and with reform movements converging in India and Indonesia, this may be the dawn of a new consumer market with 4 billion people.
  • Valid concerns remain over China’s capital position, and President Trump presents a wild card: His policies could hurt trade relations and China’s “One Belt, One Road” policy.
  • Overall, however, China is the biggest contributor to global growth and boasts 18 per cent of total global equity-market capitalization. As China assumes a larger role in major global indices, it should play a larger role in investors’ portfolios.

Key takeaways

  • President Xi is determined to fashion a more modern, dynamic and economically prosperous China than his predecessors did
  • China wants to transition away from agriculture, focus on innovation and retool its industrial capabilities – but its maritime expansion and increased defence spending could raise tensions
  • We view China as the big investment story of 2017; it is the biggest contributor to global growth and should continue playing a larger role in investors’ portfolios Advisor

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Important Information
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.

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