What investors should know about China’s evolving economy

China’s rebalancing away from investment and exports and toward consumer consumption has important implications for investors.

A closer look at rebalancing

Historically, sustaining growth is difficult for emerging markets as their populations move into the middle class—introducing economic risk. Rebalancing the economy can help.

“Success on this front should help reduce the risk of an economic crisis (by lowering the reliance on debt-related investment), address global concerns of China’s large merchandise trade surpluses, and also improve the prospects of maintaining long-term sustainable growth,” says BMO senior economist Art Woo in a weekly financial digest.

Another plus to rebalancing is that China’s growth model—as led by investment and exports—has been considered a key contributor to global imbalances, including the large U.S. current account deficit.

Read: How U.S.-China trade uncertainty could affect markets

Increasing China’s domestic consumption-to-GDP ratio won’t be a quick and easy process, however. In 2016 the ratio was about 54%.

“Rapidly shifting the trajectory of either [China’s] consumption or investment (to developed-market levels) is unrealistic as the factors underlying these trends are deep-rooted and ultimately require an extended period of adjustment,” says Woo.

Increasing the consumption ratio through a lowered household savings rate is especially challenging, he says, since associated structural factors are legion, including demographics, healthcare, job security and labour’s share of national income.

For instance, a fundamental driver of disposable income is the wage share of GDP, and for China, that share is significantly below that of developed markets. “While it seems reasonable to assume that wages will continue to take up a larger share of national income as demand for skilled labour intensifies, this process is likely to be gradual,” says Woo.

Another structural factor is the one-child policy, which ended in 2016 but will have lingering effects. For example, the policy entices households to save more since there are fewer children to provide support to elderly parents.

Woo says lowering the investment ratio should be easier, since the country is a centrally planned economy with vast powers at its disposal. But that’s changing as China becomes increasingly privately driven and decentralized. And he warns that stifling investment too heavily would hamper growth, which in turn would impede China from becoming a high-income economy.

As it stands, China’s moderization will continue to be based on urbanization and industrialization. “Beijing recognizes that the economy needs to become more productive to offset the negative effects of its rapidly aging population (i.e., rising old-age dependency ratio) and, in turn, prevent both de-industrialization and long-term growth prospects from falling too quickly,” says Woo.

To do that, China has a long-term mandate to increase domestic content of core components and materials that it produces in certain sectors—to 40% by 2020 and to 70% by 2025. As a result, “Merchandise imports excluding crude oil, measured as a share of GDP, have shrunk quite sharply in recent years (12.1% in 2017 versus 20% in 2007),” says Woo.

Longer-term considerations for investors

For investors, there will likely by opportunities as China’s domestic services sector and IT industry grow. Likewise, expect challenges as China experiences economical growing pains. For example, there will likely be a shift in demand for global goods—particularly natural resources, says Woo, and increasing overseas competition from Chinese companies.

Investing in the short term

In its latest global market outlook report, Russell Investments says it remains constructive on Asia Pacific, and it sees “no sign that this view needs to be moderated. The tailwinds of global growth and an expanding middle class in the region are outpacing concerns around high debt levels, notably in China.”

Read: Country of the month: South Korea

Though protectionism is a risk, the firm’s base case is that “we will not see a full-blown trade war.”

Russell Investments also notes that the Chinese government’s 2018 GDP target is a strong 6.5%. “Our reading is that they are anticipating further pickup in private activity, which provides them with the opportunity to rein in the deficit,” says the firm. More broadly, “activity in China has continued to be impressive.”

Read: Country of the month: China

For sustainable growth, the firm says greater supply-side reform is needed. “We have yet to see many signs of this, but the consolidation of power that has been seen should provide the opportunity.”

In weekly global market commentary, BlackRock’s global chief investment strategist Richard Turnill indicates he’s overweight Asia ex-Japan over a three-month horizon, based on the region’s encouraging economic backdrop. “China’s growth and corporate earnings appear solid in the near term,” he says. “We like selected Southeast Asian markets but recognize a faster-than-expected Chinese slowdown would pose risks to the entire region.”

For example, February economic measures (PMIs) “implied some weakening in the domestic manufacturing sector and stabilizing local growth momentum. […] Another month of falling input and output prices would suggest further slowing in PPI [producer price index] inflation, a negative for industrial profits,” he says. PMI data is next released on Mar. 31.

Read the full reports from BMO, Russell Investments and BlackRock.