China may be complex, but it is impossible to ignore

Likewise, China’s current growth might seem relatively anaemic – the recent stock market rally was short lived, GDP growth has cooled, home prices are falling, consumer sentiment is weak and its population is shrinking. Coupled with concerns over geopolitical risk and regulatory intervention, it is understandable why international investors are sceptical. But below the surface, China’s government and companies are laying the foundations for the next growth phase.

They include the economy’s transition from property and infrastructure to advanced manufacturing. This involves developing capabilities in areas such as semiconductors, robotics and artificial intelligence and is described as ‘high-quality development’. If done well, it will boost China’s long-term productivity and growth, offsetting the shrinkage of its working-age population.

Investing in China, however, is difficult. Of the roughly 8,000 listed China-based companies, only about 600 have made an average return on capital of more than 10 per cent over the last five years. Put differently, more than 90 per cent of the market hasn’t generated enough returns to justify shareholders’ investment over the period.

Why has long-term performance been so poor? In large part because competition is so intense.

This is a market where change is rapid, capital abundant, consumers fickle and competitive advantage fluid. Furthermore, its scale – a population of over 1.4 billion, an extensive manufacturing base and a rising middle class – also makes it highly attractive to copycats.

While Tesla practically had the electric vehicle (EV) market to itself in the US for years, hundreds of rivals proliferated in China from almost the start.

That competition eroded returns, but it also weeded out the weakest players. Those that survived, such as Li Auto, and their suppliers, including battery maker CATL, are now world-class operators capable of thriving on the global stage.

Some still write off China’s EV industry and other emerging sectors because of overcapacity. As we’ve repeatedly seen in the country, when production exceeds demand, prices fall and profits are squeezed or wiped out. This can cause investors to take fright.

However, for technologies that follow Wright’s Law – the rule-of-thumb that says for each doubling in production, the cost of manufacturing each unit decreases by a constant percentage – overcapacity can create the conditions for long-term competitive advantage. In simple terms, the more you make, the more ways you learn to improve the processes involved, allowing you to increase quality and cut unit costs simultaneously.

It’s how Taiwanese chip manufacturer TSMC leapfrogged its American and Japanese counterparts. And it’s a significant factor in why Chinese firms account for 80 per cent of the world’s solar panel production.

‘Overcapacity’ in newly emerging industries is, therefore, a feature, not a bug. It’s a result of deliberate policies by the Chinese government to build a competitive lead in strategic industries. These policies spur innovation, increase output and reduce prices.

Lower prices benefit consumers and accelerate EV adoption. EV penetration in China will probably exceed 40 per cent this year, compared to a global figure of about 10 per cent.

The move to EVs also has other consequences. It reduces reliance on foreign oil. It cuts pollution and increases air quality. And it creates jobs.

No conversation about China is complete without touching on geopolitics. However, it would be misguided to group all concerns under the umbrella term ‘China risk’ and suggest you can avoid it by only investing elsewhere.

The US and China’s economies are tightly integrated and mutually dependent. This increases the cost of conflict, discouraging hostile action.

However, in the medium term, rising trade barriers and firms acting to localise supply chains could accelerate economic decoupling, reducing the deterrent. This would create risks not only for Chinese companies but also businesses selling into China.

Take, for example, what we’re already seeing with semiconductor localisation. China is the largest chip consumer, purchasing more than half the world’s supply, most of which it imports.

In 2015, its government set targets to reduce that reliance. This became more pressing when Washington introduced semiconductor export restrictions against first telecoms specialist Huawei, then chip manufacturer SMIC, and ultimately across China. Covid added further impetus when many semiconductor makers prioritised orders from large western companies over smaller Chinese ones.

China may never bridge the technology gap in leading-edge logic – processors that act as the ‘brains’ of smartphones, computer servers and artificial intelligence hardware. However, most of the volume is in trailing-edge chips.

Chinese firms are set to commoditise power semiconductors, which control and convert electrical voltage in everything from vehicles to industrial systems and power grids. Next, they could seek to manufacture their own analog chips, which handle real-world signals – including sound, heat, and light – in sensors, medical equipment and other devices. These markets are currently dominated by western firms.

The emergence of the Chinese economy has arguably been the greatest economic event since the Industrial Revolution.

Just 25 years ago, the nation accounted for about 3 per cent of the world’s GDP. Today, it’s about 17 per cent, second only to the US. And we expect its rise to continue.

For all the complexities that investing in China brings, as a global investor, you cannot ignore it. It is tightly woven into international supply chains, being the largest trading partner for eight of the world’s 10 largest economies. Its policies have far-reaching implications for global companies and its interests and activities span multiple continents.

I firmly believe you cannot hope to understand the world without understanding China.

Helen Xiong is an investment manager at Baillie Gifford