«China will give preference to high quality growth»

Alex Zhang advises numerous global firms and family offices on investing in China. He was a participant in the 2016 edition of Young Chinese Leaders program and is a member, since 2019, of the Chinese Society of Friends of Spain.

We talk with him about China´s econimic outlook for 2022 and which areas should be of particular attention to foreign investors. An analysis of China´s strengths, weaknesses and risks in a year that will be key to its future.

Question: What’s your general forecast for the Chinese economy in 2022? The latest 5-Year Plan does not provide a specific growth target, but it does provide several clues or hints that can be illustrative of what the government thinks. Which sectors will lead the way?

Answer: Before diving into specific sectors, I’d like to first touch on the broader economic thinking at play in the 14th Five-Year Plan. Let’s consider the Plan’s full title, which includes “Long-Range Objectives for 2035,” a notable divergence from past Five-Year Plans in the considerable widening of its mandate beyond a typical five-year term (2021–2025). No previous Five-Year Plan has done this. The policies outlined in the Plan reflect a fundamental shift in thinking amongst China’s senior leaders, and a long-term restructuring of China’s economy. And despite continuing uncertainties around U.S.-China relations, an aging population, an unabating pandemic, and the upcoming and highly eventful 20th National Congress later in 2022, it’s important to understand just how ambitious this Plan really is.

The absence of an annual GDP growth target speaks to one of these changes in thinking. It has been argued that by setting annual GDP growth targets, you essentially transform growth into “economic input” (i.e. unproductive stimulus, cyclical capital distribution, aggressive lending) rather than a measure of economic output, which is much more meaningful. The Plan explicitly cautions against growth for growth’s sake, and instead gives preference to “high quality growth,” or what leading China economist Cui Zhiyuan of Tsinghua University would call, “inclusive growth.” The mechanics of high quality and inclusive growth are fundamental to understanding Xi Jinping’s “Common Prosperity” and “Dual Circulation,” two overlapping concepts that permeate the Plan and work hand in glove.

Common Prosperity, the broader of the two concepts, aims to redistribute and grow social and state wealth while decisively restructuring China’s supply and demand spheres to achieve this goal. Dual Circulation emphasizes both growing exports (international circulation) and expanding domestic demand, powered mainly by stimulating consumption (internal circulation), with the two reinforcing each other. Make no mistake, the Plan’s absence of a GDP growth target coupled with its many appeals for socio-economic equality disguise a deeply aggressive short and long-term vision for economic growth.

Let’s begin with how the Plan manages domestic demand and then move on to how it restructures the supply-side to meet demand. The Plan provides concrete targets aimed at improving living standards including keeping urban unemployment rate below 5.5%, requiring that growth of per capita disposable income must be synchronized with growth of GDP (I will discuss later why this is incredibly significant), increasing average years of education of the working-age population to 11.3 years and higher education gross enrollment rate increased to 60%. Other hard commitments include increasing basic elderly insurance coverage to 95%, increasing average life expectancy by 1 year (as of 2021, China’s average life expectancy is 77.13 years), certified assistant doctors up to 3.2 per 1,000 population, nursery school openings for infants under 3 years up to 4.5 per 1,000 population, and a call to further reform the minimum wage system (China does not currently set a national minimum wage).

Together with inclusive urbanization policies, and stronger protection for small to medium size businesses, these initiatives fundamentally reshape China’s demand-side by reducing the need for precautionary saving, and opening up China’s already very high household disposable income to more meaningful contribution to domestic consumption (the PRC’s gross domestic saving rate remains a world outlier at 45.7% of GDP in 2020). Expanding domestic demand is an essential component of the Plan, and critical to Dual Circulation.

But even more noteworthy is the Plan’s commitment that per capita GDP by 2035 “will reach the level of the middle ranks of developed countries.” Most economists would not consider a country developed unless its per capita GDP is above $25,000 or $30,000. For example, the U.S. per capita GDP in 2021 was $56,200, Germany was $43,800, Spain $32,000, Japan $35,200, and Korea $27,490. China’s per capita GDP in 2021 is only $10,500. To fulfill this commitment by 2035, China would need to at least double its GDP, which requires continuous annual GDP growth averaging 4.7% over the coming 15 years. Speaking most recently at the 2021 China Economic Forum, former Vice-Chair of the National People’s Congress Financial and Economic Affairs Committee and Vice Chairman of the China Center for International Economic Exchanges, Huang Qifan provided a similar prescription, advising that China would need to maintain an annual GDP growth of no less than 5% through 2035.

This is essentially the first time a Five-Year Plan communicates a robust GDP growth target (doubling by 2035) expressed indirectly as growth in per capita GDP, highlighting a new emphasis by senior leaders on the actual purchasing power of individual households. Read together with the above strategies to unlock domestic consumption, an incredibly bullish vision comes into focus.

Now for the Plan’s supply-side strategy, which deals more directly with your question. As early as 2016, Xi Jinping had studied supply-side economics through the writings of Arthur Laffer and Jean-Baptiste Say, and subsequently concluded that stimulating supply does not create its own demand, nor can demand management itself boost supply. He wrote in January 18, 2016, “China is not short of demand, but the supply of quality products and services fails to keep up with changing demand. Inadequate effective supply has caused spillover in demand and a severe outflow of consumption.” The Plan addresses this issue of current supply not meeting latent demand by explicitly listing (almost exhaustively) growth sectors of strategic importance. While the Plan actively expands domestic demand, it also aggressively restructures China’s supply-side landscape to meet this new demand. I would like to highlight supply-side sectors I view as critical for a foreign investor to consider:

Carbon Neutrality

The first one is more thematic than a sector – carbon neutrality. China has pledged very early on to be carbon neutral by 2060, and in the Plan we see energy consumption and CO2 emissions per unit of GDP will be reduced by 13.5% and 18% respectively by 2025, with peak carbon emissions set firmly at 2030. This will result in more ambitious short-term initiatives in clean energy and decarbonization.

China’s energy sector accounts for almost 90% of domestic greenhouse gas emissions. China’s energy consumption has doubled since 2005, but its energy intensity of gross domestic product has decreased significantly in the same period. While coal accounts for over 60% of China’s power generation, and new coal power plants continue to be built, but increase in solar photovoltaics capacity have outpaced those of any other country. China is the second largest consumer of oil in the world, but also houses 70% of global manufacturing capacity for electric vehicle batteries, with the Jiangsu province alone accounting for one-third of the country’s capacity.

To truly achieve a 2030 peak in carbon emissions, China will need to dramatically overhaul its energy sector and aggressively accelerate various emerging technologies to market. You can expect room for growth and investment in areas of renewable energy, power storage, new materials, traditional industry decarbonization, digitization, automation, new energy vehicles, incursions into hydrogen power, and adjacent businesses that support administration, operations, digitization, distribution and transactional settlements. Investors in this space will feel enormous tailwinds from China’s state-owned enterprise (SOE) sector.

Established in July 2020, the National Green Development Fund is the first national level green-focused investment fund backed by the Ministry of Finance, the Ministry of Ecology and Environment, Shanghai municipality, and various other state-owned enterprises. Capitalized at $13.8 billion (88.5 billion RMB), the fund is set to invest in areas such as environmental protection and pollution prevention, ecological restoration, energy resource conservation and utilization, green transportation, and renewable energy. There are currently 14 new carbon neutrality themed private equity funds undergoing approval review at the Asset Management Association of China (AMAC). This adds onto the already 40 registered private equity funds engaged in this space, of which 16 are specifically focused on traditional industry decarbonization.

You can also expect local governments and SOEs to take their own initiative to out-compete other administrative regions. China’s industrial sector is a major contributor to CO2 emissions due to the sector’s high energy intensity, the large share of fossil fuels (mostly coal) in energy use and the relatively long operational lifetimes of factories and heavy industrial equipment. Of the roughly 50 gigatons of cumulative emissions from China’s industrial sector, steel and cement sub-sectors account for 30% and 35% respectively. China’s leading steel producers have set targets to achieve peak in emissions in 2022-2023, well ahead of the national 2030 target set by the Plan. The China Building Materials Federation has also recently put forward a 2023 peak target for the cement sector as part of an effort to reach peak emissions from the broader building materials sector. These localized pushes all pose great opportunities for new entrants in green energy and traditional industry decarbonization, and should be on foreign investors’ radars.

You can also expect to see increased regulatory efficiencies in 2022. China launched a national carbon trading market in July, 2021. China’s emissions trading scheme (ETS) emphasizes reducing CO2 emissions at a unit level instead of total emissions. According to historical practices, enterprises would provide information to supervisors and receive corresponding allowances under the ETS system. Similar to the “cap-and-trade” program, each enterprise in the trading market will have carbon credits which will directly determine how much CO2 is emitted in a certain period. For enterprises requiring more CO2 emission, they will need to buy corresponding amounts of carbon credits from the enterprises willing to sell. This opens additional revenue streams for enterprises which emit less CO2 during production.

But for the automobile sector, the market of carbon credits for China works in a different way. Instead of requiring a certain quantity of zero emissions vehicle production per state like in the U.S., China instead uses a dual-credit policy that allows credits earned for the production of automobiles with fuel consumption lower than a required standard. Credits can also be earned if a manufacturer’s production ratio of new energy vehicles is above a set standard. In 2021, Tesla could earn a profit of $390 million from trading credits in China. BYD has accumulated 750,000 points in 2021, equivalent to $350 million, which exceeds half of the company’s net profit in 2021. These regulatory mechanisms offer strong incentive to incumbents and new entrants alike to dramatically invest in new energy vehicle research and development. There’s clearly a huge under-addressed market for this.

Globally, carbon emissions from transportation account for about one quarter of energy-related emissions, and if unaddressed, are expected to grow 60% by 2050. Thus, decarbonizing transportation is a climate imperative. In China, there are currently fewer than 200 vehicles per 1,000 people, compared to about 600 in the European Union and over 800 in the U.S. If China reaches the motorization rate of the EU by 2050, there will be 500 million more vehicles, equal to the current total number of vehicles in the U.S. and EU combined. In Germany and the U.S. where motorization rates are significantly higher, transport emissions account for 24% and 36% of the total respective national emissions.

As China’s motorization rate rises, it is expected that the share of transportation in total emissions would increase to up to 35% (currently 10%), making it imperative that China migrates to new energy vehicle usage. There is reason to be bullish about this. Companies like NIO, Xpeng and Li Auto, which exclusively manufacture new energy vehicles, currently make up about 30% of the total market capitalization of China’s automotive industry. The China Academy of Transportation Science projects that the share of new energy vehicles would increase from less than 2% in 2020 to over 80% by 2050.

Strategic Emerging Technologies

Moving on, and this is slightly related to carbon neutrality – investors should also look at emerging technologies where China will be in a strong position to compete globally. The Plan commits to 7% annual growth in research and development spending by 2025. If realized, China’s annual research and development spending will reach $580 billion per year by the end of 2025, more than the current $548 billion spent by all U.S. research and development contributors combined (including businesses, government, higher education, and nonprofit entities).

Additionally, the Plan vows to make research and patents more accessible to startups and businesses across the industrial chain. Note in Article 5: “We will promote the further opening of national scientific research platforms, science and technology reports, and scientific research data to enterprises, create innovative mechanisms for the conversion of science and technology achievements into practical applications (科技成果转化), and encourage the licensing of qualified science and technology achievements supported by government fiscal funding to small- and medium-size enterprises.”

The Plan also calls for raising the share of strategic emerging industries to more than 17% of GDP by end of 2025. To put this in perspective, in 2020, China’s entire industrial sector accounted for 30.8% of China’s GDP. It was by far the largest contributor to GDP, followed by the wholesale and retail industries which contributed 9.4 % and the financial sector with 8.3%. China’s industrial sector output alone exceeded the entire economy of Germany that year.

If realized, the Plan will oversee emerging technologies radically reshaping China’s entire economy, eclipsing China’s entire combined financial, wholesale and retail sectors by 2025. Foreign investors can pay special attention to areas such as digitization and automation of traditional industries, cloud computing, big data, internet of things, robotics, blockchain applications to traditional industries, new and innovative technologies in health & medicine, biotechnology, basic materials, and space and oceanic exploration.

In addition to calling for increased research and development spending, the Plan also calls for easier access to bank financing and aggressive tax policies to support the growth of emerging technology businesses. Article 5 of the Plan proposes a fascinating corporate credit program that aims to empower banks and financial organizations to develop, “science and technology financial products” including intellectual property or patent backed corporate credit.

The same section also references the need to create insurance products that would “carry out pilot projects for risk compensation for the conversion of science and technology achievements into practical applications.” This means new entrants in emerging technologies can have access to not only all of China’s institutional research going forward, but also targeted corporate credit and insurance products.

To further drive growth for small to medium size businesses in emerging technologies, China has provided additional market liquidity most recently in December, 2021 with the central bank stating it would cut the amount of cash that banks must hold in reserve, its second such move in 2021, releasing $188 billion (1.2 trillion RMB) in long-term liquidity to bolster growth. Adding important color to the selection process of emerging technologies businesses, the State Council published guidelines on November 6, 2021 calling for financial institutions to focus on small to medium size businesses that are “highly specialized, highly skilled, highly specific, and highly innovative” (专精特新).

Compounding on this, China Securities Regulatory Commission has formally recognized in a historical move, the use of variable interest entities (VIEs). In a newly issued draft regulation published December 24, 2021, the CSRC is allowing Chinese companies set up as VIEs to list in offshore markets if they register with regulators and meet compliance rules. The draft regulation also allows mainland-incorporated companies to directly list overseas without the need for a VIE if they meet the same requirements.


Next, I would like to talk about semiconductors. There are only five explicit mentions of semiconductors and chips throughout the Plan, but semiconductors are essential to all of the digitization initiatives China hopes to push forward, including but not limited to smart home devices, smart cities, personal devices other than smart phones, smart transportation, the internet of things, all of which require more advanced semiconductors.

The Plan outlines growth in 6G research and development, and aims to “accelerate the large-scale deployment of 5G networks, increase the 5G user penetration rate to 56%, and promote the upgrade of gigabit optical fiber networks.” China currently leads the world in the rollout of 5G network technology. China has more than one million 5G base stations. Shipments of 5G smartphones increased by 80% year-on-year, reaching 168 million units between January and August of 2021. China is projected to have over 430 million 5G users by 2025, whereas U.S. is expected to have only 178 million.

However, despite being a vast consumer market, China remains far from self-sufficiency in chips. China currently can only supply 16% of its demand from local sources, which makes chips China’s single largest product import, outpacing crude oil. China has already developed a comprehensive plan to becoming a world leader in chipmaking by 2030, and in the Plan, commitments towards semiconductor self-reliance include 70% import substitution by 2025 and complete import substitution by 2030. The government is already putting capital to work to achieve these objectives.

In 2014, China established the National Integrated Circuits Fund (nicknamed locally, “The Big Fund”), raising $154 billion in funding to support growth in this sector. A second National Integrated Circuits Fund was established in 2019 with $320 billion in funding. Furthermore, 15 local government semiconductor funds have been established since then and have already raised more than $70 billion in funding. In August 2020, the State Council introduced tax exemptions for chipmakers producing more advanced semiconductors. For the most advanced chips, producers will reap profits tax-free for ten years while the next most advanced category of production will earn producers a five-year tax exemption.

I believe looking at China’s semiconductor space will be critical for foreign investors for three key reasons: strong government support, lower costs with additional supply chain efficiency gains, and digitalization trends that are outpacing the rest of the world. U.S. venture capital firms including Sequoia, Matrix, and Walden International, among other foreign investors, have already participated in 58 investment deals in China’s semiconductor industry from 2017 to 2020, which is more than twice the number of deals inked the prior four years.

Question: I’d also like to discuss the role of state-owned companies, which still play a large role in Chinese economy. For some time now, there have been discussions on whether the private sector should play a bigger role in China. Do you think that state-owned enterprises (SOEs) will still be important in the next 5-year cycle? And how?

Answer: According to the Fortune Global 500 list 2021, 135 of the global top 500 companies are Chinese (eclipsing the U.S. which had 122), of which 91 are state-owned enterprises (SOEs). The Plan will greatly concentrate market share and influence into the hands of China’s SOEs going forward. You’ll start to see SOEs taking leadership roles in investment and consolidation across sectors such as clean energy, semiconductors, new energy vehicles, and other emerging technologies. To compliment this, the Plan stresses the importance of best practices and efficiency, calling on SOEs to reduce bureaucracy and explore remuneration packages that are “market competitive” and employ “medium to long-term” compensation plans, essentially signaling the oncoming of ESOP plans in the SOE space.

The Plan also calls for a deeper reform strategy called “mixed reform” (混改) whereby SOEs allow strategic “social capital” (meaning private or foreign investors) onto their cap table. This form of shareholder diversification has become in recent years a core thesis behind the restructuring strategy of the state-owned sector. To illustrate the importance of mixed reform, the entire GDP of Shanghai in 2021 is about $627 billion (4 trillion RMB), whereas the total assets of Shanghai SOEs exceeded $3.9 trillion (25.6 trillion RMB), roughly 6.4 times the size of the entire gross domestic product of Shanghai. This strongly indicates that SOE have yet to unlock their full potential, and taken in consideration with broad state policy aimed at fostering SOE competition, it is critical for any serious investor looking to invest in China to explore partnering with SOEs.

There are already many cases of successful collaboration between SOEs and foreign investors. SOE-foreign joint ventures are numerous in the automobile industry, and increasingly so as automobile manufacturing SOEs pursue deployments in new energy vehicles. More recently, SAIC-GM-Wuling Automobile, famous for producing the Wuling Hongguang mini EV, is a joint venture between Shanghai Automotive, General Motors, and Liuzhou Wuling Motors. The joint venture’s Wuling Hongguang is currently outselling BYD and Tesla with 40,395 units sold in November, 2021.

Xuzhou Construction Machinery Group, the largest crane manufacturer in the world and one of the world’s top five heavy machinery manufacturers, is currently undergoing review by the China Securities Regulatory Commission for a deep restructuring plan involving social capital (private and foreign investors). The state-owned holding company underwent mixed reform led by funds managed by CITIC and Shanghai Guosheng Group, with foreign investors including Singapore sovereign wealth fund GIC co-investing.

Together the social capital block now owns 46% of the SOE holding company, taking the government ownership down to 56%. The deal under review would see the holding company injecting $2.1 billion in assets into its public listed subsidiary, XCMG (of which it already owns 38%) including its core excavator business, which recorded revenue of $2.4 billion in 2019. The holding company will then be dissolved, and shareholders including the government and social capital block will receive XCMG stock. The Xuzhou Machinery deal is an incredible example of how China’s SOE space has become increasingly entrepreneurial and open to collaborations with outside investors.

Another angle for foreign investors to look at would be allocating into state-owned fund managers such as China International Capital Corporation, or more recently, CS Partners (a joint venture between China Merchants Capital and State Development & Investment Corporation) which is offering its first U.S. dollar fund, with State Development and Investment Corporation as its anchor LP. SOE fund managers will have access to increasingly unique and exclusive deals in China, and are generally open to discussing onboarding foreign investors.

Lastly, SOEs will become increasingly more appealing in the public markets as they solidify their market dominance and undergo consolidation and restructuring. China Duty Free Corporation is set to pursue its first foreign public listing in Hong Kong in the first quarter of 2022 with a slew of foreign institutional commitments already in place. Many investors view China Duty Free, which currently dominates China’s duty-free market with 92% market share, as a policy-hedged China consumer play that better captures long term growth in China’s consumer sector than traditional platform businesses like Alibaba or Meituan, who are undergoing increasing regulatory scrutiny. Shortly following, China Food Group is also expected to pursue a foreign public listing in Hong Kong in 2022.

Question: Another issue, related to the last one, is innovation. As SOEs take on emerging technologies, how can they compete with environments driven by private companies, such as Silicon Valley?

Answer: Looking at where China actually stands vis-à-vis the U.S. in emerging technologies, the strategies outlined in the Plan are obviously already working. China has made extraordinary leaps in core technologies of the 21st century such as AI, semiconductors, 5G wireless, quantum computing and communication, biotechnology and clean energy, such that it has now become a “full-spectrum peer competitor” to the U.S., and in some areas already the world leader, according to the recent report, “The Great Technological Rivalry” from Harvard Kennedy School’s Belfer Center. In 2020, China produced 50% of the world’s computers and mobile phones whereas the U.S. produced only 6%.

For every one solar panel produced by the U.S., China produces 70. China sells four times the number of electric vehicles, and has nine times as many 5G base stations, with network speeds five times as fast as those in the U.S. China’s progress in AI technology has even alarmed the U.S. National Security Commission on AI which warned that China is poised to overtake the U.S. as the global leader in AI by 2030. The Harvard report adds that China now clearly tops the U.S. in practical AI applications, including facial recognition, voice recognition and fintech. Global patent filings increased by 3.5% in 2020, fueled particularly by China’s 16% growth according to the World Intellectual Property Organization’s “Global Innovation Index 2021.” The report adds that China’s levels of patents by origin, scaled by GDP, are higher than those of Japan, Germany and the United States. The same is true with regard to the levels of trademarks and industrial designs by origin as a percentage of GDP.

Going back to the Plan’s commitments on research and development, the Plan calls for 7% annual increase in research and development spending in key areas of emerging technologies. The way this works in practice is very particular to how the Chinese system, and I would argue, the Chinese SOE system carries structural advantages to competition with the private sector.

Most of the research funding contemplated in the Plan will come in the form of grants from institutions like the Chinese Academy of Sciences and University of Science and Technology of China, all of which are state-owned, highly synchronized with central state policy, and while enjoying the academic prestige crucial to attracting world class talent, they also inhabit a secondary role of investment and asset management. These organizations are both academic and entrepreneurial in nature, being able to offer the most attractive and nurturing environment for scientific research via their academic mandate, while also having the latitude and flexibility to invest in the business applications of their research.

A great example would be the Chinese Academy of Sciences Institute of Automation, which is the leading AI research institute in China, with 1062 full time staff, of which 113 are professors and 287 scientific support staff, 663 graduate students, including 407 doctorate students and 256 Master students, as well as 59 post-doctorates. The institute has since 1956 spearheaded much of China’s scientific breakthroughs in facial and voice recognition, automation, machine learning, and recent technologies such as the ZTSpeech Cloud used across Alibaba’s mobile ecosystem for voice command and recognition, the speech synthesis technology embedded in Baidu Cloud, the Molecular Imaging Surgery Navigation System that is currently widely in use across hospitals and clinics, and the supercomputing ASIC front-end design known as MaPU. The Institute also owns and operates an adjacent investment arm called China AI Investment Management, which customarily steps in as a seed or angel investor to research labs that have after receiving significant grant support, solidified real world applications to their research and practical business models.

Similarly, the University of Science and Technology of China (USTC) announced the opening of its first quantum laboratory in 2020, costing USTC $10 billion. Earlier in October 2021, USTC announced that its second generation 66-qubit programmable superconducting quantum computer Zuchongzhi 2, can achieve computing speeds 10 million times faster than Google’s 55-qubit Sycamore, making China’s new machine the fastest in the world, and the first to beat Google’s. A recent study published in the peer-reviewed journals Physical Review Letters and Science Bulletin confirms this achievement. Professor Pan Jianwei of USTC later stated that his team will continue pressing forward focusing on areas of quantum error correction in the next 4-5 years.

In the above regard, it’s important to note the structural advantages that SOEs have in nurturing internal talent and commercializing scientific research. However, it’s also important to recognize that China’s top SOEs are well positioned to attract external talent. Leading China chip manufacturer, Tsinghua Unigroup which is majority owned by Tsinghua University (also an SOE), announced in November 2019 the hiring of Yukio Sakamoto – a giant in the Japanese chip industry – as Senior Vice President and head of the company’s Japanese subsidiary. As of April 2021, there are over 3,191 independent legislations across all administrative regions aimed at attracting and incubating local and non-local talent. Furthermore, SOEs are in a great position to attract partnerships with market leading private enterprises. Many SOEs have legacy assets that are highly strategic to startups who have access to cutting edge technology but lack the infrastructure or capital to quickly deploy wide.

A key takeaway is to understand that the line between SOEs and private companies will increasingly get blurred. Many private companies choose to form joint ventures with, or attract SOE investment with the hopes of increasing their chances of receiving bank financing and higher valuations in subsequent financing rounds. Similarly, SOEs seek market leading private partners to help them better deploy their inhouse resources. As an example, China Pacific Insurance Group recently partnered with Sequoia Capital China to launch a joint venture focused on investments and consolidation opportunities in the health sector.

The joint venture will invest in new business models in biopharmaceutical, medical devices, medical services and digital health, with the value add of China Pacific’s vast market reach as an SOE, and Sequoia China’s longstanding track record in nurturing talented startups. As an extreme example of this blurring, the Plan explicitly encourages the sharing of new SOE patents and research materials. Quoted earlier in my previous discussions around emerging technologies, Article 5 of the Plan states, “We will promote the further opening of national scientific research platforms, science and technology reports, and scientific research data to enterprises, create innovative mechanisms for the conversion of science and technology achievements into practical applications (科技成果转化), and encourage the licensing of qualified science and technology achievements supported by government fiscal funding to small- and medium-size enterprises.” This is significant context in understanding the SOE sector’s resolve in fostering competitive entrepreneurialism, while embracing the need to share and expand the pie through partnerships.

Question: Which emerging areas will be open to foreign investment and which ones will be closed? There are many technologies that are sensitive, especially for military uses. How will Chinese government draw a line? In other words, for an international investor eyeing emerging technologies in China, which areas could be interesting in the next few years and which ones will be off limits?

Answer: There are clear guidelines as to which sectors are restricted from foreign investments depending on level of foreign investment, from restrictions on foreign majority to categorical restrictions on any foreign investment. These can sometimes get very nuanced. For example, there are sweeping restrictions on any foreign investment in aquatic fishing in Chinese territorial waters, and businesses breeding genetically modified crop seeds, livestock and other produce. However, there is one huge exception for businesses engaging in new wheat varieties and seed production wherein foreign investors may not own more than 34%. Similarly, all print, broadcast or streaming publications must be majority owned or controlled by a Chinese party, with foreign investors welcome to be co-investors. However, for news publications discussing domestic politics, China’s economy and redistributing foreign news publications, the controlling party must be an SOE.

In emerging technologies, the line is drawn clearer. The following areas of business are expressly prohibited from foreign investors: development and application of human stem cells and gene diagnosis and treatment technologies, any form of humanities and social science research institutions, geodetic surveying, any surveying or mapping technologies, mineral geology, businesses that research or heavily survey domestic geophysics, geochemistry, hydrogeology, environmental geology, remote sensing geology and other surveys, domestic water transport, postal and domestic express mail businesses, any business engaging in the selling of tobacco, satellite television broadcasting or any ground receiving facilities and key components production, and any business engaging in the exploration and mining of rare earth materials, radioactive minerals and tungsten.

A quick note about AI and semiconductors. Most state-owned fund managers that invest heavily in the AI or semiconductor space would turn away foreign limited partners due to the funds mostly being a blind pool. However, if you speak to individual portfolio companies, they often welcome foreign investors, or already have foreign investors. As long as the foreign investor doesn’t seek to take operational control or majority shareholding in a Chinese AI or semiconductor company, foreign investment is usually allowed.

Question: One last question, not directly related to the above. It seems that one large issue for China’s economy is the outlook for its real estate sector. We’ve recently seen Evergrande defaulting on its USD debt and there’s been an endless debate on the possibility of a big crash for a few years now. Is this big crash likely to happen, given what’s been going on in the last few months? How is the Chinese government addressing the troubles of the real estate industry?

Answer: It’s important to approach this question with some perspective, as much of the doom and gloom voiced across global markets has largely been misplaced or overstated. China’s real estate market is massively oversupplied. There are over 90,000 developers in China, and about 900 million urban residents. That’s one developer for every 10,000 residents. China builds an average of 15 million new homes per year, which is over five times the number in U.S and Europe combined, yet a quarter of these homes remain unsold.

Additionally, around 78% of the wealth of urban Chinese is in residential property, versus just 35% for Americans. If oversupply driven by unfettered lending and development continues, policymakers believe it will in fact result in an eventual price collapse, widespread corporate bankruptcies, and by extension, people losing their savings. China’s top priority in the real estate sector is cooling down the supply-side, and addressing true demand with better quality control and ensuring pre-sold properties can be developed to completion and delivered on time.

In this regard, China is more concerned about property prices rising, as opposed to a property crash. China’s foreign currency bank deposits are at a record $1 trillion, while the trade surplus in the first nine months of 2021 are at $440 billion compared with the 2015-2019 average of $336 billion and 2020’s $325 billion, according to Morgan Stanley estimates. The immense dollar surplus gives China an important cushion against any future shocks in the world economy, and provide an important liquidity option in a worst-case scenario.

Additionally, there are very robust controls placed on pricing for new and secondary property transactions that effectively prevent a collapse. Pricing guidelines are issued to housing registrars and banks to effectively prevent the consummation of deeds of transfers and mortgages in any transaction where pricing falls outside a discrepancy of 15% (above or below) the pricing guideline for an individual lot. These measures along with increased controls on corporate debt and credit approvals, is aimed at decreasing price volatility, reducing leverage, and restructuring supply and demand of property in favor of needs-based development and purchasing.

There is sufficient liquidity to ensure completion of unfinished developments. Domestic corporate credit and development lending has been made readily available. 200 billion RMB of loans were approved in October 2021, up from 150 billion RMB in September, 2021. We should see this trend continue into 2022. For developers who have crossed the “three red lines” of credit which include 70% ceiling on liabilities to assets, 100% cap on net debt to equity ratio, and cash to short-term borrowing ratio of at least 1:1, SOEs are stepping forward to help purchase assets and ensure completion and delivery of existing developments.

With that all said, the threat of corporate bankruptcies has always been high, and in no way has come about on account of recent policy shifts alone. Just in the first half of 2020, 228 real estate developers went bankrupt. Many of the current pricing and de-leveraging policies you’re seeing are an attempt to preempt the risk of corporate bankruptcies in the future. In return, the administration is willing to let the market determine the fate of individual developers, with strong tools in hand to prevent volatilities.

This may not be good news for foreign bond holders, as their bets rest on whether the developer has enough revenue generating assets and medium-term liquidity to successfully restructure their debt in a way that doesn’t drive shareholder equity to zero. This is a reality facing many developers, and only in a few cases would the state come in to refinance debt. What China’s regulators can deliver is at least the assurance of property prices stabilizing and the completion and delivery of developments, but certainly not a widespread debt bailout, as may be wishfully contemplated by some investors.

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