China is moderating economic weaknesses and may become reliable global engine in 5-15 years

China’s economy is not falling into a black hole. Wheels are in motion for economic reforms.

China’s mainland equities — known as the A-shares — will be included in the massive MSCI Emerging Markets Index starting in June 2018. Some 222 Shanghai and Shenzhen listed companies made the cut. For now, the weighting is under 1%. In the not so distant future, it will rise to 5%. Brendan Ahern, CIO of KraneShares in New York predicts China A-shares allocation will hit 17% at full inclusion in several years. That additional 17% allocated to China will raise its weight to over 40% of the MSCI Emerging Markets Index, an index tracked by around $2 trillion in both active and passive investment funds here in the U.S. alone.

China’s A-shares beat the MSCI Emerging Markets and the S&P 500 on Wednesday, but has been a laggard now for years. The incessant bear narrative on China being on the cusp of a hard landing, a housing bubble burst, or a credit crunch has kept investors away. China is the second largest economy in the world. The slightest hint of over-reach by its lenders, and oversupply caused by municipal level companies who have full-employment as their mandate, has consistently turned investors off to China since 2015. No matter how you measure it — the MSCI China H-Shares index (Hong Kong listed Chinese companies) or the Deutsche X-Trackers CSI-300 A-Shares fund (ASHR), investing in Chinese equity has been a money loser. A-shares ETF in particular are down over 45% since June 26, 2015 while emerging markets as whole rose by nearly 3% and the S&P 500 is up by 15%.

China’s economy has two very distinct sides to it: on the one side is a dynamic and progressive manufacturing and services economy supporting the rising consumer class and on the other, a heavy industrial sector weighed down by debt and excess capacity whose time is past, says Edmund Harris, portfolio manager for the Guinness Atkinson China and Hong Kong Fund (ICHKX) and the Renminbi Yuan and Bond Fund (GARBX). The stocks included by MSCI reflect both sides. “There are good companies in the first group if you know how to look,” he says, a nod to active money management instead of ETFs.

China’s problems of an aging population, oversupply, and a credit bubble still exist, but progress is being made to moderate them.

China has switched to a 2 child policy and will likely completely eliminate restrictions on children. This has boosted the birth rate and will reduce the drop in the working age population between now and 2040. The working age population might even be close to the same if there is effective incentives on having children.

China had 18.5 million births in 2016 and will likely have similar numbers in 2017. This was the level of births in 1999. Sustaining births per year at 20 million would stabilize or allow for very gradual change in the working age population.

The IMF has recently projected that China can sustain 6+% annual GDP growth for 3 years. This is important to give China time to strengthen national, provincial and corporate balance sheets and for the middle class consumer economy to become the main economic driver.

Chinese companies now have have greater sources of capital, foreign capital, and it is possible to have less reliance on local debt.

China’s large companies have increased coverage of interest payments to over 6 times. This is the best since 2010.

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