Emerging or developed market? China’s economic uniqueness defies labels

Never has an emerging market been so influential in the global economy; the scale of China’s markets demands its own analysis framework
To grasp the next stage of China’s development, investors must take it for what it is – nearly the world’s largest economy and one of its largest and most diverse markets

David Chao

Published: 10:00pm, 15 Feb 2023

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In the last Year of the Rabbit in 2011, China officially leapt over Japan to claim the mantle of the world’s second-largest economy. Can China jump again, out of the emerging-markets rabbit hole to achieve the coveted developed-market status?

Indeed, the end of Covid-19 controls in China is unleashing a wave of economic activity that should reignite growth for the entire globe.

At the World Economic Forum in Davos last month, Chinese Vice-Premier Liu He said: “China’s national reality dictates that opening up to the world is a must, not an expediency. We must open up wider and make it work better.”

It “matters tremendously”, said International Monetary Fund managing director Kristalina Georgieva, also at Davos, as China’s successful economic reopening “is very likely the single most important factor for global growth in 2023”.

There is little doubt China’s reopening is a boon for the global economy. While Chinese economic growth has moderated in recent years, it is still expected to remain significantly stronger than that of developed countries.

Concerns about regulatory risk, which contributed to a serious downturn in China market sentiment from late 2020, has largely abated. The goals of “common prosperity”-aligned regulations have come into sharper focus: better risk management in financial services companies, stronger data protection, avoiding big tech monopolies, improving worker conditions and, of course, combating climate change.

The objective of common prosperity was never to drive out foreign investors or undermine the market economy. It is to ensure high-quality growth through China’s next stage of development.

So what is this next stage? China is already the world’s largest economy on a purchasing power parity basis and the second largest in nominal gross domestic product. It is poised to become the largest economy within this decade, although with population growth essentially over, the focus must turn to high-quality and sustainable growth through technological innovation and increasing productivity.

These efforts must continue so China can improve its per capita GDP, which at about US$12,000 remains well behind its global peers. Also, restrictions on capital account convertibility – the right of residents and non-residents to freely trade currencies and assets at will with each other – remain widespread.

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These characteristics make China an emerging market in traditional economic analysis. But never has an emerging market been so influential in the global economy: China claims highly impressive superlatives, such as the world’s largest trading nation, second-largest bond market and second-largest national equity market.

The scale of China’s markets means its “emerging market” label is unhelpful in understanding its investment landscape, and index providers are struggling.

China appears dramatically underweight in global indices, yet dramatically overweight in emerging market indices. It accounts for about 10 per cent of global equity market capitalisation but less than 4 per cent of MSCI’s All Country World Index and the FTSE All-World Index. Conversely, China overwhelms emerging market benchmarks. At the end of last month, it made up 33.49 per cent of the MSCI Emerging Markets Index.

China’s economy and markets are now so large that there is a small but growing group of investors who approach China as a specific investment allocation, dedicating substantial analytical and investment resources.

Time to drop China from emerging market indices? Easier said than done

Perhaps the best case for spinning China out from emerging markets is that it is so unique, it requires its own analysis framework.

Emerging markets have always been a heterogenous group, but they share crucial macroeconomic characteristics. Their economies are generally not as productive as in developed markets and per capita incomes are much lower. Their financial markets tend to have lower capitalisation with less liquidity and diversity of issuers in stocks or bonds.

They are also significantly driven by the global economic cycle, even those that run external trade surpluses, where the value of exports exceeds that of imports. So they tend to benefit when global growth is rising and the US dollar softening, but suffer when financial conditions tighten, global growth slows and the dollar strengthens.

China is an exception to all these. Its market is increasingly driven by secular characteristics, due to its economic scale and diversity, and the depth and liquidity of its financial markets. China’s monetary policy tends to be countercyclical to that of other large economies, which drives different asset performance trends. These factors alone make Chinese assets an important portfolio diversifier.

Most emerging markets are small, open economies highly exposed to the global economic cycle and US monetary policy. These days, the Chinese economy has become a critical factor in evaluating emerging market performance.

China is still emerging, and we should remember that political and structural considerations are just as important factors in considering developed-market status. South Korea, after all, remains an emerging market according to MSCI classifications, despite lifting restrictions on won trading hours and removing stock registration rules to address this. China’s unique political system complicates its emerging vs developed market labelling.

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In our post-Covid world, static labels from a different investing era are perhaps no longer as helpful. It’s more accurate to take China for what it is – nearly the world’s largest economy and among its largest, deepest, most liquid and diverse financial markets.

Equally, we should take emerging markets for what they are – a wide range of countries and sub-asset classes that deserve focus on their own merits, rather than a sideshow rounding error in indices increasingly dominated by China.

David Chao is a global market strategist (Asia-Pacific) at Invesco