Economic growth is important, but investor returns depend on more than that. In China’s case, the deepening and opening up of its financial markets are factors that will boost returns – and help it escape the middle-income trap

China’s economy stands at a key juncture. The route it takes will have a complex impact on the world’s financial markets. Reviewing the historically nuanced relationship between economies and markets helps to put this in context. 

Emerging markets’ high rates of growth are often pointed to as a key reason to buy into their stock markets, but economic growth is not the sole determinant of returns. High growth does translate into higher revenues – an important component of total returns – but fast-growing emerging markets can also see dilution.

Dilution happens when a company issues additional shares of stock, often because they need more capital to invest, zapping the value of existing investors’ shares by reducing their proportional ownership. Dilution lowers returns to investors, below what revenue growth would have suggested these stocks are worth.

The fact that growth doesn’t necessarily dictate investor returns is an interesting paradigm for Beijing, if we broadly consider the effect of China’s slowing future growth on its markets.

During 2019, China will pass a milestone in its development: its per capita gross domestic product, measured using market exchange rates, will reach US$10,000. At that mark, China will be considered a “middle-income country”.

China’s per capita GDP has doubled since 2011 and increased 10-fold since 2000. This massive improvement in the living standards of a population that exceeds 1 billion has been one of the quickest and biggest economic success stories in history.

However, in the past, once reaching this threshold, other emerging economies have seen their growth slow. Many seem to get trapped in this middle-income group – even as they continue to grow, their living standards get no closer to those enjoyed by citizens of wealthy countries.

This middle-income trap has become a hot topic among investors considering taking advantage of improving access channels to China’s financial markets: is greater exposure wise given the likely limits on China’s potential? The answer is that China is likely to escape this trap, but growth will still slow in the coming years as a result of worsening demographics and limited productivity gains.

However, just as dilution can lower total returns below what is implied by price appreciation alone, financial deepening in countries growing richer can boost returns – and there are good reasons to believe this will happen in China.

One useful measure to gauge the trajectory for China’s financial markets is the equity market capitalisation-to-GDP ratio, which tends to rise as economies develop. China’s, currently about 60 per cent, is already fairly high compared with some other economies at an equivalent stage.

However, many developed market economies, including the US but also Taiwan, have market cap-to-GDP ratios exceeding 100 per cent, implying a lot of room for growth in the Chinese equity market.

Similar dynamics are likely to play out in bond markets. The Chinese bond market today is worth US$13.2 trillion, or 100 per cent of GDP, compared with 130 per cent of GDP for the value of the US bond market.

Despite bond and stock market index inclusions, foreign ownership of China assets remains low by international standards, at 3 per cent of A-share equities and 2 per cent of bonds. By comparison, foreign investors own around 23 per cent and 24 per cent of the US equity and bond markets respectively.

As foreign owners take advantage of recently expanded access to China, their ownership will rise closer to the country’s overall share of global markets – Chinese securities make up, by market capitalisation, roughly 8 per cent of global equity markets and 13 per cent of global bond markets.

These shifts will drive structural change in China’s markets. For example, having more institutional investors in onshore equities may exert a stabilising influence on China’s equity prices – now among the emerging-market world’s most volatile, largely due to retail investors’ primacy in the market.

China’s increasing integration into the global financial system should also lead its asset market returns becoming more correlated with global markets – something that is already happening.

While China’s equity and bond markets are the world’s second largest, the investments available still do not match China’s economic heft. Amid these changing dynamics on the ground, it’s worth keeping a close eye on the difference between growth and returns.

While China is unlikely to fall into the middle-income trap, the inattentive investor may get stuck in the middle-returns trap if headline economic growth is the only factor driving his or her decision-making.