CHINA’S CENTURY?

CHINA'S CENTURY?

THE ECONOMIC GIANT'S NEXT ACT

March 2019

FRANKLIN TEMPLETON EMERGING MARKETS EQUITY

Contents

Key takeaways

1

Brisk expansion potentially losing steam

2

Broader tensions at play

5

Never underestimate China's strengths

6

China's "new economy"

7

Navigating China's opportunities selectively over the long term

10

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This commentary reflects the analysis and opinions of the authors as of March 8, 2019, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments.

Because market and economic conditions are subject to rapid change, the analysis and opinions provided are valid only as of March 8, 2019, and may change without notice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy.

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Key takeaways

China is at a crossroads. After years of heady

growth, it now faces a potent mix of external and internal challenges that threaten to curb its momentum. Its prospects will hinge on how well it responds to these challenges, on top of broader policy dilemmas. High on investors' list of concerns are the US-China trade standoff and China's economic restructuring.

"New economy" programs and policies that

favor innovation are beginning to give China an edge over developed markets. Consumer-focused initiatives offer opportunities both to stimulate the economy and support the pursuit of a better life for China's citizens.

Our near-term outlook for China is cautious

with the potential for volatile markets as the country navigates challenges. We expect China's economic growth to slow over the next few years as de-risking becomes a priority. But we do not foresee a hard landing, given strengths in its policy execution ability and economy. We believe the future still holds promise for China, if its rebalancing efforts result in an economy that is sturdier and more sustainable.

China's century? The economic giant's next act

1

Brisk expansion potentially losing steam

Is China's growth story due for an ominous twist? In mere decades, the country has transformed from a closed nation into the world's second-largest economy just behind the US. Behind its brisk expansion, however, tensions have been brewing. China now faces a potent mix of external and internal challenges that threaten to curb its momentum.

Start with the US-China trade standoff. China's hefty trade surplus has drawn Washington's ire. But so have its technology transfer and intellectual property policies, seen alongside its ambition to become a high-end manufacturing power. Embodying that ambition is China's "Made in China 2025" program, which lays out its goals to become a dominant player in strategic industries such as robotics and aviation in the coming years. So far, the twists and turns of trade talks have shaken markets. Both countries have raised tariffs on each other's goods. The US has also restricted sales of advanced components and other types of technology to specific Chinese companies. Trade frictions have yet to undercut China's dominance in global supply chains, but prolonged uncertainty could cause companies to have second thoughts about investing and producing in the country.

`` China now faces a potent mix of external and internal challenges that threaten to curb its momentum."

China's century? The economic giant's next act

2

While China's trade surplus has been a lightning rod for debate, a general weakening in its external accounts has gathered much less attention. China's current account surplus--a source of support for the yuan--has been narrowing over the years, as illustrated in Exhibit 1. In late 2018, the yuan touched a 10-year low against the US dollar.1 At first glance, China should welcome a weaker currency as that makes its exports cheaper. Yet a sharp drop in the yuan is unlikely to be in its interest, not least for the additional heat it would attract from the US. A fragile yuan could also trigger capital flight and hit wider market confidence.

China's current account balance has been narrowing Exhibit 1: Current account balance (% of GDP) 2007 - 2017

12%

10%

8%

6%

4%

2%

0%

Sources: World Bank, International Monetary Fund, Balance of Payments Statistics Yearbook and data files, and World Bank and OECD GDP estimates, as of January 2019.

1Source: Bloomberg data, as of October 2018.

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

China's century? The economic giant's next act

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