What if zero-Covid fails in China?

Markets have not priced in the possibility of a large, uncontrolled Covid outbreak in mainland China, argues Pendal senior credit analyst TERRY YUAN. Here Terry outlines how that scenario would impact investors

CHINA’S zero-Covid policy is one of the most important under-the-radar issues facing investors.

While most countries have accepted the need to live with Covid, China has decided that uncontrolled spread within its borders is too dangerous.

The impact of China’s Covid policy on markets over the next few years could be widespread, affecting inflation, interest rates, currencies and equity sectors.

Given the extreme transmissibility of Omicron (and potential future variants) as well as the outbreak in Hong Kong, we believe the market has not priced in the possibility of a large uncontrolled outbreak in mainland China.

If there is a big outbreak China’s reaction will likely be swift and heavy handed, including lockdowns, mass testing and stimulus:

• Travel restrictions would remain tight, limiting immigration and associated capital flows into Australia and the rest of the world. The more successful the zero Covid bubble, the more likely Chinese citizen would stay at home for tourism and education (much as Australians did over the past two years). We can assume this would limit supply of labour and put upward pressure on wages, inflation and interest rates. 
  
  
• A bounce-back among Australian travel and immigration companies could be delayed given the dollar-weighted importance of Chinese immigration
  
  
• Lockdowns, quarantines and hospitalisations would impact Chinese workers at factories, services firms and infrastructure providers. This would create bottlenecks in shipping and production, leading to more inflation.
  
  
• Stimulus via fiscal and monetary easing — while the rest of the world was doing the opposite — would put pressure on Chinese interest rates.

China’s zero Covid policy could put upward pressure on wages, inflation and interest rates — and negatively impact sectors reliant on tourism and immigration over the next few years.

This means Australian investors should keep a close eye on airport, airline, hotel and education-related related companies in their portfolios.

Another consideration might be staying away from companies that lack pricing power.

At Pendal, we are carefully weighing this as one possible future scenario.

After navigating the initial Covid sell-off, post-pandemic rally and recent inflation spike, we are constantly looking for the next thing flying under the radar.

We are carefully selecting exposures to companies that have less exposure to China’s zero Covid policy, but have strong earnings stability, balance sheet strength and sustainability credentials. 

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Why China persists with Covid-zero

Why does China refuse to let Covid like the rest of the world? 

The answer seems to be a combination of issues:

1. China is more vulnerable

Most of the Chinese population has been vaccinated with lower efficacy traditional inactivated viruses, rather than newer, higher efficacy MRNA vaccines.

Higher population density compared to the rest of the non-Asian world could increase the speed of transmission and more quickly overwhelm the Chinese hospital system.

Healthcare infrastructure in China, even in urban areas, is inferior to Australian standards, notes Pendal’s head of income Amy Xie Patrick

Even if Omicron infections result in a lower rate of hospitalisation relative to prior variants, the absolute numbers would likely overwhelm the hospital system.

Meanwhile, China does not want to rely on US vaccines given geopolitical tensions and potential for the US to threaten a ban on exports of MRNA vaccine supply (as it did with computer chips).

China wants to foster a successful domestic COVID vaccine and pharmaceutical industry for domestic security and a future international export avenue.

2. Political stability and timing

The Omicron wave hit at a particularly sensitive time for China — just before the Beijing Winter Olympics and Chinese New Year, the biggest holiday of the Chinese calendar.

Uncontrolled spread in Chinese cities would have captured global headlines as a failure of the Chinese government.

This would be playing on Chinese leader Xi Jinping’s mind as he approaches the Communist Party National Congress later this year, where he will seek an unprecedented third five-year term.

The last two leaders (Jiang and Hu) only had two terms before being forced to retire.

Positions on various Chinese ruling bodies will also be up for grabs. Uncontrolled Covid would likely hurt the incumbent. 

3. Social contract

Without elections, China’s top leaders understand they must deliver a growing standard of living for most citizens.

Otherwise, the recent Hong Kong riots could spring up all over China. Ubiquitous camera phones would likely capture any heavy handed crackdown by the government.

Every Chinese leader has studied how and why dynasties and governments failed in China’s 2000-year history.

Confucian society centres on the family unit and respecting elders. An elevated hospitalisation or death rate for the elderly would leave a deep scar and resentment for the government.

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When might China abandon its zero COVID policy?

China could abandon its zero-Covid policy when a domestic pharmaceutical champion successfully develops a higher efficacy vaccine or treatment and begins manufacturing the product at scale. 

Alternatively, after Xi Jinping’s re-election China could authorise foreign-produced vaccines with higher efficacy (eg Pfizer or Moderna) for a mass domestic booster campaign.

This would allow China to abandon its zero-Covid policy and gradually reopen to the world in 2023.