The Chinese economy is attracting more foreign capital due to structural changes and its belated entry into major bond and equity indices. These shifts could have significant implications for other emerging markets.
For thousands of years, Chinese citizens hailed the dynastic Emperor as the ruler of Tianxia, or ‘all the lands below heaven’. China was Zhongguo, the ‘middle kingdom’ – literally the centre of the planet.
In modern finance, China has been just as central to the worldview of emerging market investors. After its entry into the World Trade Organisation in 2001, China’s rapid development and growing appetite for resources boosted other emerging economies. Exports from low- and middle-income nations to China rose by a factor of 12 between 1995 and 2010, compared with a twofold increase in their exports to everywhere else.1
Despite its transformation into a trading and manufacturing powerhouse, however, China has not traditionally attracted foreign capital flows commensurate with its vast size. Restrictions on foreign investment, coupled with inefficient domestic markets, deterred international investors. But this could be about to change, with big implications for capital flows across emerging markets.
Two key drivers are leading China to hoover up more overseas capital. The first is its declining current account surplus, which reflects structural shifts in the Chinese economy. Morgan Stanley analysts forecast China will run a deficit this year, for the first time since 1993.2 The government is loosening the rules over foreign investment as it seeks to plug the gap.
The second driver is China’s inclusion in several global market indices. The weighting of Chinese A-shares in the MSCI EM equities index is rising and China is also on the brink of joining major fixed income benchmarks, potentially sparking outflows from other index constituents. The combined effect of these developments is likely to be increased competition for capital among smaller emerging economies dependent on foreign financing.
“There are legitimate worries about the shifting tide of global capital towards China and whether this will mean a falling supply of capital for other emerging markets, exposing them to tighter financial conditions and lower growth rates over time,” says Maulshree Saroliya, macro strategist at Aviva Investors in London.
Start with the structural shifts in the Chinese economy. In 2007, China’s current account surplus stood at about ten per cent of GDP, but this had declined to 0.4 per cent by the end of 2018, according to official figures. Short-term headwinds have contributed: the US-China tariff dispute has hit exports and a rise in commodity imports means China’s current account balance is now more sensitive to global oil prices.
In a sense, the declining surplus is a natural consequence of China’s development. Savings rates are expected to gradually decrease; one indication of this shifting dynamic is that affluent Chinese are spending more abroad on overseas trips, leading to a US$240 billion deficit in the tourism sector in 2018, the biggest on record.3
For now, China’s overall domestic savings rate remains relatively high, at around 45 per cent of GDP. A big proportion of these savings has been sucked in by hefty fiscal stimulus packages over recent years, but as China moderates its growth targets and unwinds stimulus the current account balance is likely to stabilise in positive territory, argues Saroliya.
China’s appetite for raw materials is already beginning to decline as it reduces its emphasis on state stimulus: iron ore imports fell in 2018, for the first time in a decade.4 This could impact major trading partners such as Brazil and South Africa, two of the chief beneficiaries of China’s resource-intensive investment model over the past two decades.
The share of Chinese imports that came from developing countries stood at 33 per cent in 2017, according to Bloomberg data, down from 36 per cent in 2012 – a small shift, but indicative of the direction of travel.5
“As the Chinese economy matures, other emerging markets may have to carefully monitor its demand for raw materials and think more deeply about the long-term growth drivers in their domestic economies,” says Will Ballard, head of emerging market small-cap equities at Aviva Investors. “Take Brazil: it may no longer be able to export so much iron ore or crude oil to China, which could hurt its growth prospects going forward.”
The decline in China’s surplus has other implications for the wider emerging market world. As its current account slips towards negative territory, the government is accelerating efforts to liberalise the financial system and bring in more foreign capital.
Beijing initially restricted access to onshore markets, allowing a select group of foreign investors to participate via the Qualified Foreign Institutional Investor (QFII) programme, which issued quotas to pension funds and other large institutions. Since UBS and Nomura became the first institutions to be given QFII status in May 2003, around 300 foreign institutions have received licences.
Now new channels are opening to offer a wider range of investors access to onshore RMB-denominated assets.
“The China Interbank Bond Market and the Bond Connect – which uses the same exchange infrastructure as the Shanghai-Hong Kong Stock Connect – have allowed foreign bond investors much greater access to the onshore Chinese market,” says Stuart Ritson, emerging market debt portfolio manager at Aviva Investors.
“One significant consequence of these moves towards market liberalisation is that they have cleared the way for China to be added to global indices, whose inclusion portfolios need to be replicable for international investors,” Ritson adds.
The process started with equities. Chinese large-cap A-shares have featured in the MSCI Emerging Markets Index since mid-2018 and their weighting is being ramped up to over three per cent of the index in a two-stage rebalancing process in 2019. As the MSCI index is tracked by more than US$2 trillion of active and passive funds, the rebalancing could lead to outflows of US$40-55 billion from other emerging markets over the next six months, according to estimates from UBS.6
“US$40-55 billion is a big number, but this is spread across all of EM so the impact on individual countries is diluted. Countries like Korea and Taiwan are most vulnerable as they are the second and third largest index weights, respectively. That may influence active fund managers’ thinking, although the bulk of the flows will be passive,” says Ballard.
A similar reallocation of fixed income capital is likely after China joins major bond indices. The Bloomberg Barclays Global Aggregate Index was the first of its kind to add China, launching a 20-month phasing-in period on April 1, 2019. On the roster for inclusion are Chinese government bonds and those issued by policy banks to fund state projects.
This is already influencing capital flows. A Reuters analysis of official data shows that, as of the end of April, offshore holdings of Chinese government bonds were at the highest level ever recorded, at RMB 1.1 trillion (US$163.7 billion), an increase of RMB 19 billion over the previous month.7 Overall, its inclusion in the Global Aggregate Index could prompt US$100 billion of inflows into Chinese bonds, according to our estimates.
The Chinese local-currency bond market could swell by a further US$120 billion if China is added to the FTSE World Broad Investment Grade Bond Index, which is due to announce a decision on China’s inclusion in September. China is also on the JPMorgan Chase & Co watchlist for inclusion into the most widely followed EM local currency index – the JPM GBI-EM Global Diversified – potentially adding another US$20-30 billion to the inward rush of capital.
Implications for fixed income
While the overall scale of the projected inflows is relatively modest in the context of China’s US$13 trillion bond market, the net result will be positive for Chinese government bond prices. The trend may also have a wider macroeconomic impact by expediting the yuan’s ascent to international reserve currency status, potentially sparking more foreign investment in China’s corporate bond market over the longer term.
“The capital gravitating towards China will come from managers that passively follow the benchmarks as well as active investors eager to take advantage of attractive inflation-adjusted yields on Chinese bonds. Correlations between Chinese fixed income and developed markets have traditionally been low, offering active managers additional diversification benefits,” says Ritson.
The impact elsewhere could be negative, however, as much of the capital flowing into Chinese bonds is likely to be reallocated from other emerging markets. The risk is most pressing for the smaller economies present in the JPMorgan local currency indices, which tend to be reliant on foreign capital.
If China is added to the GBI-EM index, as expected, its weighting could reach the upper limit of ten per cent after the implementation period of at least ten months. This would reduce the weighting available for other index constituents. Morgan Stanley estimates Colombia’s share of the index could drop by 1.5 per cent, for example, potentially resulting in US$2 billion of outflows from Colombian bonds.
The low yields offered by Chinese bonds could mitigate some of the knock-on effects on China’s inclusion, however. “Given that Chinese bonds yield less than many markets in the index, some investors are likely to underweight China to maintain a higher allocation to the other markets. And the phased implementation should limit distortions. However, some of the mid-sized markets such as Indonesia and Poland could see index weight reductions of nearly one per cent, introducing a negative technical factor that investors should consider alongside other macro risks,” Ritson says.
Equity investors ponder EM ex-China
Over the longer term, China’s inclusion in global equity indices could have wider-ranging effects. As China’s share of market benchmarks begins to ramp up to reflect its share of global GDP, perceptions of its position relative to other emerging markets are likely to shift, potentially leading investors to reconsider their approaches to the asset class.
As the EM index gets more and more dominated by China, it will change the dynamic for investors
“As the emerging market index gets more and more dominated by China, it will change the dynamic for investors,” says Alistair Way, head of emerging market equities at Aviva Investors. “Say China gets up to 40 per cent of the MSCI index, which could well happen if more of China’s capital markets are included. How meaningful does EM become as an asset class in that scenario?”
Way draws an analogy with the position of Japan in the 1980s, when companies in the rising Asian economy had a 44 per cent share of the MSCI World Index – more than double its proportion of global GDP – as investors sought to tap into the success of Japanese multinationals such as Sony.8 Japan’s share of the index fell sharply in the early 1990s as the market bubble burst.
While China’s growth path looks more sustainable, its rise could distort indices in a similar way. One consequence is that investors may begin to treat China and a few other richer emerging markets as a class of their own, increasingly devoting specific resources to the Chinese market and managing other emerging market investments separately, much as the Europe, Australasia and Far East (EAFE) Index allows investors to cordon off North American markets today.
“It’s likely many investors will want to manage their China exposure separately, perhaps looking at bespoke solutions that group China with more advanced Asian economies such as Taiwan and Korea, which are already developed markets in every respect apart from capital-market efficiency. We’re still quite far from that stage, but it’s clear that trying to group those countries with smaller – and in some cases, politically troubled – economies could make for quite a messy and indistinct asset class in the future,” Way adds.
Winners and losers
As China exerts an ever-greater gravitational pull, competition for foreign capital will continue to heat up across emerging markets. But there are steps policymakers can take to ensure they continue to attract their fair share of investment.
A wealth of academic research shows that while capital flows are influenced by global macroeconomic conditions such as monetary policy in advanced economies, country-specific ‘pull’ factors still play a big role in determining success. Recent studies have found the quality of domestic institutions, idiosyncratic country risks and the strength of fundamentals were major drivers of capital flows in the post-crisis period, along with ‘push’ factors such as overall risk appetite and US interest rates.9
“These findings suggest policymakers can attract foreign investment by making domestic institutions more resilient and improving macroeconomic policies. In an ever-more competitive EM universe, these factors could be important in separating the winners from the losers,” says Ritson.
For equity investors, political stability, entrepreneurial dynamism and economic flexibility are especially important factors to consider as they look for stock-picking opportunities in a shifting emerging market landscape. China, India and the Association of Southeast Asian Nations (ASEAN) rate highly on these metrics; Brazil and South Africa less so.
“India has issues in terms of governance, but it’s a big, dynamic economy with lots of entrepreneurs who want to start small companies and turn them into big companies. ASEAN also looks well-positioned – it’s a region that is relatively stable politically, and economies such as Vietnam are primed to take the manufacturing base away from China as foreign companies look to relocate due to rising Chinese wages and the tariff dispute with the US,” says Way.
“By contrast, other emerging markets such as Brazil and South Africa resemble developed markets in their slow growth rates, but they are also politically troubled and structurally problematic. Although a good company can transcend its environment, we haven’t seen as many interesting opportunities from a bottom-up perspective in these markets,” Way adds.
- ‘Winners and losers from China’s commodities for manufactures trade boom,’ VOX EU, September 2017.
- ‘The transformation of China’s capital flows,’ Morgan Stanley research note, February 2019.
- ‘China’s current-account surplus has vanished,’ The Economist, March 2019.
- ‘China’s 2018 iron ore imports fall 1 pct, first annual drop since 2010,’ Reuters, January 2019.
- ‘For emerging markets, China’s shift to consumer goods is a blow,’ Bloomberg, February 2019.
- ‘EM FX: Implications of the $140bn MSCI EM shift,’ UBS, March 2019.
- ‘Foreign investors raise China holdings as index inclusion begins,’ Reuters, May 2019.
- ‘America’s disproportionate weight in global stockmarket indices,’ The Economist, April 2017.
- Marcel Fratzscher, ‘Push factors versus pull factors as drivers of global capital flows,’ Vox CEPR Policy Portal, August 2011.