Much like the previous recession in 2008, China has emerged from the economic headwinds in pole position for recovery. Having recovered early from the harrowing days early on in the pandemic as a result of draconian lockdown measures, it now looks to be the only economy in the world that will see growth amid the present downturn. Beijing announced a rapid growth recovery of 3.2% in 2Q2020 following a sharp 6.8% contraction in 1Q2020.
China’s unexpected recovery is a bright light for beleaguered EMs struggling to stimulate their way out of recession. During the Global Financial Crisis (GFC) a decade ago, it was China’s strong and resilient growth that pulled EMs out of the financial doldrums and onto the road to recovery. But China was an export-oriented economy in a free trade world then; it is now more focused on domestic consumption in a more protectionist environment. Can China save EMs again?
Fiscal discipline
One main obstacle to this is the reluctance of the Chinese government to pour economic stimulus into the economy like it did during the GFC. Beijing poured RMB4 trillion ($791.8 billion) of fiscal stimulus into its economy in the wake of the previous downturn in a bid to keep its development story alive. According to The Wall Street Journal, this massive stimulus subsequently increased Chinese demand for raw materials and other goods, ultimately underpinning the recovery of EMs like Brazil and across Asia.
But what also resulted was a decade-long struggle with debt. According to Andy Rothman from Matthews Asia, China’s debt-to-GDP ratio prior to the GFC was relatively low and stable at about 150% of GDP. Following the crisis however, this ratio jumped dramatically and stood at around 253% of GDP as of September 2018. This has led to perennial concerns from financial markets about a possible Chinese debt crisis, despite its debt levels being lower than five of the G7 advanced economies.
As Beijing has been working on deleveraging its economy in the years before the crisis, it now has significantly less headroom for fiscal stimulus spending going forward. Paul Hsiao, global economist at PineBridge Investments, Hong Kong, estimates that fiscal stimulus in China will amount to just 5% of GDP this year compared to the 10% supplied in 2008 and less than half of the 12% top-line fiscal response announced by the US so far. “The implicit logic behind these actions (or inaction) is that the increased risk of a financial crisis would be the last thing China, and the world needs during already challenging times,” he remarks.
This would imply, however, less demand growth in China and therefore, a substantially weaker demand rebound in EMs as well. Still, Reuters estimates that the stimulus package planned by Beijing for infrastructure spending could reach up to RMB 2.8 trillion — the largest since the GFC. Homin Lee, macro strategist for Asia, Lombard Odier, also sees China’s outsized impact on global industrial commodity and capital goods trade proving to be a crucial anchor for EM growth recovery in the post-Covid-19 economy.
Protectionist perils
More worrying is the Chinese economy’s increasing shift from export-oriented growth towards domestic consumption, weakening its ability to drive the global economy. While once the factory of the world producing for more well-off countries, China has increasingly been producing for its domestic market even before the US-China trade war, as its large population joins the ranks of the global middle class. China’s net trade surplus accounted for only 1.3% of its GDP in 2018 while domestic consumption contributes 60% of its GDP growth.
“Currently the Chinese economy is recovering briskly and will help other emerging nations. However, China’s drivers of economic growth are shifting from resource-hungry manufacturing to more domestically generated services and hence may be less supportive of growth elsewhere,” say First State Investment's Jamie Grant, Head of Emerging Markets & Asian Fixed Income, and Anthony O’Brien, Interest Rates & Currency Strategist, Fixed Income and Multi-Asset Solutions. They see this trend continuing into the long-run as China increasingly shifts away from manufacturing towards services. Services are presently traded at a lower volume than manufactured goods, though this volume has been rapidly increasing.
There have also been concerns about Made in China 2025 — a more active industrial policy introduced by the Chinese government to encourage domestic high-end manufacturing to avoid the “middle income trap”. But the programme has often been perceived as a protectionist policy to protect China’s tech sector, which has deepened trade tensions between China and the developed world in an increasingly global trade conflict. Trump’s initial tariffs during the early days of the US-China trade war was widely seen as retaliation against the policy.
“Any boost that arises from each country’s effort to enhance self-reliance will be probably offset by the loss of global efficiency in different supply chains, leading to minimal net positive impact in the near-term,” says Lee. Yet Grant and O’Brien say that the policy could ultimately prove to be a boon for EMs, since China’s move up the value chain could offer EMs an opportunity to fill the gap as a producer of cheap, low quality goods. Supply chain disruption from the trade war could reroute investment and trade to EMs outside China, providing a path to long-term growth.
An uncertain future
For some analysts, the future remains bright for China despite the doom and gloom of Covid-19. “China’s commitment to growth is backed by strong, well thought through policies that recognise and understand what the country and economy needs over the medium to long term,” say First State’s Grant and O’Brien. Despite its struggles with debt, the pair believe that China’s financial position is strong, allowing it to weather the economic storms ahead.
Lee of Lombard Odier, however, is not so sure. He cites China’s ageing demographic as a potential structural obstacle to further growth, despite remaining constructive about its prospects for a long-term transition to a less labour-intensive economy. While Beijing has implemented aggressive structural reforms to open its capital markets and liberalise state-owned enterprises, Lee suspects that this key future growth driver could take some time to implement, leading to a period of slower growth for China.
“We believe geopolitical tensions, particularly involving increasing restrictions with Chinese tech firms, the potential for a sluggish global recovery post-Covid, and a persistent debt overhang, remain headwinds for China,” notes PineBridge’s Hsiao. Investors, he believes, should invest in gold as a hedge for negative real yields and equity risks while avoiding sovereign bonds due to low yield.
For EM equities, South Korean assets could be especially favourable, Hsiao adds. Aside from Seoul’s success in fighting Covid-19, these equities also benefit from the secular uptrend in the tech sector. Furthermore, they should benefit from early-cycle expansion, a weaker US dollar, and accelerating Chinese credit. Bullish Grant and O’Brien also recommend investors to take advantage of Stock Connect — a cross-boundary investment channel connecting the Shanghai Stock Exchange and the Hong Kong Stock Exchange — to tap into the exciting Chinese stocks.
But humility is a virtue in these uncertain times, warns Lee, due to less clarity about the future. “Investors should focus on quality companies and secular winners who can navigate this environment well in the long-term, with a robustly diversified multi-asset portfolio serving as the central anchor” is his simple advice.
