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Emerging Markets

CHINA ECONOMY: The domino effect

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As China’s economy rebalances, emerging markets brace for the impact. For some, the change could be beneficial

If there is anything that demonstrates the scope of China’s ambitions in global trade, it is the Nicaragua Canal.

In June of this year, the Central American country’s government signed a $40 billion, 100-year concession with a Chinese infrastructure vehicle, HK Nicaragua Canal Development Investment Company, to build and operate a waterway linking the Pacific and the Atlantic Oceans, providing an alternative to the Panama Canal.

China’s rising economic and political clout has already begun to reshape world trade. For the past half decade, Chinese consumption has driven commodity markets: Mozambique’s coal, iron and gas, copper from the Democratic Republic of Congo, Zambia and Chile. Across the world, investments by Chinese companies and parastatals (corporations owned partly or wholly by the government) are credited with having a transformative effect on frontier market economies. In August, $5 billion in deals for energy, infrastructure and environmental projects were signed off in a single visit to Beijing by the new Kenyan president, Uhuru Kenyatta; a new manufacturing hub in Ethiopia, created by one of China’s largest textile conglomerates, promises to move fragments of the Chinese apparel industry offshore.

Although the overseas expansion of China’s domestic champions began in the early part of the new millennium, the narrative of economic rebalancing towards the East and “South-South” relationships gathered pace after the global financial crisis highlighted the imbalances between countries with large current account surpluses and foreign exchange reserves, against those in the developed world running on debt. It was Chinese demand that put a floor under commodity prices, and producers have in many cases reorganized themselves to focus on the new centre of demand.

However, for several years there have been warnings from economists that China is due a hard landing as it tries to reorient its export-led economy into one more focused on internal consumption and innovation. Although the more dire predictions have not been manifested, the country’s growth is showing signs that it cannot defy gravity indefinitely, as the government tries to rein in loan growth from its current rate of 20% to bring it more in line with GDP growth. The ramifications of that slowdown could be significant.

China’s investment-driven growth led to strong domestic demand, which created a market for the rest of the world, but this growth was fuelled by expanding municipal balance sheets and a growing shadow banking system, experts say.

“I think overall the whole emerging world has become very sensitive to Chinese demand. You see that for maybe one-third or half of all emerging countries, China has become the biggest trade partner, whereas traditionally it was Europe or the US,” Maarten-Jan Bakkum, senior emerging markets strategist at ING Asset Management, says. “Particularly for a group of countries where exports consist mainly of commodities, they have become super-dependent on Chinese demand. If the leverage in the Chinese economy becomes so big that it cannot sustain fixed investment growth forever, that will have a big impact on commodity prices.”

KNOCK-ON EFFECTS

That will almost inevitably have knock-on effects in other Asian economies whose markets are geared towards supplying China with raw materials, such as Indonesia. Likewise, commodity-led economies in Latin America and Africa, already seeing depressed demand from their traditional trading partners in Europe, could suffer even more.

“The economic slowdown of China can be very detrimental through its effects on commodity prices,” Mauricio Cardenas,

Colombia finance minister, tells Emerging Markets. But he hastens to add that oil, which is his country’s main export, has been “relatively insulated” from the recent slowdown in China.

“We all know that the commodity super-cycle for commodities is over,” Kamel Mellahi, professor of strategic management at Warwick Business School, says. “You have to look at the details and see what countries are selling to China.”

The motivations behind Chinese investments into Africa and Latin America are complex, mixing a centrally-led desire to secure strategic resources with pure corporate incentives and the entrepreneurship of smaller businesses, which have moved en masse alongside the larger parastatal investments. The China Development Bank, the country’s largest policy lender, has an African loan portfolio of nearly $19 billion, and has invested more than $2.4 billion into the continent’s infrastructure projects, its president, Zheng Zhijie, told a recent forum.

While the relationship between Beijing and governments in emerging markets has been characterized by critics as one of land and resource-grabbing, there has been a notable shift in the terms of engagement in the past few years. In some but not all of the countries that have attracted considerable Chinese investment, there has been state-backed momentum behind deepening the economic engagements.

“I think the government policy is to push companies to go abroad,” Mellahi says. “The official rhetoric is that ‘we are here to help African countries, and other emerging economies.’ But whether companies are doing it because they are entrepreneurial or because they see an opportunity, it’s hard to tell.”

In June, Huajian, one of China’s largest footwear manufacturers, led a $2 billion investment into a “shoe city” in Ethiopia, a huge textiles hub that will supply world markets with branded garments and apparel. The textiles industry, which has often been at the forefront of offshoring over the past few decades, shifting between low-cost centres, was one of the earliest drivers of China’s industrial growth. As Chinese enterprise looks to mitigate the rising costs of labour at home, it is now itself offshoring, at the same time taking advantage of preferential trade agreements that offer goods of African origin tariff-free or low-tariff access to Europe or the US. Other Asian countries, in particular Bangladesh, have attracted Chinese factories as well.

 

Since the Chinese market began to liberalize under Deng Xiaoping, the government has actively encouraged and supported its parastatal and large domestic private companies to invest overseas. Alongside an obvious policy of securing strategic resources has been one of backing manufacturers and construction businesses with diplomacy, concessionary loans and contracts as they head overseas. UNCHARTED TERRITORY

While Chinese investments in manufacturing and infrastructure have been welcomed by China’s overseas partners and gone some small way to mitigating the criticism that the country’s economic relationships are one dimensional, they are also a symptom of the Chinese competitiveness problem.

These investments higher up the value chain are also in some cases strongly related to the state’s foreign policy goals, which means that they could be isolated to some degree from China’s own internal challenges.

“I think that’s as yet undetermined,” Merlin Linehan, founder of the consultancy China In Africa, says. “China as a capitalist country, or a more capitalist country, has never undergone a major slowdown since Tiananmen Square, so I think it’s uncharted territory. I think it will be very interesting to see whether they do scale back overseas expansion, or whether that’s determined to be in the national interest so they continue at all costs.”

The same could be true of Latin America. “In every meeting between leader and leader, it’s mentioned that there needs to be a rebalancing of the relationship and in particular more in the way of imports from China for a more diversified set of goods and also investment in value-added sectors,” Margaret Myers, who heads the China-Latin America programme at the Inter-American Dialogue, says.

In some places that rebalancing has begun to happen. The larger, deeper economies such as Brazil are attracting automakers and other, higher value investments from China. JAC and Chery, two of the country’s largest vehicle manufacturers, have set up with a view to sell to the local market. Others, though, such as Peru, have relationships entirely based on resources, with more than 90% of exports still primary commodities.

As in Africa, if the tightening of Chinese domestic credit impacts the ambitions of the export-import bank or the China Development Bank, there could be a knock-on effect for certain markets which struggle to access international finance.

“China is the lender of last resort for countries like Venezuela and Ecuador,” Myers says. “Having defaulted on loans and not having a relationship with the IMF or World Bank, then China’s really their only friend.”

A putative slowdown is only part of a longer-term change in how China’s economy interacts with the rest of the world. The Chinese government wants to transition its export-driven, developing economy into a middle-income one that is supported by domestic consumption. In the past the state and regional governments have shored up growth by building infrastructure and allowing the credit bubble to build, but the new government has indicated that it is less willing to do so. The first major sign of this transition could be due later this year. Simon Derrick, head of currency strategy at Bank of New York Mellon, believes that China, which has previously managed its currency carefully to promote exports, is considering allowing the renminbi to float at a moment when demand in the world economy is still weak, but there are signs of recovery.

“This is actually what [the new Politburo] is looking for, a more sustainable model for growth as they move from being a developing nation to being a middle-income nation, and as they move from being an export-oriented nation to a domestic economy that functions rather more efficiently,” Derrick says.

“It hasn’t been a wholesale rejection of what was put in place in the previous decade, but they are certainly moving away from a growth-at-all-costs model. That would be extremely difficult to do in a world where everything was on its back.” Conversely, liberalizing the renminbi when global demand and confidence in the Chinese economy are high would put enormous upward pressure on the currency from capital inflows.

Allowing the renminbi to float could have wide-ranging impacts on other emerging economies. While many have benefited from China’s growth, in some cases they also compete with Chinese industry, and some still have to invest heavily in keeping their currencies competitive.

China’s eventual shift from being a consumer of finished goods, rather than of raw commodity exports will, once again, change the role it plays in world trade. A more consumption-led China will need more high technology products, wages will need to increase and emerging markets that are already further up the value chain are likely to benefit all the more. The impact that it will have on less developed emerging markets, however, is less clear. While demand for food and fuel will likely remain high, identifying who the winners in the changing industrial landscape will be could be one of the most important investment trends of the next decade.

— Additional reporting by Antonia Oprita

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