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China and emerging markets fixed income

January 2022
Marketing Material

Taking China out of EM

For many investors, China holds the key to emerging markets. But it's time to start thinking of them independently.

01

China and EM

There are good reasons to think of China separately from the rest of the emerging market (EM) universe.

Although the country still falls well short of developed market status, China’s size, economic power and the maturity of parts of its economy set it aside from other emerging countries. 

So while, for most investors, it’s almost impossible to think about emerging markets without putting China front and centre, they might be better served by separating the two – by putting China in one box and the rest of the emerging universe in a other.

Many emerging economies are at least as well placed on various social indicators as China was 30 years ago when its economy really started to take off. This suggests they too are in a good position for strong, sustained development. What’s more, they are likely to be better placed to register improvements on environmental, social and governance metrics.

 
02

A great divide

China undoubtedly played a major role in the development of emerging market debt as an independent asset class, particularly following the country’s accession into the World Trade Organization in 2001. China’s ever bigger role in global trade has made it an economic engine for the emerging world.

This has been reflected in the rise in the number of countries in the EM hard currency debt index (from 30 to 75 over the past three decades), in the size of the debt market, and in the share of global debt market made up by emerging economies, even excluding China.

Fig. 1 - Growing dominance
China's economy as percentage of world GDP
China GDP
Source: IMF, Bloomberg, Pictet Asset Management. Data as at 11.01.2022.

But with  Xi Jinping’s political rise – he became the country’s president in 2013 – China has turned increasingly inward, culminating in its ‘common prosperity’ campaign launched in 2021. At the same time, other emerging countries are starting to outgrow their role as mere cogs in the Chinese economic machine. 

Clearly, economic linkages between China and the rest of the emerging universe are strong. But it’s important not to overstate these ties. For example, the European Union is a bigger trading partner, in aggregate, with EM economies than China. It makes up 21.3 per cent of total export exposure of emerging countries, while China makes up 18.8 per cent.1 At the same time, the EU and the UK account for 52 per cent of capital provision to EM. 

03

An index behemoth?

On the surface, there doesn’t seem to be a problem with an ever growing China weighting in emerging market bond indices – unlike in equities. Chinese bonds make up just 10 per cent of the JP Morgan EM local currency bond index (GBI-EM GD) and a little under 5 per cent of the hard currency denominated EM bond index (EMBI Broad GD).2

Fig. 2 - Raising capital
Emerging markets fixed income market capitalisation (USD bn)
EM FI market cap
Source: JP Morgan. Data as at 04.01.2022

But on closer inspection, there are issues, not least China’s dominance in drawing in capital from around the world. In other words, there is the risk that it has started to financially crowd out other emerging markets. But a reappraisal of China relative to the wider emerging universe could yet see this reverse, with increasing flows heading elsewhere. It will also help that emerging markets broadly are becoming less dependent on foreign capital than they once were – local investors make up an increasing proportion of demand for emerging market debt.

And there are technical reasons to consider Chinese bonds separately from other emerging market debt.

For instance, the average correlation of returns on Chinese hard currency debt to other countries in the EMBI index is low relative to that of other low-beta EM countries like Chile, Malaysia and Panama.3 These correlations, in turn, are related to a number of factors, including divergent macro-economics, different economic composition and idiosyncratic risk.

Furthermore, Chinese local sovereign debt is uncorrelated with other Chinese risk assets as well as with the wider GBI-EM index.4 As a result it adds diversification to portfolios of EM local debt.

Fig. 3 - A broadening universe

JP Morgan emerging market fixed income indices, number of countries included in each index by date 

number of countries in index
Source: JP Morgan. Data as at 04.01.2022
04

Excellent platforms

Social fundamentals across emerging economies bode well for future growth. They are now more or less where China was when its own growth surge started 30 years ago – the Chinese economy has expanded by an average of 9.1 per cent annually since then, according to IMF data.5 While other EM economies are unlikely to take off as dramatically as China did from 1990, they are starting from a strong base.

Take life expectancy – China’s in 1990 was 69 years at birth, while in 2019 that of low and middle income countries was 71. By 2019, Chinese life expectancy had risen to 77 years.6 Infant mortality is lower in EM economies now than it was in China 30 years ago, while the number of children born per woman is approximately the same. China’s surge in urbanisation, from 26 per cent of the population three decades ago to 61 per cent in 2019 is relevant here too – right now the proportion among low and middle income countries is 51 per cent.7

China’s age dependency ratio – the proportion of the population of non-working age, that is below 14 and above 65 – has fallen from 52 to 42 since 1990. In low and middle income economies that proportion is 55.8 But where China’s dependents were skewed to the young in 1990, they are now shifting towards the old. By contrast, in other emerging economies the age profile is still tilted more towards youth, which suggests the dry tinder that drives growth – productive people entering the workforce – now favours those countries over China.

China’s historical birth control policies have, in theory, left every married couple in responsible for the care of four elderly parents – and eight grandparents. Over time, this will make demographics an ever more significant factor in China’s workforce and labour costs. In effect, this will remove a major source of Chinese competitiveness relative to other countries or regions with better demographic profiles. The result could well be a shift – at least at the margin – in investment and capital flows away from China.  

Sub-Saharan Africa, the Middle East, North Africa and South Asia are best placed in this regard. Latin America could also benefit, given its proximity to the US market. Whether the countries could absorb such investments is another matter, though here ESG factors will clearly matter, with progress in governance likely to play a significant role.

Fig. 4 - Mobile innovation

Number of mobile cellular subscriptions (per 100 population) vs number of patent applications ('000) in Low and Middle Income Countries

mobile phones patents
Source: World Bank World Development Indicators, Pictet Asset Management. Data as at 04.01.2022

Meanwhile, human capital indicators are improving, suggesting productive potential. Literacy rate in low and middle income countries is 74 per cent, only slightly below where it was in China in 1990. By 2014 secondary education in these countries was 71 per cent – that compares to 37 per cent in China in 1990.9

And a growth in digitalisation could allow emerging economies to avoid the expensive and slow adoption of the sort of capital-intensive infrastructure that was key to developed economies’ growth. Mobile phone technology means that vast networks of expensive landlines are no longer necessary. Access to information makes agricultural markets more efficient, allows for a rapid dissemination of new ways of doing things and can improve the quality of education. Electricity infrastructure can be made local with the adoption of solar and wind power. These high octane technological developments can drive rapid productivity gains, which, in turn, will boost capital flows. 

And it will help that across the emerging world, institutions have been reformed and strengthened – legal systems are more reliable, government departments less prone to corruption. The average Transparency International corruption score for 33 leading emerging economies has been creeping higher during recent years.10  Governments have accepted the need for sensible fiscal rules, while central banks have been given a measure of independence.

05

Alternatively sustainable

One concern investors in China face is the country’s relatively poor scores on environmental, social and governance grounds. Although China has made improvements, questions about how committed it is to meeting Paris and COP26 measures leave other emerging economies looking more attractive – at least in terms of potential. 

Clearly it’s not fair to expect very poor countries to meet the same standards as rich (or richer) ones. This is the reason why we’ve developed a scoring metric that takes GDP per capita as well as progress and potential when factoring in sustainability. Using these metrics, it is possible to construct a portfolio of countries that suitably replace China, matching China’s risk and return profile but with better sustainability scores.

Smaller emerging countries have greater incentives and broader scope to work with multilaterals to ensure they have the financing necessary to meet sustainability objectives for longer-term sustainable development. 

 
06

China matters

China’s pace of growth may be slowing but it is still a powerful driver for the global economy. It is a dominant consumer of commodities and a huge producer of manufactured goods. Its vast population means that it is heading towards becoming the biggest economy in the world over the coming decades.

It helps to consider China independently of the wider emerging markets universe - and vice versa.

But all these factors and others are also reasons why we believe China needs to be considered separately from other emerging economies. Even within the heterogenous world of developing countries, China is substantially different. And so it helps to consider China independently of the wider emerging markets universe – and vice versa.