How is China’s slowing economy affecting emerging markets?

For the past two decades Chinese consumer demand, production and investment have acted as major growth drivers for the global economy. The country’s presence is now acutely felt across emerging markets from South-east Asia to the Middle East, and sub-Saharan Africa to Latin America. Outbound flows of foreign direct investment (FDI) and international travellers, coupled with robust demand for natural resources, capital and technology, have seen China influence global market dynamics and reorganise trade flows. In 2019 China accounted for $118bn in outbound FDI and sent 166m tourists abroad. It is also the largest export market for countries as diverse as Indonesia, Mongolia, Myanmar, Peru, Saudi Arabia and Australia. Moreover, the Belt and Road Initiative (BRI) – Beijing’s strategy to develop a modern global trade network – is projected by financial services firm Morgan Stanley to cost in excess of $1trn and connect 65 countries by 2027.

The global spread of Covid-19 in the first half of 2020, the first case of which was reported in central China in late 2019, has once again highlighted China’s outsized role in the world economy. Countries all around the globe are feeling the impact of supply chain disruptions and loss of tourism revenue originating from China, while many low- and middle-income nations are struggling to repay debt for BRI projects as they take out loans to fund responses to Covid-19.

Turning Tides

Even before the pandemic, China’s centrality in the international trading and financial system was posing challenges. Across Asia Pacific and further afield, deepening investment links – often through BRI infrastructure projects – were raising concerns over transparency and the retention of economic sovereignty. Fear of overexposure was accentuated by worries that China could use debt, investment or tourist flows to influence trading partners on issues such as territorial sovereignty, human rights and security. This led a growing number of voices to be critical of China and any plans to sign on to additional BRI projects.

Moreover, directly impacting the Chinese economy was the ongoing trade dispute with the US, which had unsettled financial markets and disrupted global supply chains since 2018. Therefore, prior to the Covid-19 outbreak, China’s economy was already undergoing steady deceleration. In 2019 Chinese imports fell by 2.8% on account of weakening domestic demand and rising tensions with the US. This slowdown accompanied attempts to execute complex structural reforms designed to move away from a reliance on construction and exports, towards a greater emphasis on innovation and higher-value-added services and manufacturing.

Credit Crisis

A combination of factors that were impacting the economy prior to the outbreak will persist beyond 2020. Central among these is corporate debt levels, which rose sharply after the 2007-08 global financial crisis on account of a state-led effort to stimulate growth through credit saturation. Between 2009 and 2015 total credit grew at an average annual rate of 20%, according to the IMF, rapidly outpacing nominal GDP. By the end of 2017 corporate debt had reached 160% of GDP, up from 101% in 2007. Debt-to-equity ratios have also risen substantially since 2009, and corporate loan defaults totalled $20bn in 2019. That year China’s total debt – including corporate, government and household debt – reached 300% of GDP.

Rising debt speaks to underlying structural issues. With a disproportionately large share of the post-2008 credit influx financing large-scale infrastructure and real estate development projects, some analysts are flagging declining capital efficiency – when higher and higher levels of capital are required to boost productivity – as a serious point of concern. In a slowing macroeconomic environment, many Chinese firms are struggling to service debt while remaining profitable. State-owned enterprises (SOEs), which number in the tens of thousands and support key sectors of the economy, figure prominently in the nexus of debt, overcapacity and sluggish productivity growth. It is estimated that the segment holds half of China’s total corporate debt, while accounting for less than 25% of GDP.

Household debt, which is generally seen as less problematic than corporate or government debt, has also drawn concern. In 2018 household debt reached 60% of GDP and, for the first time, the average household’s debt equalled its income, according to the People’s Bank of China, the central bank. Surging housing prices and the growing prevalence of credit cards are the leading reasons of elevated consumer debt. With the economy slowing and indebtedness rising, an increasing number of households are reducing their purchases, frustrating efforts to rebalance China’s economic profile away from exports and towards domestic consumption.

Tackling High Debt Levels

Recognising that excessive leverage in the financial system could potentially catalyse a wider crisis, Chinese authorities have taken a number of steps since 2015 to bring debt under control. Such measures encompass a crackdown on the under-regulated shadow banking sector, higher capital requirements that force banks to better account for non-performing loans, efforts to reduce debt-fuelled outbound FDI, and improved government coordination mechanisms to better handle the deleveraging process and risk assessments. However, this process puts China’s economy in a bind: curtailing credit flow acts as a break on growth, stems business and household spending, increases bankruptcies and risks increasing the unemployment level.

This dilemma is particularly noticeable in the SOE segment, where supply-side reforms geared towards paring down debt, reducing overcapacity and boosting productivity have drawn criticism for being insufficient relative to the scale of the challenge. Policymakers have promoted firm consolidation to create economies of scale, tolerated some SOE bankruptcies, called for reduced subsidies and improved market discipline, and promoted mixed ownership – if not outright privatisation. Nevertheless, powerful interest groups have proven effective at stymieing comprehensive reform efforts. The ruling Communist Party’s active role in corporate decision-making under President Xi Jinping, coupled with a pervasive fear that SOE reform will result in massive employee layoffs and social unrest, reinforces scepticism over whether the political system is capable of executing necessary systemic reform.

Upending Supply Chains

A number of additional developments further complicate China’s growth picture. Principal among these is its deteriorating relationship with the US. After decades of building intertwined trade and financial networks, both sides now talk openly of economic and technological decoupling. Since 2018 the US and China have exchanged multiple rounds of damaging tariffs on a broad catalogue of products and services. Simultaneously, the administration of US President Donald Trump, which began in January 2017, has moved to curtail Chinese FDI and ramp up restrictions on the export of strategically important US technology to Chinese firms.

These measures have substantially affected the countries’ trading relationship. US tariffs have eroded the cost advantages residents once enjoyed by buying Chinese-made products, thereby significantly diminishing China’s export volumes to the US and forcing factory closures, driving up unemployment in the export sector. As a result, the overall volume of bilateral trade has shrunk, and Chinese FDI into the US fell from $46.5m in 2016 to just $5.4m in 2018. The Trump administration has taken specific actions against telecoms giants Huawei and ZTE that have disrupted their access to key US-made inputs such as semiconductors and software. While this is officially billed as retaliation for trade violations and theft of US intellectual property, some consider the crackdown on the two tech providers to be part of a broader effort to contain China’s rise by slowing its ascent to becoming a global technology leader in areas such as 5G and artificial intelligence.

These developments, occurring against the backdrop of rising labour costs and an increasingly onerous regulatory environment in China, have contributed to a growing number of foreign multinationals reassessing their China-based operations and looking elsewhere for production and material sourcing. China itself has also begun to shift some operations abroad and explore alternatives to US-sourced products and manufacturing inputs. This is opening the door for emerging markets to get in on the action, as companies around the world seek to shift FDI in manufacturing and assembly operations to other low-cost nations.

Surrounding Asia

Trade uncertainty between the world’s top-two economic heavyweights has resulted in benefits to Vietnam in particular. While Chinese exports to the US market fell by 12% in 2018, those from Vietnam increased by 34%. With major tech players such as Foxconn, Samsung and Nokia ramping up production in the country, Vietnam has become a crucial part of many firms’ China-Plus-One strategy for supply chain diversification that pairs Chinese operations with one other – usually Asian – country.

Malaysia has similarly benefitted. Since the onset of the trade dispute, FDI has surged into Penang due to its well-established technology and electronics supply chains, and the country’s tariff-free access to the US market. In 2019 the island saw a 456% increase in FDI and a doubling of new jobs to 15,000 compared to 2018. Indeed, the Myanmar government says the situation has created a more favourable investment environment for the country. “Our first priority should be to attract Western firms that may be looking to relocate out of China, and the second should be to increase exports to China that had previously been supplied by the US,” U Than Myint, the minister of commerce, told OBG.

Similar dynamics are at play in Indonesia, which remains poised to benefit from Chinese trade, FDI and tourist flows in the decade ahead. The archipelago’s tourism industry will likely continue drawing in greater volumes of Chinese visitors after international travel restrictions related to Covid-19 are lifted, as Indonesia markets a range of alternatives to the popular Bali island under the 10 New Balis project. Large-scale, Chinese-funded transport and infrastructure projects – including the $6bn Jakarta-Bandung high-speed rail line and a $1.5bn hydropower plant on the island of Sumatra – underscore China’s economic footprint in the country, while in November 2019 the multilateral Asian Infrastructure Investment Bank, which was founded by China, expressed interest in providing funds to help relocate the capital to East Kalimantan.

Growing Footprint in Africa

As the largest economic partner of Africa, China is slated to help drive growth across the continent in the medium term. With a slowing economy at home, many Chinese companies are looking at African markets to re-route manufacturing operations, sell products and services, and deliver infrastructure projects. Despite fears over debt-trap diplomacy and a corresponding loss of economic sovereignty, as well as concerns regarding environmental and human rights standards, a host of African countries have sought partnership with China for development projects in recent years. In many cases, Chinese funding is seen as the most viable tool to complete projects in economies with low levels of private investment and massive need for infrastructure spanning transport, power and telecommunications. Chinese investment in a series of railway connectivity projects, which are seen as crucial to facilitating regional and international commerce, has drawn particular interest. These include the Lagos-Kaduna standard-gauge rail in Nigeria; the Nairobi-Mombasa line in Kenya; and the construction of a 470-mile electric railway to link Ethiopia’s landlocked capital, Addis Ababa, with neighbouring Djibouti.

China’s presence in Africa expands beyond infrastructure development: the country is the leading export recipient for nearly all of the continent’s resource-rich nations. This appetite for natural resources has been paired with substantial Chinese investment in retail, farming, logistics, housing, light manufacturing and ICT.

Investment in the Middle East

Before the Covid-19 pandemic brought factories to a halt in many parts of the world, commodity exporters across the Middle East and North Africa were benefitting from China’s continued industrial operations. Saudi Arabia provides a case in point: in 2019 the country saw its oil exports to China spike by 47% on account of US-China trade tensions and a number of agreements between stateowned oil giant Saudi Aramco and private Chinese refineries. Energy exports are just one component of an increasingly robust relationship underpinned by an alignment between the kingdom’s Saudi Vision 2030 development strategy and China’s BRI initiative. As a growing number of Chinese firms look to enter the Gulf market, the Saudi Arabian General Investment Authority is bullish that ongoing reforms to the kingdom’s investment environment will attract Chinese capital and technical expertise to aid in further developing the manufacturing, petrochemicals and alternative energy industries, which will support the Saudi economy at a time of renewed low oil prices.

China’s footprint in MENA is also clearly seen in Egypt, where inbound FDI from China has grown markedly from a low base, rising by 66% year-on-year in the first three quarters of 2019 to $74.9m. The latest in a series of meetings between President Abdel Fattah El Sisi and President Xi in September 2018 saw the two sign deals estimated at $18bn that span the real estate, energy and transport sectors. A 7.23-sq-km plot with a focus on manufacturing in the strategic Suez Canal Economic Zone is being developed by Chinese firm Tianjin Economic-Technological Development Area, and had attracted over $1bn in investment by the end of 2019. Chinese firms will also play a critical role in the financing and construction of Egypt’s new administrative capital east of Cairo – a multibillion-dollar undertaking for the government.

Into Latin America

Much like South-east Asia, Mexico appears a logical beneficiary of US-China tariffs and rising costs within the Chinese labour force. As US goods imports from China fell by a substantial 16% ($87.3bn) in 2019, Mexico saw trade with its northern neighbour rise by 0.5% to $614.5bn, supplanting China as the US’ largest trading partner. Proximity, cultural familiarity and tariff-free access underpinned by the United States-Mexico-Canada Agreement that replaced the North American Free Trade Agreement are crucial reasons in explaining Mexico’s appeal as a manufacturing and assembly centre for those wishing to cater to the US market. Mexico’s electronics and automotive industries, in particular, can expect to reap the benefits of supply chain diversification away from China.

South America, which is experiencing an extended period of modest economic growth despite a rapid rise in exports to China over the past decade, showcases the drawbacks of reliance on the Chinese market. Many countries on the continent have been historically dependent on the export of raw materials to the detriment of developing competitive manufacturing industries to capture more value added, thus the effects of China’s slowdown are being felt acutely in the form of sluggish demand for minerals, and agricultural and forestry products. Peru, Argentina, Brazil and Chile, which are all deeply enmeshed in trans-Pacific trade networks, had been particularly hard hit by China’s slowdown even prior to the Covid-19 pandemic. At the same time, Chinese FDI has not reached the continent in the same volumes as seen in other regions. Still, China offered $141bn in loans to Latin America and the Caribbean between 2005 and 2019, of which 90% went to Venezuela, Brazil, Ecuador and Argentina.

Repaying Debt During Covid-19

While Chinese loans for large-scale infrastructure projects have been welcomed by many emerging markets around the world, meeting payments for these arrangements has been made more difficult for countries that also need to secure loans in order to mitigate the economic and health effects of the Covid-19 pandemic. In mid-April 2020 G20 creditor nations, including China, agreed to suspend debt repayments for low-income countries for the remainder of the year. However, China added caveats to its agreement that effectively excluded hundreds of large loans tied to BRI projects. Such moves have been seen as reinforcing the threat of debt-trap diplomacy, and could steer developing countries away from Chinese assistance in the years to come, narrowing an avenue to Chinese productivity and growth.