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Industry voices

Commentary: The bigger risk to emerging markets isn’t Trump, but China

While President Donald Trump's recent round of tariffs will likely have a considerable effect on the Chinese economy, authorities in China have a number of tools at their disposal to combat U.S. protectionism. Innovation and technological development, investments in renewable energy and disposable income growth will also likely aid the domestic economy.

To put the effect of tariffs in context, it is worth taking a step back in time. China's accession to the World Trade Organization on Dec. 11, 2001, was a pivotal moment in economic history. The country had been steadily rising in global stature since turning its back on Maoist orthodox policies in the 1980s, but its accession dramatically changed its fortunes.

The export market was a key driver behind China's economic growth. Exports grew from $279 billion to about $2.3 trillion today. This resulted in rapid urbanization and swathes of investment in infrastructure and development financed by the greatest credit expansion in history. Nonetheless, just as the country evolved into the global powerhouse it is today, the forces that drive the economy are rapidly changing. Exports as a percentage of GDP were just 20% in 2001 and peaked at 37% in 2006. Although exports are still growing in absolute terms, today they have returned to about 19% of GDP. Although China will be impacted by Mr. Trump's tariffs, its authorities are hardly powerless to mitigate them.

The Chinese authorities have implemented various reserve requirement ratio cuts to stimulate the economy. The latest cuts will likely release about 500 billion renminbi ($72.2 billion) in funding for the country's five large state banks and 12 national joint-stock commercial banks and 200 billion renminbi for midsized and small banks to increase lending to small businesses. The government still has room to implement further reserve requirement ratio cuts. Fiscal policy will likely continue to be more actively driven by tax and fee reductions and local government bond issuance to support ongoing infrastructure investment projects. Despite considerable headwinds, foreign-exchange reserves remain robust at $3.1 trillion with about 21 months of import cover.

From a domestic perspective, China has substantially increased its investments in technology. In 2013, China had zero share of unicorn companies worldwide. In 2018, the country now constitutes 38% of unicorn companies, slightly behind the U.S. at 39%. Artificial intelligence is forecast to be a key driver of future growth. Estimates suggest it will constitute about $7 trillion of the economy by 2035. Real consumption growth will likely be higher than GDP growth over the next five years, leading to a continued economic rebalancing toward consumption. Higher personal incomes together with lower savings rates will also aid the country's sustainable upgrade in consumption over the coming years.

Renewable energy is also an exciting theme that the country continues to develop. China's five-year plan states that non-fossil energy should account for 15% of energy consumption by 2020. Furthermore, the country's proposed automotive transformation is radical, with carmakers needing to amass credits for new energy vehicles, or NEVs, equivalent to 12% of sales by 2020.

Conversely, it is fair to say that Chinese economic activity is somewhat milder than it has been. The Li Keqiang index is a good proxy for the general macroeconomic environment and it is clearly weaker. This result is partially due to the general shift to consumption from investment that is a natural development for an economy of China's size and scale. Moreover, firmer regulations have also been responsible. Banks' wealth management products have been a key financing source for infrastructure investment and tightening has certainly had a negative effect. As of July 31, the government has slightly relaxed its aggressive stance on banks' wealth management products, which should be positive in the near term for various industrial and material companies. More importantly, even as authorities are implementing tax cuts to boost consumer spending, the main question is whether consumer confidence and economic activity is impacted not just in China but in neighboring emerging markets.

China's macro fundamentals are strong, policies are moving in the right direction and therefore we believe the current correction in equities is a buying opportunity. Global liquidity remains strong and progress with regards to the United States-Mexico-Canada Agreement, informally known as NAFTA 2.0, will likely improve confidence in the global economy and somewhat restore momentum in global trade and export volumes. Sentiment concerning the trade war has likely already bottomed out and high-level talks between China and the U.S. will probably resume following the midterm elections. Mr. Trump's tough negotiation tactics have been a bitter pill to swallow for Chinese and emerging market equities year to date, but the agreements struck with Canada, Mexico and North Korea suggest that a deal is the most likely conclusion. While retaliating against U.S. tariffs, China has largely refrained from taking stronger actions and has recently allowed more U.S. firms to enter Chinese markets. For example, Tesla Inc. and BASF will be building wholly owned plants in China. These overtures and recent efforts by China's central bank to stabilize its currency are likely to help achieve a consensus between the two sides over the next few months, given that the continuation of concerns at an elevated level will eventually have a negative effect on the U.S. economy.

John Malloy is co-manager of the emerging and frontier markets team at RWC Partners Ltd., based in Miami. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.