As China gradually emerges from lockdown, emerging market debt and equity investors are trying to gauge the impact of the coronavirus pandemic on its economy – and the knock-on effects for other emerging markets.
The photographs were like scenes from a disaster movie: traffic-free motorways, shuttered shopping centres, neon signs blinking over deserted city squares. The spectacle of China in lockdown shocked the world and gave an indication of things to come in the early stages of the COVID-19 pandemic.
China is emerging from quarantine just as other countries enforce their own hard-line measures to contain the virus. There has been a “gradual but slow return to normalcy” over recent weeks, according to Michael Pettis, a professor of finance at Peking University. Beijing’s subway trains are partly filled with commuters and road traffic in the capital is now at between half and two-thirds its usual level, he observes. But the streets remain quiet and non-food shops are mostly empty.
How China handles the crisis from here will be of interest to policymakers and health professionals in other countries
How China handles the crisis from here will be of interest to policymakers and health professionals in other countries, who are wary of the risk of fresh outbreaks as quarantine measures ease and crowds start mingling again. Investors, too, are watching China closely, as the speed of its economic recovery will have significant implications for the rest of the world, particularly other emerging markets.
Sudden stop
Official figures provide a stark picture of the scale of the collapse in economic activity during China’s quarantine in January and February. Year-on-year industrial production plunged by 13.5 per cent over the two-month period, with fixed asset sales and retail sales down by 24.5 per cent and 20.5 per cent respectively, according to the National Bureau of Statistics. Labour-intensive sectors with long supply chains were among the hardest hit – output in both the textiles and automotive industries dropped around 30 per cent – with leisure and travel also badly hit.1
China’s first-quarter GDP probably contracted versus the previous quarter for the first time since the country was in the throes of the Cultural Revolution in 1976
The effect of the abrupt slowdown in both production and consumption is that China’s first-quarter GDP probably contracted versus the previous quarter for the first time since the country was in the throes of the Cultural Revolution in 1976. Estimates vary as to the severity of the impact. China Beige Book, a consultancy, believes quarter-on-quarter GDP growth may have fallen by 11 per cent.
David Nowakowski, multi-asset and macro strategist at Aviva Investors, says quarterly output may have dropped even further, by 12 per cent or more. While uncertainty surrounds the outlook for the rest of 2020, COVID-19 appears to be inflicting far greater damage to the Chinese economy than the severe acute respiratory syndrome (SARS) outbreak of the early 2000s, or even the global financial crisis of 2008-’09.
Despite this, the government’s relatively quick and effective response to the coronavirus has calmed domestic markets. Chinese equities have been less volatile than global peers in 2020: the benchmark Shanghai Index fell around 15 per cent between the beginning of January and mid-March, compared with a 30 per cent drop in the S&P 500 over the same period.2
“Chinese equities have been notably resilient despite China being at the centre of virus outbreak,” says Alistair Way, head of emerging market equities at Aviva Investors. “As well as some of the traditionally defensive sectors – consumer staples, pharmaceuticals, utilities – tech and internet have held up reasonably well; this reflects the boost to gaming and e-commerce, and the likelihood of massive tech infrastructure investment due to the rise in people working from home globally.”
Chinese government bonds have been in demand among some fixed income investors
Chinese government bonds, meanwhile, have been in demand among some fixed income investors, thanks to the stability of the renminbi and the widespread expectation the People’s Bank of China will implement a “slow-but-steady” monetary easing policy to aid the recovery.
“The early signs that China has contained the COVID-19 outbreak and that its economy is gradually normalising, combined with it being a beneficiary from lower energy prices, aids sentiment,” says Stuart Ritson, emerging market debt fund manager at Aviva Investors in Singapore. “Chinese bonds have similar dynamics to developed markets – bonds rally in response to weak economic data and an increase in investor risk aversion – and these features have contributed to demand from foreign investors.”
Fiscal bazooka?
Early indications are that manufacturing in China has begun to recover. The manufacturing purchasing managers’ index (PMI) data published on March 31 showed an unexpected improvement to above the 50 “neutral” reading during that month, after February’s record drop (see Figure 1). However, PMI is only an indication of travel, not an absolute metric, and there are credible reports that some provincial officials have been encouraging companies to embellish their data to give the impression of a stronger recovery.3
Figure 1: Chinese manufacturing PMI
Chinese consumption also seems to be reviving, albeit slowly, as citizens emerge from isolation. Government officials have reportedly been instructed to eat out in restaurants to encourage the populace to resume their normal lives.4
Few analysts expect China to be firing on all cylinders for some time to come. A decline in global demand will constrain exports over the coming months
Nevertheless, few analysts expect China to be firing on all cylinders for some time to come. A decline in global demand will constrain exports over the coming months. And fiscal stimulus may be less effective than the response to the financial crisis, when Beijing’s lavish spending on roads, railways and other heavy infrastructure projects revived the Chinese economy and boosted commodity exporters across the world.
Now that the composition of China’s economy has changed, the government is likely to channel stimulus measures towards less material-intensive sectors such as data centres, healthcare and telecoms, according to the Institute of International Finance (IIF), a trade body. And the government has less overall fiscal room for manoeuvre than in 2008, when it pumped $590 billion into the economy – around 13 per cent of its GDP at that time. Much of China’s growth since then has been fuelled by debt: overall debt-to-GDP climbed above 300 per cent of GDP in 2019, according to IIF data – more than double its level before the last crisis.
Increasing public debt much further through a massive stimulus could, in turn, limit the PBC’s capacity for further monetary easing. Pettis argues that while substantial fiscal stimulus is likely – probably channelled through provincial-level borrowers – any attempt to maintain growth rates over five per cent would require an enormous increase in leverage that could severely distort the country’s monetary system. Policymakers have yet to adjust their full-year GDP growth target of 5.6 per cent, which now looks extremely unrealistic.
“In the three years after 2008, China's reserves surged by 60 per cent, whereas they have been stable or grown very sluggishly since 2016 and are unlikely to rise by much this year,” Pettis says. “Because the central bank is required to set the value of the currency within a band, and because China's capital controls are very porous, this sets a limit on the amount of domestic monetary expansion possible that did not exist in the 2008-‘11 period. A substantial fiscal response, in other words, cannot be accommodated by an equally substantial monetary response.”
Much depends on whether China has stamped out COVID-19 or merely slowed its spread
Nowakowski is less concerned about public debt levels than growing leverage among companies and households, which may dampen activity as China emerges from the pandemic. Much depends on whether China has stamped out COVID-19 or merely slowed its spread.
“Corporate and household debt are already high – especially the former – and will rise substantially. This additional burden may weigh on corporate spending and investment, even with lower policy rates. Households might balk at taking on additional risk via consumer debt or mortgages without a ‘healthier’ outlook, both on the economy and risks of future outbreaks,” he says.
Capital flight
Beyond China, the economic effects of the pandemic have panicked investors in other emerging markets. Foreign investors pulled $83 billion out of emerging market debt and equities between 21 January and 23 March (see Figure 2). This is more than three times the equivalent cross-border outflows in the three months following September 2008.5
The relative strength of the dollar has played a role in this capital flight, along with concerns over how the crisis and the associated collapse in demand for exports like commodities will hit emerging economies. Saudi Arabia’s decision to boost output slashed the price of crude after a breakdown in talks with Russia on March 6; this has exacerbated the impact on oil producers from the coronavirus-related demand shock. Poorer countries are also suffering from sharp falls in revenue from tourism and remittances from migrants at the same time as they ramp up spending on healthcare and social welfare to deal with the outbreak.
Figure 2: Portfolio outflows from emerging markets
Central banks have responded pro-actively, with many cutting rates despite depreciating currencies. This is unusual, Ritson points out: historically, emerging market central banks have implemented pro-cyclical policies at times of financial stress in order to stabilise their currencies, whereas this time they are prioritising output, which may reflect an expectation that low levels of inflation will persist in the wake of the crisis.
Stronger emerging markets have trimmed current account deficits, improved their fiscal positions and taken greater control over monetary policy
The emerging market debt sell-off in the early stages of the coronavirus pandemic was indiscriminate, but many emerging countries are more resilient than they were during the “taper tantrum” of 2013, when the prospect of a Federal Reserve interest rate hike spooked investors. Stronger emerging markets have trimmed current account deficits, improved their fiscal positions and taken greater control over monetary policy since then. This is likely to be reflected in portfolio flows over the coming weeks as sentiment turns and investors become more discerning, Ritson believes.
EM strengths and weaknesses
The crisis has already highlighted existing divisions between stronger and weaker emerging economies, by putting governance and economic resilience to the test. South Korea, for example, has led the world in coronavirus testing and is being hailed as a model for many Western countries; by keeping track of COVID-19 clusters, it has been able to contain the outbreak without shutting down its whole economy. Brazil’s leadership, by contrast, has invited criticism by questioning the seriousness of the pandemic despite infections among senior members of the government.6
The economic effects will diverge widely. Economies in north Asia, along with India, should benefit from lower energy prices; commodity exporters in Latin America look more exposed.
Prior to the crisis, growth in Asia had been strong, debt levels low and current account balances modest
“Prior to the crisis, growth in Asia had been strong, debt levels low and current account balances modest,” says Carmen Altenkirch, emerging market sovereign analyst at Aviva Investors. “In contrast, Latin America’s starting point in terms of growth and fiscal balances are much weaker. Chile, for example, had already begun spending more to quell discontent in the aftermath of recent political protests, and its budget deficit could rise to as much as ten per cent of GDP this year.”
Other Latin American nations, such as Mexico, also look fragile in a world of lower commodity prices. Brazil could be particularly vulnerable: not only has it bungled its response to the pandemic, but it has increased its direct trading links to China, and may be among the nations worst affected by the Chinese slowdown. In the wake of the global financial crisis, Brazil was one of the countries that benefited most from the surge in Chinese demand for resources; the story is likely to be different this time around.
Among other oil producers, central Asian economies such as Russia and Kazakhstan will be hit by the decline in the price of crude, but they have low external liabilities and policy flexibility should enable them to weather the storm. Oil producers with weaker current account balances and looming debt repayment deadlines will likely be the worst affected: Ecuador, for example, has already requested a 30-day grace period to try to meet its interest payments to creditors.
The pandemic is in its early stages in Sub-Saharan Africa and could inflict a heavy toll on the region’s health systems. The region is more vulnerable now than in 2008, government debt is higher and there is less fiscal space to respond to the crisis. However, its economies have limited debt due for repayment over the next five years, thanks to successful liability management exercises in recent years, and support from the multinational institutions is available.
The IMF has announced a $1 trillion lending facility for countries hit by COVID-19, while the World Bank plans to spend $160 billion over the next 15 months
The International Monetary Fund (IMF) has announced a $1 trillion lending facility for countries hit by COVID-19, while the World Bank plans to spend $160 billion over the next 15 months, largely on budget support and projects aimed at helping countries improve their health infrastructure to tackle the virus.
“IMF and World Bank financing will not be sufficient, but it is a very important piece in the funding puzzle. The size of the financing gap – particularly for oil exporters and countries dependent on tourism and remittances – will likely be much larger. Much will depend on what happens to commodity prices, and how quickly the global economy emerges from lockdown,” says Altenkirch.
The post-COVID-19 world
As for the impact on emerging market companies, investors will need to proceed with caution as COVID-19 hits earnings, argues Way. Firms with weak balance sheets will struggle to survive over an extended period as demand for their products or services slumps. Some companies may come under political pressure to channel resources towards government efforts to fight the pandemic.
“It’s important for emerging market equity investors not to completely lose our nerve and go ultra-defensive after a big market fall. Equally, however, we need to be ruthlessly discerning as we look through our holdings and form a judgement on which companies might struggle to survive an extended period of demand destruction owing to balance sheet or operational gearing, and also those that could be under political pressure for national service. It’s also sensible to be risk-averse in our approach to banks in weaker emerging markets,” Way says.
Investors in emerging markets will need to think about how different the world will look when the COVID-19 threat finally passes
Over the longer term, investors in emerging markets will need to think about how different the world will look when the COVID-19 threat finally passes. Some companies and industries will flourish; others will not. Firms involved in cashless payments, communications and networking may emerge stronger, for example, while those tied to travel and aviation could suffer lasting damage.
For now, however, fighting the pandemic is the priority. Until a cure for the virus emerges, the outlook for emerging markets – as with the rest of the world – remains uncertain. China is at the centre of this story: its success or failure in tackling any further outbreaks while maintaining economic output will be felt far beyond its borders.
“China will suffer from isolation from other countries, lower demand, and potential future outbreaks of the virus as it continues to normalise travel and industry,” says Nowakowski. “Unlike SARS in 2003, COVID-19 looks like it is here to stay until a vaccine arrives – which may not happen at all, and in the best case is still many months away. China is the bellwether for how the world will be able to cope in the meantime.”