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Emerging Markets Can't Evade a China Slowdown

Expect any turbulence in the nation’s financial markets to be transmitted across the developing world.  

Emerging Markets Can't Evade a China Slowdown
Visitors look at an electric stock board. (Photographer: Kiyoshi Ota/Bloomberg)

(Bloomberg Opinion) -- U.S. measures to confront China on trade are shifting from tariffs to imposing restrictions on the activities of Chinese firms, which will have adverse consequences not only for the yuan but emerging markets overall.

With China accounting for 40% of the gross domestic product in developing economies, investors should expect the yuan’s recent weakness to accelerate as Chinese savers seek to hedge their risk by switching to dollar-denominated investments. Despite efforts by the central bank to stem the fall, the currency is likely to depreciate beyond the closely watched threshold of 7 per dollar at which the currency last traded in April 2007. This would have adverse implications for both China’s debt as well as the economy’s rate of growth.

Emerging Markets Can't Evade a China Slowdown

With total dollar-denominated debt of Chinese companies rising in recent years, also expect defaults to surge in response to a weakening yuan. Particularly affected would be companies in the property sector, which owe debt denominated in dollars but cater to Chinese tenants and buyers who pay in yuan. Defaults tend to have a domino effect because lenders to property developers, in turn, would be unable to service obligations to savers from which they get their funds.

Chinese local-currency obligations accounted for 6% of the Bloomberg Barclays Global Aggregate Index as of April, and the share will increase in coming months. When the phase-in is completed, Chinese debt will form the fourth-largest component in the index after the dollar, euro and yen, according to Bloomberg. Expect trade tensions and the fallout on other emerging-market debt to push the index lower in coming months.

Emerging Markets Can't Evade a China Slowdown

On the equity front, China was included in various MSCI indexes last year. The share of China in the MSCI Emerging Market Index is forecast to more than triple from less than 1% at initiation to about 3.3% by the end of 2019. Passive investors using such indexes for exposure to emerging markets will find that other developing economies cannot make up for losses they incur in Chinese equities.

China’s 1.3 billion population, and an increasingly affluent middle class, have made it a major purchaser of goods and services from other emerging markets. It is the largest export destination not only for neighboring Asian countries but also for countries such as Brazil.  Australia, a major mineral and commodity exporter, has already felt the adverse impact of the slowing Chinese economy. Expect any turbulence in Chinese markets to be transmitted across the developing world.

Emerging Markets Can't Evade a China Slowdown

Developments in the summer of 2015 support my expectations for the yuan and emerging markets. After the Shanghai Stock Exchange Index had hit that year’s high of 5,166 on June 12, fear that the U.S. Federal Reserve was about to implement its first interest-rate hike since the financial crisis put pressure on the yuan and emerging markets. The Fed’s decision not to go through with the rate increase that September was not sufficient to provide a reprieve. Instead, the carnage in global markets continued through the end of the year.

China has increased its global dominance since its mini-crisis of 2015. The International Monetary Fund estimated in April that the country’s $14.2 trillion gross domestic product is larger than the euro zone’s $13.6 trillion, and is second only to the U.S.’ $21.3 trillion. And reflecting the yuan’s increasing usage as a global currency, the IMF included it in the Special Drawing Rights (SDR) currency basket in September 2016.

Investors should be aware that the country’s growing dominance in the global economy means that the U.S.’s latest measures would be negative for their holdings beyond China.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Komal Sri-Kumar is the president and founder of Sri-Kumar Global Strategies, and the former chief global strategist of Trust Company of the West.

©2019 Bloomberg L.P.