China: The Only Emerging Market That Really Counts

Jan 05, 2019
finance

Book: Trading Fixed Income and FX in Emerging Markets Authors: Dirk Willer, Ram Bala Chandran, Kenneth Lam Publisher: Wiley (2020) ISBN: 978-1-119-59905-0

This post covers the first half of Chapter 3: “China: The Only Emerging Market that Counts.”

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The One EM That Actually Matters

In the previous chapter, we talked about how emerging markets get pushed around by global factors and the Fed. EM countries are basically boats on the global macro ocean, and the Fed is the one making the waves.

But here’s the thing. The Fed doesn’t really care about EM. When the Asian financial crisis hit in 1997, the Fed still hiked rates. The crisis spread to Russia, and the Fed finally cut rates the next year. But not because they wanted to help EM. They cut because the Russian default blew up Long-Term Capital Management, a big hedge fund in the US, and the S&P 500 started tanking. The “Powell Put” is an S&P put. It is not an EM put.

There is exactly one exception: China.

How China Became the Center of Everything

China’s rise really kicked off when it joined the WTO in December 2001. The authors call this one of the most underappreciated events in recent market history. At the time, markets barely noticed. But since then, China’s GDP has grown at 9% per year on average, exports in USD terms have grown 15% per year, and the current account balance ballooned from under $20 billion per quarter to $420 billion at the 2007 peak.

China became either the largest (PPP terms) or second-largest (market exchange rate terms) economy in the world. It’s the manufacturing floor for everyone. And while the Trump administration has been trying to turn that back, it’s not easy. Even as Chinese exports to the US fall, exports from China to the rest of the world increase. China is just hard to replace.

China: The Importer of Choice

Here’s where it gets real for EM investors. The authors look at Chinese imports as a percentage of each exporting country’s GDP. The numbers tell the story:

Vietnam leads at 22.9%, followed by Malaysia (17.4%), Korea (11.5%), Singapore (10.6%), and Thailand (9.1%). The pattern is clear: China’s impact hits its Asian neighbors the hardest, because a huge chunk of any country’s trade tends to be local.

But commodity exporters also show up high on the list. Chile at 7.6%, South Africa at 7.0%, Peru at 6.2%. Even Brazil at 2.9% feels it.

On the other end? Mexico sits at just 1.0%, and the US at 0.8%. Remember that Mexico number. It comes back later.

The Commodity Link Is Massive

China’s growth has been insanely commodity-intensive. All that infrastructure building and fixed asset investment eats raw materials for breakfast. Between 2006 and 2016:

China was responsible for 97% of incremental demand for iron ore
61% of incremental demand for copper
38% of incremental demand for crude oil
26% for soybeans

Read those numbers again. Ninety-seven percent of the world’s new iron ore demand over a full decade came from one country. That’s not a market participant. That’s the market.

The authors push back on the idea that China’s growth will become less commodity-intensive going forward. Sure, consumer goods need fewer raw materials than infrastructure projects. But housing stock growth, car penetration, electricity grid expansion… all of that still needs a lot of stuff. And even if demand growth slows a bit, we’re talking about a much larger base. The beta of copper to the China PMI has actually increased over recent years.

Two Ways to Measure China Dependence

There’s a neat trick the authors use. Direct exports to China is one measure, but there’s a second: China-sensitive commodity exports as a percentage of GDP. It doesn’t matter if you ship your iron ore to Japan or Germany. If Chinese demand drops and prices fall, you’re getting hurt regardless.

When you combine both measures, the picture changes a bit. Malaysia, Korea, Singapore, and Thailand stand out for direct exports. But Russia, Chile, and Peru are just as sensitive through the commodity price channel. Central and Eastern Europe, India, Mexico, and Turkey are the least sensitive.

China Stimulus Moves Commodity Currencies

Want proof that China stimulus matters for EMFX? The authors plot two leading indicators for Chinese growth (a monetary conditions index and a credit impulse index) against a basket of commodity EMFX. The correlation is striking. The ebbs and flows of China’s economic stimulus show up directly in commodity currency performance.

Sometimes FX moves with the stimulus in real-time. Sometimes FX leads. But sometimes the FX market is slow to react, like when the stimulus impact started fading in 2017. That kind of lag creates trading opportunities.

The Leverage Problem (That Never Quite Blows Up)

Total domestic non-financial sector debt went from 140% of GDP in 2007 to 240% in 2016. That’s a scary number. The IMF is worried. Chinese authorities are worried too.

But here’s the authors’ honest take: nobody really knows how much debt is too much. Academic estimates keep going up. Countries that would have been called dangerously overleveraged ten years ago are doing fine today. The authors remember the first “China is bust” scare of their careers in 2004. Fifteen years later, the numbers got scarier, but the bust never came.

One reason? China’s economy is basically one big balance sheet. Regulators can shift resources around in ways that other countries simply can’t. That doesn’t mean there’s no risk. It just means timing a China bust is nearly impossible. The authors’ best guess is that a meaningful amount of Chinese assets will need to be foreign-owned before authorities lose control. And foreign ownership is still in early innings.

Current Account Surpluses Are Disappearing

China’s current account surplus went from +10% of GDP in 2007 to just +0.4% in 2018. The authors expected it to turn negative by around 2022. The reasons: China’s growing middle class imports more consumer goods, tourism spending is rising, and China’s manufacturing market share gains are probably topped out.

This matters a lot for policy. A current account surplus is like a safety net during downturns. You don’t need foreign savings to keep things going. Without it, China becomes more vulnerable to sudden stops of capital flows. The Chinese authorities have managed to accumulate massive debt partly because they didn’t need to rely on foreign money. That changes when the current account goes negative.

The Capital Account Is Opening (Slowly)

As of 2019, foreign ownership of domestic A shares was just 3.2%. Foreign ownership of local bonds was 2.8%, with China Government Bonds (CGBs) a bit higher at 7.9%.

This low foreign participation explains why the correlation between Chinese A shares and the S&P 500 has been all over the place, swinging between -0.4 and close to 1.0. But the trend is clearly upward. As more foreign money comes in, China’s markets will become more connected to global markets.

The opening is happening on multiple fronts. HK Connect launched in 2014 for equities. MSCI started adding A shares in 2018. On the fixed income side, Bond Connect launched in 2017, and Bloomberg began adding China to its global aggregate index in April 2019. JPMorgan’s GBI-EM followed. The FTSE Russell WGBI is expected to include China eventually too.

All of this is great for attracting capital inflows to offset domestic money leaving the country. But it comes at a price: deeper integration means global shocks will hit China harder. And given the leverage in the system, that makes the world more precarious.

The 1.9% That Shook the World

On August 11, 2015, the PBOC let the CNY move by 1.9% in a single day. The biggest single-day move in over a decade. They said it was part of moving toward a more flexible exchange rate.

The market freaked out.

The S&P 500 dropped more than 10% in four days. Two-year US rates fell from 0.97% to 0.78%. The Fed, which had been planning to hike at its September meeting, blinked and held. China had literally changed the path of US monetary policy.

And here’s the wild part: even though the Fed going dovish is normally bullish for EMFX, it wasn’t enough. EMFX kept selling off until early 2016, when USD-CNY finally peaked. It took China burning through roughly $600 billion in FX reserves (from $3.6 trillion in July 2015 to $3.0 trillion by early 2017) to stabilize things. And even that might not have been enough on its own. The DXY happened to turn around at the same time, so it’s still unclear whether it was intervention, capital controls, or just luck.

The Heavy Hand of the PBOC

China manages the CNY against a currency basket that’s dominated by USD and EUR. Every day, the PBOC sets a “fix” for the CNY, and the market watches whether it’s stronger or weaker than what basket movements would imply.

When the fix deviates from the theoretical level for a few days in a row, the market reads it as a signal. The PBOC wants a correction in direction or pace. And usually, the market listens. In a calm environment, the game for traders is to anticipate what the PBOC wants, not to fight it.

The 2015 episode was one of the rare moments where the market didn’t listen, and it cost the PBOC a trillion dollars in reserves to restore order. But that takes a massive shock. Normally, the combination of large FX reserves, guidance to state-owned banks, and capital account controls gives the PBOC serious control.

12-Month CNH as a Warning Signal

Here’s a practical trading signal. The offshore yuan (CNH) is often more volatile than the onshore CNY, especially on the bearish side. That makes the ratio between the two a useful indicator for how extended a sell-off has become.

Even better: look at the 12-month CNH forward. It’s the main vehicle for expressing negative China bets. When the 12-month CNH trades more than 5% weaker than CNY spot, that has historically been a good signal that the sell-off is getting mature. Time to start looking for a reversal.

Once a CNY move has gotten extreme on the weak side, bullish positioning is better expressed in CNH rather than CNY, since CNH has more room to snap back.

EM Asia and Commodity FX in China’s Crosshairs

The authors calculate betas of major currencies to the 12-month CNH, after controlling for EUR-USD moves (important because EUR is a big part of China’s basket, so without that control, betas would be overstated).

The highest betas belong to commodity currencies (ZAR, CLP, AUD, COP, NZD) and Asian currencies (KRW, AUD, NZD), ranging from about 0.5 to above 0.9. Next tier: JPY, CAD, RUB, TWD, SGD, NOK, sitting just below 0.5.

And the outlier? MXN. Mexico’s peso is almost as safe as the Swiss Franc when it comes to China fears. Mexico competes with China in the US market, so a US-China trade war actually benefits Mexico. Supply chains that leave China often don’t go back to the US. They go to Mexico.

Accessing Chinese Fixed Income

For investors wanting to actually trade Chinese bonds, there are three main access points:

Bond Connect (launched 2017): The newest and most streamlined route. Allows international investors to trade onshore Chinese bonds through Hong Kong infrastructure. No onshore account needed.

CIBM Direct (launched 2016): Direct access to the China Interbank Bond Market. Requires registration with the PBOC but offers broader access than the older schemes.

QFII/RQFII: The original schemes (Qualified Foreign Institutional Investor and its renminbi variant). These require PBOC approval and have quotas, making them more restrictive. QFII started in 2013 for bonds.

The big catalyst for flows has been index inclusion. Bloomberg added China to its global aggregate index starting April 2019, phased in over 20 months. That alone could bring around $150 billion of foreign inflows. JPMorgan’s GBI-EM followed. FTSE Russell’s WGBI is expected to add China eventually.

Historically, when other EM countries got added to major indexes, actual inflows exceeded the estimates based strictly on AUM tracking those indexes. The reforms countries make to qualify for inclusion improve liquidity, which attracts non-indexed money too. If that pattern holds for China, foreign ownership of CGBs could reach 20% by 2023.

The CNY’s Future as a Global Currency

The internationalization of the CNY is still early. As of early 2019, the CNY’s share of international payments was under 1.9%. But it’s growing fast, helped by inclusion in the IMF’s SDR basket in 2016 and by the Belt and Road Initiative.

From a trading perspective, the CNY was already the third-most-traded FX after EUR and JPY by late 2018. And the CNH already anchors most of Asia FX more than the JPY does. The correlation of USD-CNH to USD-Asia is both higher and more stable than the correlation of USD-Asia to JPY.

The sun, as the authors put it, has set for the JPY as Asia’s anchor currency. The CNH is taking over.

What to Take Away

China is the EM that matters. Not because of some abstract economic theory, but because the numbers are so big they’re undeniable. When China buys commodities, prices move. When the PBOC nudges the CNY, emerging market currencies feel it. When China stimulus fades, commodity EMFX follows.

For traders and investors, the key signals to watch are: China’s monetary conditions and credit impulse (for commodity EMFX direction), the PBOC’s daily fixing (for near-term CNY direction), and the 12-month CNH forward (for how stretched positioning has become).

In Part 2, we’ll look at how to actually trade Chinese rates, why CGBs are “the JGBs for millennials,” and what signals Chinese bond yields send about the global business cycle.