Emerging markets, the rise of China and the pandemic

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In our latest podcast, BNY Mellon chief economist Shamik Dhar caught up with Insight fixed income manager Colm McDonagh to get a gauge on the changes wrought by Covid-19 and what they might mean for investors in emerging markets

Shamik Dhar (SD): There’s been a lot of talk recently about how emerging markets might look in a post-Covid-19 world. What’s your view on rising protectionism, the shortening of supply chains and the trend towards reshoring? Is that a threat to the emerging markets growth story?

Colm McDonagh (CM): There’s a reasonable amount of uncertainty surrounding how any part of the global economy will look after this. In terms of reshoring, it’s pretty clear that a lot of companies are going to have to rethink their strategies. I do think many of the emerging markets may begin to move away from the export-led economic model that’s dominated until now in favour of a more regional approach.

There’s a political angle too. Right now everyone’s going through the same exercise. How do we rebalance our economy in a way that won’t create fiscal or political risk?

SD: I think it’s fair to say a new world was kind of emerging anyway. There was a degree of deglobalisation going on before Covid-19 and the pandemic has just accelerated those trends. My own feeling is that – yes, supply chains will shorten – but the US and Europe in particular may just look to diversify away from China as well and we might see the emergence of regional trade blocks along these lines. In that scenario, the opportunities for EMs don’t disappear entirely; they just take a different shape – and some might actually benefit.

CM: I think you’re right. Like many others, we’ve been thinking through how the global and financial architecture has begun to change in recent years. Clearly, the US has been the dominant force along with Europe – but as China has emerged, that’s begun to evolve into this multipolar world where we have three main centres for monetary, economic and currency policy. For many countries it’s become clear that the more important trading, political and economic relationship is with China; not the US. It makes for a tripolar world and we think Covid-19 could accelerate that evolution.

SD: That’s an interesting point: I suppose the question is whether that’s informed your investment decisions or not in the run-up to Covid-19 and in the time since then?

CM: I can give you an example. If you think about the beginnings of eurobonds many years ago. They were created to tap into the savings that people had in dollars outside of the US. The question we were asking ourselves was this: could we see something similar being created in China’s case?

Think about the One-Belt-One-Road initiative and what that means for China’s soft power and economic influence outside of its borders. If you have these logistical routes being built and partially financed by China, do you end up in a situation where the world increases its offshore renminbi savings – in which case could you see the formation of the equivalent of a dollar/Eurobond market in the renminbi/eurobond market? Are we seeing the beginnings of a move away from the dollar-centric financial architecture we’ve become so used to over recent decades?

SD: But I suppose the question would be how would the US respond to that? It’s pretty clear the narrative of the US/China relationship has changed fairly dramatically since about 2015/2016 onwards. Ten years ago, with the One-Belt-One-Road programme, you could argue the West’s response was one of benign neglect – but I think we’ve moved beyond that to active opposition in many spheres.

CM: No question, there’s competition there. But our takeaway is that China is simply learning from what the US has done over the years. There are many ways of increasing your global reach. I know it’s been called the exorbitant privilege of the dollar – but the fact that it’s the reserve global currency does bestow some quite meaningful power on the US. Why wouldn’t the Chinese have noticed this – and why wouldn’t they too try to figure out a way to achieve the same or similar benefits? From the US perspective, they haven’t really had that many challenges to their currency hegemony so it’s something they’re going to have to think hard about in the coming years.

SD: Clearly that’s a long term ambition for the Chinese – however, I suspect it will be some time before they’ll be able to achieve it. In the short run it seems to me the dollar shortage has reappeared, particularly during the uncertainty in March. It’s almost been a bellwether of global stability: it rises whenever financial stability is under threat and falls whenever things get a bit calmer.

CM: There’s an unusual complication that comes with that too. Suddenly when you have the pre-eminence of the dollar and you have companies and countries financing themselves in dollars then, as the Fed has discovered, you can’t just look to your own borders. You have to factor in the rest of the world and the implications of that dollar scarcity. We witnessed that in the provision of dollar-swap liquidity to other key, larger economies in the most recent crisis. It’s now very much a part of the Fed’s playbook.

SD: Broadening things out, I wanted to get your view on how emerging market fixed income has evolved in recent years. Ahead of Covid-19, there was discussion about the rise of idiosyncratic risk and how emerging markets are far less of a cohesive asset class than they have been in the past. Do you think Covid-19 has accelerated that process?

CM: If anything, I’d say the pandemic has served to remind people what an incredibly diverse asset class it is. You go back 20 years and the emerging markets fixed income universe was much, much smaller. If you had volatility in one part of the world, that would cross over to other emerging market countries. There’s been such a big change in the years since then, though, both in terms of the speed and scale of evolution in different parts of the world that it’s almost unrecognisable. The asset class is no longer treated as one monolithic whole: these days, investors are far more inclined to divide and then sub-divide again into those idiosyncratic risks.

It’s also worth noting that the investor base has changed too. It’s no longer just the purview of international investors: there’s far more domestic capital taking part these days too. The rise of emerging market pension funds, insurance companies and sovereign wealth funds has seen to that.

The way different parts of the emerging market world has responded to Covid-19 illustrates this point perfectly. You take parts of Asia that witnessed the first infections and, in many cases, appear to have dealt with the pandemic most efficiently and are now on the path to some semblance of recovery. Then contrast that with Latin America, where for a whole range of political, economic and social reasons, the response has been very different. Even just in that example you get an idea of the breadth of difference in and among the EM universe.

81965 GE0177, 17 NOV 2020

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