27 Jul China’s great decoupling and what it means for investing in “emerging markets”
As published in FA News on 22 July, 2021 by Kyle Wales
With China’s great decoupling a top-of-mind consideration for most investors, the emerging markets investment story has become about China on the one hand and all the other emerging markets on the other.
Thus, the term “emerging markets” as an investment destination is proving increasingly less useful for investors. The term was coined by economists at the International Finance Corporation (IFC) in 1981 to replace the term ‘less developed’ because it had fewer negative connotations and it would help promote investments into those countries.
From the start, the broad cohort of countries within the grouping had far more aspects that set them apart than brought them together. The term lumped together exporters of manufactured goods (including China), countries with high GDP per capita whose economies were too focused on a single sector (like Israel, UAE and Kuwait), commodity exporters (like South Africa), and large domestically focused economies (such as India).
However, since then China has outgrown its emerging market peers and now has little in common with them, while still being part of the MSCI Emerging Market (EM) stock index, of which it forms too large a part.
It was always a mathematical inevitability that China’s importance on the global stage would rise. Where we sit today, with China unquestionably a global superpower, it is easy to forget that in 2001, Chinese GDP per capita on a purchasing power parity (PPP basis) was under $4,000. It is $18,000 today – an increase of 350%. By way of a comparison, during this period South Africa’s GDP per capita has increased from $10,000 to $12,000 – a mere 20%.
China’s total GDP (also on a PPP basis) surpassed that of the US in 2014, making China the largest economy in the world on that measure and its economy is expected to surpass that of the US in nominal US dollars in 2032 – making it officially the biggest economy in the world.
China’s weighting in the MSCI Emerging Market Index is at nearly 40%
China’s weight in MSCI’s Emerging Market (EM) Index has mirrored the rise of its economy. This trend was accelerated by MSCI’s decision to include Chinese large cap A shares (mainland listed Chinese shares as opposed to Chinese shares listed in the rest of the world) in May 2018. These shares hadn’t been included in the MSCI EM Index due to capital controls within China. China now accounts for 38% of the MSCI Emerging Markets Index, up from just 5% in 2001. From an investor perspective, this has created a similar problem to the weighting of Naspers/Prosus in local indices, giving rise to EM ex China mandates to reduce concentration to China.
The correlation between China’s economic growth and the other emerging markets is breaking down.
Gross fixed capital formation has always been an outsized contributor to the Chinese economy – and it remains so. Gross fixed capital formation made up 43% of China’s GDP in 2020 (the same ratio for South Africa is 13%). However, the nature of that spend is changing. Less of it is being spent on bulk infrastructure spend (which is more commodity intensive) and more of it into making China “fit-for-purpose” for a technologically focused world.
In the decade to 2010 (2000-2010), commodity exporting countries, which accounted for the majority of the BRICS countries, benefitted from China’s rise because as China’s economy grew so did its demand for commodities. This no longer the case. While China’s GDP continued to grow strongly in the decade to 2020 (2010-2020), the GDP growth performances of South Africa, Brazil and Russia have been poor. India’s economy, which continued to perform well in the decade to 2020, is not a commodity exporter.
China has emerged stronger, both economically and strategically
For many emerging markets, the decade to 2020 has been a return to the 1980’s, when many emerging markets were considered “failed states” rather than being on the road to higher per capita incomes and standards of living.
In South Africa, we have witnessed a “lost decade” due to corruption and poor leadership. Brazil had its own corruption scandal, “Lava Jato” which led to the imprisonment of its former president Lula, who has (post his release from prison) re-emerged as a strong political challenger to the controversial Bolsonaro. Finally, in Russia, we have seen perceptions of political risk become elevated through the actions of Vladimir Putin, which has included the invasion of Ukraine, the persecution of his opponents and anti-Western rhetoric.
It is thus no longer a winning strategy to invest in a broad index of stocks when investing in these economies if one is focused on generating absolute (rather than relative) returns, but increasingly necessary to pick amongst winners and losers.
In the case of China, not only have we seen it emerge economically stronger but strategically stronger as well. While the rest of the world used Ricardo’s theory of comparative advantage as the basis for free trade and creating global supply chains, China has gone along with this when it worked in its favour, while all the time aiming for self-sufficiency from the rest of the world. It has already become the world leader in certain essential technologies like 5G, and is throwing significant resources behind catching up with the West in areas like commercial aircraft manufacture and semiconductor manufacturing.
While any attempt at generalization is fraught with error, placing China in the same bucket as the rest of the emerging markets, increasingly looks like a case of mistaken identity. To let one’s investment universe be defined narrowly on what constitutes an “emerging market” or not is similarly misguided, suggesting that funds should evolve towards having truly global mandates, with stock selection forming the basis for investing in these countries rather than hoping for “a rising tide to raise all boats”. However, the one possible exception is China, which, more often than not, is proving to be the tide.
