Emerging markets: heading for a China-less recovery?

China played a crucial role in the global economic recovery after the 2008-09 financial crisis, but the post Covid-19 recovery will be different: We expect China to slow its international engagement over the next few years. In this context, Angola, Kenya, Ethiopia, Ecuador and Ghana, along with Brazil and South Africa, could struggle to find alternative international sources for funding, investment and trade to sustain their economic growth. The Chinese economy is likely to experience profound changes in the medium to long run, with a shift in the country’s priorities (dual circulation strategy), the slowdown of economic growth and a heavy domestic debt burden (see our recent report for more details). As a result, we expect China’s role as the global growth driver to recede in the coming years. To identify what this could mean for low- and middle-income countries, we look at three different channels of impact: debt, investment and trade.

Figure 1 – Vulnerability to China turning inwards via the debt, investment and trade channels

First, China is likely to gradually disengage from the debt-financing of low- and middle-income countries amid on-going repayment challenges. For our sample of ten economies , this would result in a USD47bn external financing gap by 2025. Over the past decade, Chinese financing to capital-scarce emerging and least developed economies had grown significantly , in line with its strategic objectives and the Belt and Road Initiative (BRI launched in 2013, see Appendix). This lending definitely helped some countries bridge their infrastructure gaps (e.g. Ethiopia, Kenya, Zambia). However, China also granted large amounts of commercial loans to countries with high default or sovereign risks, such as Argentina, Ecuador and Angola . These loans were sometimes backed by natural resources (see Appendix), ensuring that borrowing countries enjoyed acceptable interest rates depite a sensitive credit rating. Such asset-backed loans were generally accompanied by agreements for Chinese firms to own part of oil fields or refinery projects, offering an alleged “win-win solution” to both parties.

But the tide turned in 2020 (and even before the Covid-19 outbreak), with increasing repayment difficulties of debtors and debt renegotiations . Ongoing partial defaults and payment deferrals have certainly paved the way for a slow decline in Chinese outbound lending in the coming years, accompanied by a more selective lending strategy. Indeed, the restructuring of Chinese commercial loans appears complex and incurs important losses for China. Moreover, the physical seizure of commodities and/or assets  by Chinese entities has turned out to be hard to implement in practice.

For each of the ten countries in our sample, we use the share of external debt to China in total external debt as a proxy for Chinese engagement . We obtain a total financing gap of USD47bn (see Figure 2), accounting for 1.4% of total 2019 GDP of these countries. This represents a financing gap of 7% of 2019 GDP in Kenya, 6% in Angola, and close to 5% in Ethiopia and Zambia. The financing gap accounts for 2.2% of our sample’s total forecasted external financing needs  by 2025. Breaking it down by country, this means 15% of Ethiopia’s external financing needs by 2025 would be left uncovered amid China’s partial disengagement, while the share is 13% for Zambia and 11% for Kenya.

These countries would have to secure funding from elsewhere (official international lenders and financial markets) to refinance the large amounts of eurobonds maturing in 2022 and 2023. Yet, already high debt stocks with other official international lenders and the record-high borrowing costs on international markets would make it difficult to offset these China-related financing gaps.

Figure 2 – 2021-2025 Projected China debt financing gap

Second,  the slowdown of the Chinese economy and higher control and selectivity over foreign investment could put Kenya, Ecuador and Ghana the most at risk in the coming decade. China’s outward FDI (OFDI) picked up after 1999 with the “Going Out” policy, under which China relaxed or eliminated many rules on outbound investment and actively promoted it. According to official sources, the stock of non-financial OFDI from China increased eightfold from 2009 to 2018 (from USD246bn to USD1,982bn). Nonetheless, flows of OFDI have slowed in the past few years and while we do not expect China’s dual circulation strategy to halt OFDI in emerging countries, it could continue to slow down going forward for four reasons:

1. In the wake of renminbi scares in 2015-16, the government moved to tighten regulation around OFDI to control capital outflows. It set limits on state-owned enterprises’ overseas investments and increased scrutiny of large outward transactions by private firms.
2. There have been implementation challenges in the BRI (see here for more details), now exacerbated by the Covid-19 crisis. These challenges probably call for foreign investment being more disciplined around national economic targets, e.g. industrial autonomy and innovation.
3. Some emerging countries could follow the U.S. and EU by increasing scrutiny over foreign investment and acquisitions, especially as international opinion of China is turning less favorable. For example, Indian authorities revised the FDI policy in October 2020 , increasing scrutiny of investment carried out by entities of neighboring countries that share a land border with India (thus including China).
4. The structural slowdown of the Chinese economy and large stock of debt domestically (see here for more details) mean that outward investment is likely to slow in the coming decade. In particular, we find a 70% positive correlation between growth in the stock of China’s OFDI, and real GDP growth with a 2-year lead.
   
   

Lastly, beyond the positive trade impulse in the short-term, the structural slowdown and rebalancing of the Chinese economy is expected to trigger a cumulative loss of exports of up to USD24bn by 2030 for the ten countries in our sample. Being the first economy in and out of the slump, China is leading the global recovery out of the Covid-19 crisis in 2020. The strong rebound of the Chinese economy since Q2 2020 has mostly been driven by surprisingly resilient exports (see here for more details), together with robust activity in the construction and infrastructure sectors. Obviously the latter sectors are also good news for China’s trade partners, mainly for commodity exporters.

However, in the long run, the Chinese economy is on a path towards a structural slowdown under the impact of a declining labor supply and capital accumulation, as well as slowing productivity gains. We estimate that China’s GDP growth could average between +3.8% and +4.9% over the coming decade (after +7.6% in the 2010s), depending on the success of structural reforms in lifting potential growth (see here for more details). Furthermore, increasing protectionist rhetoric across the globe, along with the dual circulation strategy launched this year, are likely to transform the country’s foreign trade. In particular, China’s trade strategy seems to prioritize maintaining export market shares while reducing reliance on imports.  

Taking into account these structural changes, we can quantify the amount of Chinese domestic demand  that will be ‘lost’ compared to a situation with growth similar to the 2010s for countries exporting to China. We find that in value terms, Brazil, Angola and South Africa would incur the largest cumulative loss of exports by 2030, amounting to up to USD14bn, USD5bn and USD2bn, respectively (see Figure 4). In relative terms, Angola, Zambia and Ghana would be the most hit, with the cumulative loss of exports by 2030 amounting to up to 5.8%, 1.4% and 0.9% of their respective GDPs.

Figure 4 – Cumulative loss of exports by 2030 caused by Chinese structural changes (slowdown and rebalancing)