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Adjusting to China’s syndrome

East Asian economies are heavily plugged in to the region’s powerhouse and feel the shocks when it slips, but these countries are finding ways to cope, writes Rodrigo Amaral

At a glance 

• China’s rapid growth has played an important role in raising prosperity across East Asia.
• Conversely, slower Chinese growth could threaten the vitality of the region.
• Equities are more vulnerable to this effect than bonds.
• However, it should not be forgotten that emerging markets have their own growth drivers.

For decades, China’s spectacular growth was a boon for other East Asian economies. A new era of moderate growth promises to be challenging for the region.

China’s importance for the economic health of its neighbours is hard to be underestimated. It is the main trading partner for South Korea, Singapore and Hong Kong, the second largest for Indonesia, Malaysia, Vietnam and Thailand, and the reliance on the Middle Kingdom is exacerbated by a flow of direct and financial investments that has swollen in recent years. 

According to Natixis, economic links with China, in the shape of exports, tourism or investments, amount to almost 20% of Singapore’s GDP, 14% in the case of Taiwan, and 13% for Vietnam. According to the International Monetary Fund (IMF), cross-border loans to China represent 27% of all banking assets in Hong Kong, 15% in Singapore, and 7% in Taiwan. The IMF also estimates that flows of Chinese investments to other Asian nations reached $300bn (€270m) in 2015.

When China flies, therefore, regional economies tend to thrive. Conversely, when it slips, Asian economies stumble along with their giant neighbour. And it appears to have been slipping for at least half a decade, when annual GDP growth has fallen from double digits to 6-7%, dragging down many of its neighbours in the process. The correlation is clear in capital markets, as research by the IMF has found statistical evidence that the ups and downs of China’s stocks have a growing influence on the behaviour of equities in neighbouring economies. 

Today, China already carries as much weight on the performance of regional stocks as Japanese exchanges and only the US exerts a stronger pull on Asian markets.

It is a different story with fixed income as, according to the Bank of International Settlements (BIS), the isolation of the Chinese bond market makes it unlikely to affect the behaviour of the asset class elsewhere. But the Chinese economy can move regional bonds by hampering the perspectives of growth for individual firms, business sectors or even whole economies, and also by affecting the general mood of investors. 

Both the IMF and the BIS, however, say that the main source of contagion from China to other Asian economies is via direct trade links. In this sense, some countries suffer more than others, according to the extent that their industrial base was developed under the expectation that demand from China would continue to grow strongly for the foreseeable future. This trend is clearly evident in Korea, whose economic engine has decelerated notably along with China’s in recent years. 

“South Korea’s economy is strong in areas such as shipping, shipbuilding, automobiles, petrochemicals and refining,” says Samir Mehta, a senior fund manager at JO Hambro. “All those sectors have been impacted by the slowdown in China.” In fact, Korean GDP expanded by 2.6% in 2015, a sharp drop from the 6.5% rate of 2010, one year before China started to show the first signs of cooling down. 

“Exports of industrial equipment from South Korea to China, which used to post very strong growth, have slowed down in the past two years,” agrees Mathieu Nègre, head of global emerging market equities at Union Bancaire Privée.

Another market much exposed from the trade side is Taiwan which, like Korea, exports many intermediary goods used by Chinese companies in their production lines. Taiwanese firms also own a large number of subsidiaries in China, and slower growth rates can put the return from those investments in question. 

On the other hand, both South Korea and Taiwan are well integrated with export markets in the developed world, which can help to offset lower Chinese demand, Nègre says. “Korea and Taiwan sell a high volume of products to China, but at the same time they are well correlated with exports to developed markets. They are probably more dependent on economic growth in the US and Europe than in China,” he says. Of course, to compensate for a China slowdown, the US and Europe would have to show more activity.

Other markets in the region are affected by the sharp reduction of China’s demand for commodities. This was especially the case for Indonesia and Malaysia, the former a top provider of timber, and the latter, of oil to the Chinese market. 

“Indonesia has adjusted more successfully than Malaysia. Policy-making environment has looked better there,” Nègre says. “The government is determined to conduct reforms and is pushing up infrastructure spending. So although commodity exports answer for 25% of fiscal revenues, and China is a big client, investors have a positive view of Indonesia.”

The economy that has suffered the most from lower Chinese demand for commodities is, in fact, a developed one – Australia, which sells almost a third of its exports to China. For the likes of Korea and the Philippines, which are net importers of commodities, the China-related price slump has actually proved useful to counterbalance other economic headwinds.

But the immediate economic slowdown is not the only, and maybe not even the main, story of what is happening in China and how it affects the rest of Asia. In the long run, the economic relationship could be quite different because of the stated plan of the Chinese government to change the country’s growth model. In the past few years, China has tried to move away from the heavy public investments plus cheap exports formula of the past decades, towards one that favours domestic consumption and value-added, high technology industries. 

The change remains a work in progress, and analysts doubt that the government will stop pumping money into infrastructure, housing and other public investments while the economy is stuttering. But some effects of the new economic tack can already be spotted around the region. “One of the sectors that has been given a boost is tourism, and among the biggest beneficiaries of this trend have been Thailand and South Korea, which have seen the number of Chinese tourists increase disproportionally,” Mehta says. 

Companies are also increasingly transferring production plants outside of China to take advantage of lower labour and production costs. “Low manufacturing has moved to Vietnam, Cambodia, Bangladesh and Indonesia,” says Ashish Goyal, the Singapore-based head of emerging markets equities at NN Investment Partners. “Investors can take advantage of this trend indirectly by looking at the companies that are moving their production lines to these countries.”

Furthermore, Danny Dolan, managing director of China Post Global, says the change of direction taken by China could also result in stronger flows of foreign investments to other economies as it frees resources in the long run. “China is a major FDI [foreign direct investment] supplier globally, and a key investor in its neighbouring countries,” he says. “As China transitions, the FDI impact may be negative in the short term, but will be strongly positive longer-term.” 

The spillover effects of China’s new economic trends in Asia are mixed, and they could take a wide array of forms, both positive and negative, in years to come. So far, however, it seems that the worst expectations have been avoided as fears of a hard landing for the Chinese have abated. “The unemployment situation has not worsened across Asia, which has been a positive surprise,” says Anthony Chan, economist for Asia ex-Japan at AllianceBernstein

Geopolitical tension, an inheritance of long and fraught common history, is always a factor in the regions as well, but it does not seem to be a major source of concern right now, despite some bold talk on issues such as territorial disputes in the South China Sea. “It is looming in the background, but markets do not seem to be much affected by it,” Chan says.

Alicia Garcia Herrero, the chief economist for Asia and Pacific at Natixis, points out that investors should not forget that emerging Asian economies have their own growth drivers, with countries like Indonesia and the Philippines benefiting from a large and young population and dynamic domestic economies. “Asia can develop in a sustainable way even without strong rates of Chinese growth,” she says.

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