Trade wars, belts, roads and all in between

Phnom Penh, Cambodia

Over the past year, the news flow from China that has affected frontier markets has been about either the China-U.S. trade war (its impact has been reviewed in previous blogs) or China’s “Belt and Road Initiative” (BRI for short). The latter, an odd-sounding entity, and its potential impact on global markets are difficult for many global investors to understand.

Recently, China wrapped up its Second Annual Belt and Road Initiative (BRI) Forum in Beijing. The BRI Forum included 37 heads of state (including two EU members), and 173 co-operation documents were signed with 125 countries. The event was the culmination of a broad-based foreign and economic strategy that began in 2013, focused on 84 countries (and counting). Of the countries targeted, 75% are classified as “frontier markets,” and 40% are located in Asia. So China’s strategy, which is multi-faceted and complex, is likely to have an impact on both frontier and emerging markets.

From my perspective, the key to understanding BRI is to widen one’s historical and economic lens. On the historical side, the BRI policy is part of what can be called China’s “reversion” to developed market status, which began after the death of Chairman Mao in 1972. What do I mean by that? China has over 5,000 years of rich history, and during that period, was one of the world’s most powerful countries. Those years of supremacy included a central role in global trade (part of which was the fabled “Silk Road”) and having direct influence over a large Asian region. The nineteenth century (as seen in Chart 1) was more difficult (in China it is known as the “century of humiliation”), and China reached its ultimate low when it almost consumed itself in the Cultural Revolution and Great Leap Forward. With the death of Mao and reforms by Deng Xiaoping (whose economic reforms were recognized by Time Magazine, which awarded Deng the title “Man of the Year” in 1977), China began a path back to “normal”.                  


Chart 1: Global GDP % share since 1000
Chart 1:  Line graph showing fluctuations of U.S., China and Euro area GDP as percentage of Global from year 1000 to 2015.  China's changes described in previous paragraph.
Source: Angus Madison.


On the economic side, we need to look at investment flows beyond the headlines. For most investors, BRI news usually revolves around large-scale Chinese government infrastructure projects (such as the coal-fired power plants shown in Chart 2) in emerging and frontier markets such as Pakistan, Sri Lanka or Malaysia. Most projects are seen as opaque and risky for the receiving country (we have seen projects cancelled in Malaysia, stalled in Africa and re-evaluated in Sri Lanka).


Chart 2: Coal-fired capacity under development with Chinese finance
Chart 2:  Map showing countries with coal-fired capacity, financed by China as of July 2018.  The impact of this investment described in the previous paragraph.
Source: Global Coal Plant Tracker (July 2018, Institute for Energy Economics and Financial Analysis).


To better understand this “Chinese normalization” process via the BRI, we must analyze capital flow data that include not only infrastructure spending but also private business reactions to the broader BRI policy framework. Accordingly, foreign direct investment (FDI) is likely the best proxy to understand the impact of BRI on frontier markets. Chart 3 outlines Chinese FDI data and breaks it down by region of destination and use of proceeds.

Chart 3:  Chinese FDI in 2017

  Private FDI Infrastructure Global M&A
DM 25.9% 8.7% 75.5%
Asia 44.8% 40.0% 12.8%
Latam 8.9% 7.3% 8.8%
ME/Africa 20.4% 44.0% 2.9%

Source: Citibank.

The data indicates that most infrastructure spending is directed at the Middle East and Africa (mostly for fossil fuel extraction in countries such as Angola). But we also see private businesses spending nearly 50% of these flows in Asia (mostly Southeast Asia). This trend is driven by Chinese companies investing in new factories in BRI countries (mostly in Vietnam). These companies, which focus primarily on light manufacturing (textiles, toys, etc.), are reacting to the BRI economic strategy (i.e. China moving up the value chain and focus on robotics, aerospace, etc.). Hence government support is likely less going forward, and so too is taking advantage of lower operating costs in countries like Bangladesh. The U.S.-China trade war has merely accelerated this trend. Conversely, other Chinese companies that are keen to move up the value curve have ventured into developed markets such as the U.S. and Europe, and bought businesses for patents, technology and other IP.

Therefore, I believe the best opportunities for frontier investors are in specific frontier countries, such as Vietnam and Bangladesh, that are benefiting from the private capital flows. Consumers in these markets should experience rising incomes from manufacturing jobs as the countries gain export market share. And this trend is sustainable over the medium to long term as China reasserts itself in the global economy.

Thanks for reading!

Adam J. Kutas, CFA

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