Just as April brought a glimmer of hope to the global economy, May has reminded market participants of the vulnerability of emerging market economies and equities to disruptions in world trade.
Since the US-China trade war escalated early this month, EM equities have fallen by more than 8 per cent, more than twice the decline in developed market equities. EM equity exchange traded funds have experienced two weekly net outflows of more than $10bn, after six previous weeks of net inflows.
Many EM countries rely on thriving world trade to stimulate their economies, by exporting commodities and/or low-end manufacturing products and intermediate inputs to global supply chains. Slowing world trade has already created headwinds to many EMs: even before the early May tariff rises, the World Trade Organization had expected growth in world trade to slow to 2.6 per cent this year after an uptick to 4.6 per cent in 2017.
Against the backdrop of slowing world trade, the escalating US-China trade war exacerbates the problems of weak global demand for many EMs. Of particular concern is the reduction of import demand from China for commodities and intermediate inputs due to falling exports to the US, which declined by close to 14 per cent year on year in the first quarter of 2019.
This reinforces the moderation in China’s trade with many EM countries in recent years, reflecting Beijing’s efforts to rebalance its economy from investment and export to domestic consumption as well as to increase the local content of its manufacturing products — from 40 per cent to 70 per cent in key sectors by 2025.
An example of the immediate impact of trade tension is the 7 per cent year-on-year decline in exports from South Korea in the first four months of 2019, driven by falls in semiconductor sales to its biggest market, China. An example of the medium-term trend is China’s trade with sub-Saharan Africa, which had grown steadily for 20 years before peaking at about $120bn a year in 2012-14 and falling by about 40 per cent since then.
Cushioning the impact of slowing trade on EMs is the diversion of trade and investment flows from China due to US tariffs. This has benefited some EM countries, including Mexico and Brazil (stepping in as US exports of soyabeans to China have collapsed), and several countries in Asia. So far, the clear winner is Vietnam. In the first four months of 2019, registered foreign direct investment into Vietnam has jumped by 81 per cent year on year to $14.6bn, according to the Vietnamese Ministry of Planning and Investment. US imports from Vietnam increased 40 per cent year on year in the first quarter to almost $16bn, boosting the US trade deficit with the country to $13.5bn.
On balance, the benefits of trade and investment diversion to specific countries, along with supportive policy moves expected in the US and China, are probably not enough to offset the overall weakness in trade and heightened risk sensitivity among international investors regarding EMs.
Consequently, projected EM growth has been revised downward by up to 0.2 percentage points over the next year or so. A key tail risk to EMs is a repeat of the events of 2015-16: China experiencing slowing growth, sharply falling equities and a depreciating currency. The likelihood of such scenario is still low, but has clearly risen with the escalating trade war.
Beyond the immediate future, but also stemming from Trump’s muscular approach to trade issues, two potential risks have emerged, at least to certain EM countries and at the margin.
One is the US effort to reform the self-designation of “developing country” status by two-thirds of WTO members to benefit from Special and Differential Treatment — a reform idea shared by many developed countries. The US has proposed eligibility criteria to claim the status, denying it to countries that are members of the OECD or the G20, are classified as high-income countries by the World Bank (per capita income of $12,000 or more), or have a share of more than 0.5 per cent of global trade. These criteria could put several major EM countries in the spotlight.
In addition, the US has removed India and Turkey from the list of countries eligible for its General System of Preferences, which grants duty-free shipments of designated goods to the US.
The other risk is the political one of getting entangled with the US decision to ban dealing with the Chinese telecoms group Huawei — doing business with Huawei risks courting US disfavour. Over the past decade, quite a few EM countries have partnered with Huawei in building out their 3G, 4G and likely 5G telecom infrastructures and it will be difficult for them to change.
The headwinds arising from the US trade war with China, as well as trade tensions with other major trading blocs and countries, are here to stay. Increasingly, EM countries are suffering the collateral damage of the trade war.
Hung Tran is a nonresident senior fellow at the Atlantic Council and former executive managing director of the Institute of International Finance