Special Report
Highlights We have deciphered global trade linkages to determine which countries are most at risk from a slowdown in EM/China imports. Our analysis takes into account not only the destinations of shipments but also the types of goods. Peru, Chile, Korea, Malaysia and Thailand are the most vulnerable to a slowdown in industrial sectors in EM and China. The least vulnerable emerging economies to this theme are Mexico, Turkey, Colombia, India and Russia. Feature The growth desynchronization1 currently taking place between developing and advanced economies warrants a detailed analysis of trade flows by countries as well as types of goods to assess the vulnerability of various economies to the global trade slowdown. This report's objective is to reveal which countries are most vulnerable to a slowdown in domestic demand in emerging markets, including China. Our main macro theme remains a considerable slowdown in EM/China capital spending, and a moderate slowdown in their consumer spending. We used these macro assumptions to produce a vulnerability ranking for both developing and developed countries. Why Do China And EM Matter? Annual imports by emerging markets including China stand at a combined $7 trillion. This overshadows both U.S. and EU imports, which collectively stand at $4.6 trillion, and underscores the importance of EM and China in global trade (Chart I-1). Chinese imports excluding processing trade - inputs that are imported, then processed and re-exported - make up $1.6 trillion, i.e., constituting 23% of the $7 trillion total of EM plus China imports. Furthermore, the most vulnerable part of the EM/Chinese economies are capital expenditures. The latter represent a significant portion of the global economy (Chart I-2). Aggregate investment expenditures in developing countries including China are as large as those of the U.S. and EU together. China itself accounts for half of EM investment expenditures. Moreover, capital spending is the largest component of the Chinese economy, constituting 42% of GDP. By comparison, Chinese exports to the U.S. and EU together account for only 7% of GDP. Chinese shipments to the U.S. constitute a mere 3.6% of mainland GDP (Chart I-3). Chart I-1EM/China Imports Are Much Larger ##br##Than U.S.'s And EU's Combined Chart I-2EM/China Capex Is As Large ##br##As U.S.'s And EU's Combined Chart I-3Structure Of Chinese##br## Economy In turn, Chinese imports are much more leveraged to the country's capital spending than to household expenditures. Table I-1 shows that imports of consumer goods excluding autos account for a mere 15% of total Chinese foreign goods intake. Table I-1Import Composition Of Chinese Imports With construction and infrastructure spending being a substantial part of mainland capital expenditures, China's investment cycle is very sensitive to the money/credit cycle. This is because no construction or infrastructure investment can be undertaken without credit (loans, bonds and other types of financing). Therefore, China's credit cycle - which drives its domestic capex cycle - is a key predictor of Chinese imports and many commodity prices (Chart I-4). Despite the latest liquidity easing in China, the cumulative effect of previous liquidity tightening as well as the ongoing regulatory clampdown on the financial system are still working their way through the banking and shadow banking systems. Our assessment is that it will take some time before the cumulative effect from the recent liquidity easing takes hold and helps growth recover. China accounts for a significant portion of total EM exports (Chart I-5). Shipments to China constitute 18% of emerging Asia's and 22% of South America's total exports. As the mainland's capex cycle and imports continue to decelerate, EM ex-China exports will slump. This will not only generate a negative income shock in EM economies but will also result in currency depreciation, which will push up local interest rates and tighten banking system liquidity (Chart I-6). Overall, a major downturn in the EM ex-China capex cycle and a moderate slowdown in household consumption will ensue. Chart I-4Chinese Imports ##br##To Decelerate Chart I-5Importance China For Emerging Asia ##br##And South America Chart I-6EM Ex-China: Currency Depreciation##br## = Higher Local Rates How are different countries exposed to these forces? Methodology The global marketplace for goods is a complex system. Modern trade is dominated by the exchange of intermediate goods within different supply chains.2 Furthermore, trade flows between countries are dependent on the types of goods that are traded (industrial versus consumption goods, for instance). Our objective is to compute each country's exposure to China and the rest of the EM industrial sectors that are at the epicenter of a slowdown, as we elaborated above. We have developed the following methodology, summing up the following three parameters3 for each major economy in the world: 1) Exports to China that are used for industrial purposes (Table I-2). Table I-2Vulnerability Ranking Of Exports To China In order to adjust for the sensitivity a certain export has to China's industrial sector, we assigned three coefficients to them: 0, 0.5 and 1. Agricultural commodities and non-durable consumer goods are assigned a coefficient of 0, and are therefore omitted from this aggregation. The basis for this is that agricultural goods are not sensitive to the industrial sector, and we do not expect a slump in China's consumption of non-durable goods. A coefficient of 0.5 is assigned to industrial fuels and semi-durable goods. This entails a moderate slowdown in these imports by China. Our rationale is that demand for industrial fuels is somewhat sensitive to the industrial sector, but not significantly as they are also consumed by the consumer sector. Industrial metals, capital goods and durable consumer goods are assigned a coefficient of 1, meaning maximum vulnerability. The former two are directly tied to the industrial sector, (construction and infrastructure, in particular) while the latter one will suffer as discretionary big-ticket item spending will weaken in the wake of a potential decline in financial assets and real estate values. We also have made an adjustment to account for goods that are exported to China and then re-exported to developed markets for final consumption. We assume these goods are not vulnerable, as we are not negative on U.S. and EU final domestic demand. Based on our estimates, around 30% of intermediate manufacturing goods shipments to China from Japan, Korea, Malaysia, the Philippines and Thailand are actually re-exported from China to developed markets for final consumption. We therefore removed this amount from the aggregation to properly reflect the vulnerable portion of their exports. 2) Exports to EM ex-China that are used for industrial purposes (Table I-3). Table I-3Vulnerability Ranking Of Exports To EM Ex-China In order to adjust for the sensitivity of certain exports to the EM ex-China industrial sector, we assigned the same coefficients as above. The reason is that agricultural goods and non-durable consumer goods (a coefficient of zero) will not be sensitive to a slowdown in EM ex-China industrial sectors. Industrial metals, capital goods and durable goods, on the other hand, will be very vulnerable (a coefficient of one). Industrial fuels and semi-durable goods will be modestly affected (a coefficient of 0.5). 3) Exports to complex economies4 (i.e. Germany, Japan, Korea, Sweden and Switzerland) that are susceptible of being re-exported to emerging markets. We estimate that 30% of intermediate exports that are shipped to these very advanced economies end up being re-exported to EM and China. So, 30% of any country's intermediate goods exports to the complex economies is considered vulnerable. Vulnerability Ranking Chart I-7 sums up the three variables introduced above - total amount of vulnerable exports - and ranks countries based on their exports that are susceptible to an EM/China industrial slowdown as a share of total imports. Chart I-7Vulnerable Exports To China And EM As A Share Of Total Exports Chart I-8 lists countries based on the size of their vulnerable exports as a share of their GDP from highest to lowest. Chart I-8Vulnerable Exports To China And EM As A Share Of GDP Chart I-9 presents our ultimate trade vulnerability ranking which combines both parameters - vulnerable exports as a share of total exports and GDP. Peru, Chile, Korea, Malaysia and Thailand are the most vulnerable to a slowdown in industrial sectors in EM and China. The least vulnerable emerging economies are Mexico, Turkey, Colombia, India and Russia. Chart I-9Overall Vulnerability Assessment These macro themes and rankings constitute an important but not sole part of our country view formation. There are many other factors - both global and domestic - that enter the formulation of our country views. That is why this ranking is not entirely consistent with our country recommendations. The lists of our overweights and underweights across EM equities, fixed-income, credit and currencies as well as specific trades that we recommend can be found on pages 9-10. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Pease see Emerging Markets Strategy Weekly Report "Desynchronization Compels Currency Adjustments", dated September 20, 2018, available at ems.bcaresearch.com 2https://unctad.org/en/pages/PublicationWebflyer.aspx?publicationid=2109 3 All values are measured in US$ and are measured as % of total exports. The data is from the United Nations and dated as of December 31, 2017. 4https://www.media.mit.edu/projects/oec-new/overview/ Equity Recommendations Fixed-Income, Credit And Currency Recommendations
