Asia

Highlights US crude oil output will continue its sharp recovery before leveling off by mid-2022, in our latest forecast (Chart of the Week). The recovery in US production is led by higher Permian shale-oil production, which is quietly pushing toward pre-COVID-19 highs while other basins languish. Permian output in July was ~ 143k b/d below the basin's peak in Mar20, and likely will surpass its all-time high output in 4Q21. Overall US shale-oil output remains ~ 1.1mm b/d below Nov19's peak of 9.04mm b/d, but we expect it to end the year at 7.90mm b/d and to average 8.10mm b/d for 2022. We do not expect US crude oil production to surpass its all-time high of 12.9mm b/d of Jan20 by the end of 2023. Instead, exploration & production (E&P) companies will continue to prioritize shareholders' interests. This means larger shares of free cashflow will go to shareholders, and not to drilling for the sake of increasing output. While our overall balances estimates remain largely unchanged from last month, we have taken down our expectation for demand growth this year by close to 360k b/d and moved it into 2022, due to continuing difficulties containing the COVID-19 Delta variant. Our Brent crude oil forecasts for 2H21, 2022 and 2023 remain largely unchanged at $70, $73 (down $1) and $80/bbl. WTI will trade $2-$3/bbl lower. Feature Chart 1US Crude Recovery Continues US Crude Recovery Continues US Crude Recovery Continues Global crude oil markets are at a transition point. The dominant producer – OPEC 2.0 – begins retuning 400k b/d every month to the market from the massive 5.8mm b/d of spare capacity accumulated during the COVID-19 pandemic. For modeling purposes, it is not unreasonable to assume this will be a monthly increment returned to the market until the accumulated reserves are fully restored. This would take the program into 2H22, per OPEC's 18 July 2021 communique issued following the meeting that produced this return of supply. Thereafter, the core group of the coalition able to increase and sustain higher production – Kuwait, the UAE, Iraq, KSA and Russia – is expected to meet higher demand from their capacity.1 There is room for maneuver in the OPEC 2.0 agreement up and down. We continue to expect the coalition to make supply available as demand dictates – a data-dependent strategy, not unlike that of central banks navigating through the pandemic. This could stretch the return of that 5.8mm b/d of accumulated spare capacity further into 2H22 than we now expect. The pace largely depends on how quickly effective vaccines are distributed globally, particularly to EM economies over the course of this year and next. US Shale Recovery Led By Permian Output While OPEC 2.0 continues to manage member-state output – keeping the level of supply below that of demand to reduce global inventories – US crude oil output is quietly recovering. We expect this to continue into 1H22 (Chart 2). Chart 2Permian Output Recovers Strongly Permian Output Approaches Pre-Covid Peak Permian Output Approaches Pre-Covid Peak The higher American output in the Lower 48 states primarily is due to the continued growth of tight-oil shale production in the low-cost Permian Basin (Chart 3). This has been aided in no small part by the completion of drilled-but-uncompleted (DUC) wells in the Permian and elsewhere. Chart 3E&Ps Favor Permian Assets Permian Output Approaches Pre-Covid Peak Permian Output Approaches Pre-Covid Peak Since last year’s slump, the rig count has increased; however, compared to pre-pandemic levels, the number of rigs presently deployed are not sufficient to sustain current production. The finishing of DUC wells means that, despite the low rig count during the pandemic, shale oil supply has not dipped by a commensurate amount. This is a major feat, considering shale wells’ high decline rates. Chart 4US Producers Remain Focused On Shareholder Priorities US Producers Remain Focused On Shareholder Priorities US Producers Remain Focused On Shareholder Priorities DUCS have played a large role in sustaining overall US crude oil production. According to the EIA, since its peak in June 2020, DUCs in the shale basins have fallen by approximately 33%. As hedges well below the current market price for shale producers roll off, and DUC inventories are further depleted, we expect to see more drilling activity and the return of more rigs to oil fields. We do not expect US crude oil output to surpass its all-time high of 12.9mm b/ of Jan20 by the end of 2023. Instead, exploration & production (E&P) companies will continue to prioritize shareholders' interests. This means only profitable drilling supporting the free cashflow that allows E&Ps to return capital to shareholders will receive funding. US oil and gas companies have a long road back before they regain investors' trust (Chart 4).   Demand Growth To Slow We expect global demand to increase 5.04mm b/d y/y in 2021, down from last month's growth estimate of 5.4mm b/d. We have taken down our expectation for demand growth this year by ~ 360k b/d and moved it into 2022, because of reduced mobility and local lockdowns due to continuing difficulties in containing the COVID-19 Delta variant, particularly in Asia (Chart 5).2 We continue to expect the global rollout of vaccines to increase, which will allow mobility restrictions to ease, and will support demand. This has been the case in the US, EU and is expected to continue as Latin America and other EM economies receive more efficacious vaccines. Thus, as DM growth slows, EM oil demand should pick up (Chart 6). Chart 5COVID-19 Delta Variant's Spread Remains Public Health Challenge Permian Output Approaches Pre-Covid Peak Permian Output Approaches Pre-Covid Peak Chart 6EM Demand Growth Will Offset DM Slowdown EM Demand Growth Will Offset DM Slowdown EM Demand Growth Will Offset DM Slowdown Net, we continue to expect demand for crude oil and refined products to grind higher, and to be maintained into 2023, as mobility rises, and economic growth continues to be supported by accommodative monetary policy and fiscal support. If anything, the rapid spread of the Delta variant likely will predispose central banks to continue to slow-walk normalizing monetary policy and interest rates. Global Balances Mostly Unchanged Chart 7Oil Markets To Remain Balanced Oil Markets To Remain Balanced Oil Markets To Remain Balanced Although we have shifted part of the demand recovery into next year, at more than 5mm b/d of growth, our 2021 expectation is still strong. This is expected to continue next year and into 2023 although not at 2021-22 rates. Continued production restraint by OPEC 2.0 and the price-taking cohort outside the coalition will keep the market balanced (Chart 7). We expect OPEC 2.0's core group of producers – Kuwait, the UAE, Iraq, KSA and Russia – will continue to abide by the reference production levels laid out in 18 July 2021 OPEC communique. Capital markets can be expected to continue constraining the price-taking cohort's misallocation of resources. These factors underpin our call for balanced markets (Table 1), and our view inventories will continue to draw (Chart 8). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Permian Output Approaches Pre-Covid Peak Permian Output Approaches Pre-Covid Peak Our balances assessment leaves our price expectations unchanged from last month, with Brent's price trajectory to end-2023 intact (Chart 9). We expect Brent crude oil to average $70, $73 and $80/bbl in 2H21, 2022 and 2023, respectively. WTI is expected to trade $2-$3/bbl lower over this interval. Chart 8Inventories Will Continue To Draw Inventories Will Continue To Draw Inventories Will Continue To Draw Chart 9Brent Prices Trajectory Intact Brent Prices Trajectory Intact Brent Prices Trajectory Intact   Investment Implications Balanced oil markets and continued inventory draws support our view Brent and refined-product forward curves will continue to backwardate, even if the evolution of this process is volatile. As a result, we remain long the S&P GSCI and the COMT ETF, which is optimized for backwardation. We continue to wait for a sell-off to get long the SPDR S&P Oil & Gas Exploration & Production ETF (XOP ETF).   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish The US EIA expects natural gas inventories at the end of the storage-injection season in October to be 4% below the 2016-2020 five-year average, at 3.6 TCF. At end-July, inventories were 6% below the five-year average (Chart 10). Colder-than-normal weather this past winter – particularly through the US Midwest and Texas natural gas fields – affected production and drove consumption higher this past winter, which forced inventories lower. Continued strength in LNG exports also are keeping gas prices well bid, as Asian and European markets buy fuel for power generation and to accumulate inventories ahead of the coming winter. Base Metals: Bullish The main worker’s union at Chile's Escondida mine, the largest in the world, and BHP reached an agreement on Friday to avoid a strike. The mine is expected to constitute 5% of total mined global copper supply for 2021. China's refined copper imports have been falling for the last three months (Chart 11). Weak economic data – China reported slower than expected growth in retail sales and manufacturing output for July – contributed to lower import levels.  Precious Metals: Bullish Gold has been correcting following its recent decline, ending most days higher since the ‘flash crash’ last Monday, facilitated by a drop in real interest rates. The Jackson Hole Symposium next week will provide insights to market participants regarding the Fed’s future course of action and if it is in fact nearing an agreement to taper asset purchases. According to the Wall Street Journal, some officials believe the program could end by mid-2022 on the back of strong hiring reports. This was corroborated by minutes of the FOMC meeting which took place in July, which suggested a possibility to begin tapering the program by year-end. While the Fed stressed there was no mechanical relationship between the tapering and interest rate hikes, this could be bearish for gold, as real interest rates and the bullion move inversely. On the other hand, political uncertainty and a potential economic slowdown in China will support gold prices. Ags/Softs: Neutral Grain and bean crops are in slightly worse shape this year vs the same period in 2020, according to the USDA. The Department reported 62% of the US corn crop was in good to excellent condition for the week ended 15 August 2021, compared to 69% for the same period last year. 57% of the soybean crop was in good-to-excellent shape for the week ending on the 15th vs 72% a year ago. Chart 10 US WORKING NATGAS IN STORAGE GOING DOWN US WORKING NATGAS IN STORAGE GOING DOWN Chart 11 Permian Output Approaches Pre-Covid Peak Permian Output Approaches Pre-Covid Peak Footnotes 1 Please see our report of 22 July 2021, OPEC 2.0's Forward Guidance In New Baselines, which discusses the longer-term implications of this meeting and the subsequent communique containing the OPEC 2.0 core group's higher reference production levels. It is available at ces.bcareserch.com. 2 S&P Global Platts notes China's most recent mobility restrictions throughout the country will show up in oil demand figures in the near future. We expect similar reduced mobility as public health officials scramble to get more vaccines distributed. Please see Asia crude oil: Key market indicators for Aug 16-20 published 16 August 2021 by spglobal.com. Investment Views and Themes Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed In 2021 Summary of Closed Trades

Highlights The baht will depreciate further, given the state of the economy and external accounts. Domestic demand was already relapsing, even before the latest surge in COVID-19 cases. Now, the recovery will be delayed more. The authorities have little to offer by way of fiscal or monetary support. Credit to the job-intensive SME sector has collapsed. The balance of payment dynamics remains negative for the currency. Investors should stay short the baht. Dedicated EM asset allocators should continue to be neutral on Thailand within respective equity and domestic bond portfolios. Feature Chart 1Thai Stocks Are Facing Several Headwinds Thailand: Stay Short The Baht Thailand: Stay Short The Baht Our negative view on the baht has played out as expected.1 The Thai currency is down 10% versus the dollar since its peak in February of this year. It has also been the worst performer in Asia. The country’s stock market is struggling and going down in both absolute terms and relative to their EM counterparts (Chart 1). Going forward, odds are that the baht will remain weak. A weak currency will continue to stifle both Thai stocks’ and local currency bonds’ relative performance. Investors should stay short the baht and remain neutral Thai equity and local currency bonds within their respective EM portfolios. Relapsing Growth Chart 2Surging New COVID-19 Cases... Thailand: Stay Short The Baht Thailand: Stay Short The Baht The latest spike in new COVID-19 cases has dashed hopes for any early recovery of the Thai economy (Chart 2). Earlier this month, the central bank revised down their GDP forecast for 2021 from 1.8% to 0.7%. We concur with this bearish outlook: Private consumption in real terms was languishing as of June this year at 10% below 2019 levels. Car sales, both personal and commercial, are even more downbeat (Chart 3). After the latest surge in new COVID-19 cases, those numbers must have weakened further. Incidentally, the country’s vaccination rate, at 26% of total population (7.5% fully vaccinated), remains low. It could be, therefore, several months before any meaningful recovery in consumer demand takes place. Faced with low demand, the country’s manufacturing and shipment volumes are also weak. They are both breaking down anew from well below the 2019 levels (Chart 4, top panel). Chart 3...Will Further Delay Domestic Demand Recovery Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 4Manufacturers Are Saddled With High Inventory Amid Weak Orders... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   Weak demand also means that businesses are stuck with high inventories. Indeed, there is a widening disparity between inventory levels and shipments (Chart 4, middle panel). Furthermore, order books have slipped back to levels not seen since the height of the COVID-19 scare early last year. The combination of high inventories and tumbling orders does not portend a manufacturing recovery anytime soon (Chart 4, bottom panel). Notably, jobs and wages are also weak. Employment in the manufacturing sector is well below pre-pandemic levels (Chart 5). This trend, in turn, is hurting household income and consumer demand, completing a vicious cycle of depressed demand, weak production, falling employment and household income, and further reduced demand. The softness of the economy is accentuating the disinflationary pressure that was already entrenched. Headline and core CPI in Thailand have stayed mostly below 1% over the past five years — the lower band of the central bank’s inflation target. Now, they are flirting with outright deflation. In fact, if the impact of food and oil prices is excluded, the prices are actually deflating (Chart 6). Chart 5...Which Is Hurting Jobs And Wage Growth Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 6Thailand Is Flirting With Outright Deflation... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   Outright deflation makes it harder for borrowers to service their debts, which then discourages both borrowing and spending — making the recovery much harder. Notably, the banks’ prime lending rates remain high at 5.4%, which means real prime lending rates are quite steep at 5% (deflated by core CPI). This is at a time of very low household income and business revenue growth expectations. This trend is a strong disincentive for borrowing and consuming /capital spending. Little Policy Support What is more concerning for the economy is that policymakers can offer little to boost the economy. Fiscal stimulus has waned: government expenditure, after a surge last year, is now contracting (Chart 7). The budget proposal for the next fiscal year (October 2021 - September 2022) that was passed by the parliament in June 2021 (first reading)2 stipulates a 5.7% cut in nominal spending. Part of the reason is that fiscal deficits have already ballooned to a staggering 8% of GDP — from an average of 2.5% in the past ten years. The IMF estimates that the fiscal thrust will be zero this year, and a negative 2.4% of GDP in 2022 (Chart 7, bottom panel). The monetary policy transmission is also paralyzed. Despite easing by the Bank of Thailand — the policy rate is at an all-time low of 0.5% since May last year — credit growth is dismal. Lenders are wary of rising NPLs and are holding back new credit: The share of impaired loans (NPLs plus Special Mention Loans) of total bank loans has dramatically increased to 10%. In the case of small and medium enterprises (SMEs), that ratio is 20%. By comparison, loss provisions are much lower, at just 5.2% as of June of this year (Chart 8, top panel). Chart 7...Yet, The Government Is Planning To Cut Fiscal Spending Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 8Sharp Rise In Banks' Stressed Loans Amid Tanking Profits... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   Notably, both operating and net profits of banks had already halved (as a % of assets) by June 2021 — as both interest and non-interest incomes dropped. Profits are slated to contract further, since banks will have to make greater provisions in the future as the recent surge in new cases will produce more loan delinquencies (Chart 8, bottom panel). The specter of rising NPLs has prompted banks to retrench loans. In particular, bank credit to SMEs has plunged by a massive 34% from 2019 levels (Chart 9). Before the pandemic, banks’ SME loans made up a significant 30% of GDP. Now, they are down to 21%. Credit retrenchment of this order to the job-intensive SME sector is going to have a significant negative ripple effect. Employment will shrink further as small businesses go bust. Shrinking jobs will dent household income, and, in turn, consumer demand. Incidentally, loans to other business segments are also not rising much. Bank loans to all non-financial corporates are growing rather minimally, at 1.5% year-over-year. Going into the pandemic, the Thai household sector was already highly leveraged. Over the past two decades, banks and other financial institutions have been lending ever more to households, shunning non-financial corporates. Households’ borrowing from banks have now risen to 40% of GDP; and those from other institutions another 50%. These loans had helped boost consumer demand all those years, but now, at a time when incomes are uncertain, households have very limited appetite to borrow more to spend. This means a consumer debt-fueled demand recovery is not in the cards (Chart 10). Chart 9...Induced Banks To Massively Reduce Credit To The Job-Intensive SME Sector Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 10Thai Households Are Too Indebted To Borrow More And Spend Thailand: Stay Short The Baht Thailand: Stay Short The Baht   In brief, Thai businesses are in the middle of a toxic combination of contracting sales, absent fiscal support, slashed credit facilities, and rather high borrowing costs in real terms. Chart 11 shows that corporate profit margins of non-financial firms are struggling at a low level. It is no wonder that businesses are reluctant to invest, expand, and hire. The message is similar when we examined all companies included in the MSCI Thailand stock index. On the one hand, their EPS has fallen to 10-year lows. Thai stock prices, on the other hand, have not yet fallen as much as the shrinking EPS would imply (Chart 12, top panel). The consequence is that the valuations are remarkably stretched—near a 20-year high (Chart 12, bottom panel). Chart 11Low Margins Are Discouraging Thai Firms To Borrow, Invest, Or Hire Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 12Thai Profits, At A Decade-Low, Are Also A Headwind For Stock Prices Thailand: Stay Short The Baht Thailand: Stay Short The Baht   All in all, for Thai share prices to stage a sustainable rally, an economic recovery is essential. The first indications of that usually come from an improving order book. The latter currently shows little glimmer of hope. But investors should keep an eye on this indicator, as Thai stocks’ performance is geared to the ebbs and flows of the business order book (Chart 13). Thailand Needs A Weaker Currency The state of the Thai economy not only warrants exchange rate depreciation, but also needs a much weaker currency to help an economic recovery. The country’s balance of payment is in deficit — for the first time since 2014. A crucial reason is that the baht is still expensive, which continues to weigh on exports. Of all the export-oriented Asian economies, Thai exports recovery has been the weakest (Chart 14). Chart 13Keep An Eye On The Order Book For A Sign In Stock Recovery Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 14An Expensive Baht Held Back Thai Exports Recovery Thailand: Stay Short The Baht Thailand: Stay Short The Baht   The fact that a quarter of Thai exports go to other ASEAN countries — where demand has been and remains weak due to the lingering pandemic — doesn’t help either. As a result, the Thai trade surplus has narrowed significantly, and the current account has slipped into deficit (Chart 15, top and middle panels). The other main external revenue source of Thailand, tourism, continues to be near absent at 0.6% of GDP — a far cry from a high of 12% before the pandemic (Chart 15, bottom panel). What’s more, there is little hope of any recovery in the near future. The government now expects the number of foreign tourists this year to be as low as 0.3 million versus 40 million in 2019. On the capital account front, Thailand continues to hemorrhage both FDI and portfolio capital — just as it did the past several years. Despite that, the baht had remained strong until early this year, as a result of a substantial repatriation of bank deposits by Thai residents and, to a lesser extent, foreign borrowings. Those inflows prevented the Thai baht from depreciating. But such panic-stricken, one-off savings/deposit repatriations by Thai residents will certainly slow materially going forward (Chart 16). Chart 15The Thai Current Account Balance Will Struggle To Stay In Surplus... Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 16...While The Capital Account Balance Will Slip Deeper Into Deficit... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   There’s also little hope that FDI and portfolio inflows will pick up the slack. The reason is that the Thai economy is very weak and the return on capital is low. The latter discourages capital inflows. The fact that the baht continues to be an expensive currency in real terms, and therefore not as competitive as some of its neighbors’, doesn’t help either. The multi-nationals who are planning to re-locate out of China might find some other countries — where the currency is more competitive (such as in India, Malaysia, or the Philippines) — more attractive. Overall, the Thai capital account balance will likely slide deeper into deficit, at a time when the current account will also struggle to stay in surplus. The result will be a further deterioration in the country’s balance of payment, hurting the baht (Chart 17). Considered from another angle, if the return on capital on Thai assets is any guide, the baht could drop much more from its current levels (Chart 18). Chart 17...Putting Downward Pressure On The Baht Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 18Thai Firms' Low Rates Of Return Point To More Baht Depreciation Thailand: Stay Short The Baht Thailand: Stay Short The Baht     The reality is that, given Thailand’s current macro backdrop, a cheaper currency is what the nation needs. That will help boost growth significantly by aiding exports and promoting import substitution. Since foreign trade makes up an impressive 90% of GDP, a boost therein could kickstart the entire economy. Another result of a weaker currency will be higher inflation, something the economy seriously needs. Higher inflation will contribute to lower real interest rates which, in turn, will encourage borrowing and spending. Higher spending and inflation will help achieve higher nominal sales, boost firms’ profits, employment, and eventually, household incomes. All in all, it could allow a productive cycle to unfold. Given all these possible benefits and given that policymakers have few other tools at their disposal at this juncture, chances are the central bank will let the baht depreciate more, albeit in an orderly fashion, in the months to come. What About Bonds? Chart 19Mantain A Neutral Allocation To Thai Domestic Bonds In An EM Basket Thailand: Stay Short The Baht Thailand: Stay Short The Baht Thai local currency bonds’ absolute return in US dollar terms, as expected, is highly dependent on the exchange rate (Chart 19, top panel). Given the weak currency outlook, foreign investors should refrain from holding Thai domestic bonds outright. For foreign asset allocators, however, the matter is more nuanced. Thai domestic bonds’ relative return versus that of overall EM did not depend on the baht movement alone. This is because Thailand has been a defensive market owing to the following: a traditionally strong current account, a manageable public debt (now 47% of GDP), and a relatively low holding of bonds by foreign investors (now 12% of total). A robust current account surplus for years meant that during periods of negative growth shocks, the baht often fell less than many other EM currencies — that is, in periods of distress, the baht helped boost the relative performance of Thai bonds vis-à-vis overall EM bonds in US dollar terms. Those periods of distress also saw Thai bond yields fall as the central bank was able to cut rates due to low inflation. In addition, during those periods, local investors moved from equities to government bonds. Since the holdings of local bond investors far outweighed those of foreign investors, Thai bond yields managed to go down, even when some foreign investors dumped EM and Thai domestic bonds. As a result of these factors, Thai bonds outperformed their EM counterparts during the commodity/EM slowdown in 2014-15, and again at the height of the COVID-19-scare in early 2020 — even though the baht fell versus the US dollar during those periods (Chart 19, middle panel). All that said, the reality in the ground has changed somewhat since early last year. The Thai current account is no longer in surplus, and, given the dismal tourism outlook and slowing trade surplus, it will probably stay that way for the foreseeable future. That will keep the baht relatively weak weighing on Thai bonds’ relative performance versus their EM peers. On the other hand, the grim outlook of the Thai economy and looming deflation risk means that Thai bond yields could fall going forward relative to their EM counterparts. That will be a tailwind for Thai domestic bonds’ relative outperformance versus their EM counterparts. There is, therefore, a good chance that the headwind from a relatively weaker baht could be somewhat compensated for by a drop in Thai local yields versus their EM peers. Indeed, the periods of the baht’s weakness usually coincided with Thai bonds’ relative yield compression (Chart 19, bottom panel). This calls for a neutral outlook for relative bond performance going forward. Investment Conclusions Currency: The baht outlook remains precarious. Investors would do well to remain short the baht versus the US dollar. Domestic Bonds: Thai bond yields will go down. The Bank of Thailand will have no choice but to cut rates further. Local investors should stay long bonds. For international dedicated EM fixed-income portfolios, we downgraded Thai bonds in February of this year, from overweight to neutral in an EM bond portfolio, in view of the impending baht weakness. That turned out to be a good decision. Going forward, investors should continue to have a neutral allocation on Thai bonds, as the headwind from the baht will be mitigated by the tailwind from relative bond yield compression. Foreign absolute-return investors, however, should avoid Thai bonds in view of expected currency depreciation. Chart 20A Vulnerable Baht Will Keep Foreign Equity Investors Away Thailand: Stay Short The Baht Thailand: Stay Short The Baht Stocks: A struggling economy offers little hope for corporate margins or profits recovery soon. A vulnerable currency makes Thai stocks even less appealing to foreign investors. Without their participation, it will be hard for this market to rise sustainably in absolute terms or outperform their EM counterparts (Chart 20). Thai equities are not cheap either: the P/Book ratio is at par with EM. That said, given the Thai market’s already very steep underperformance versus the EM equity benchmark, from a portfolio strategy point of view, we recommend investors stay neutral this market within an EM equity portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Please refer to the EMS report “Thailand: Beset By A Vulnerable Baht,” dated February 24, 2021. 2 The budget bill has to pass the second and third readings expected in August before it goes for senate and royal approval.

Dear Client, This week we are sending you a joint Special Report written by my colleagues Xiaoli Tang, Associate Vice President at BCA Research’s Global Asset Allocation, and Qingyun Xu, Associate Editor at China Investment Strategy. In the Special Report Xiaoli and Qing investigate the impact on global portfolios when adding onshore Chinese assets. Their findings confirm our view that Chinese onshore equities have not been a good long-term, buy-and-hold asset for global equity investors due to extremely high volatility. However, they conclude that to improve both the absolute and risk-adjusted returns of the onshore equity market, investors can apply an equal-weighted, five-factor smart-beta strategy or active sector/industry allocation strategies. More importantly, they find that both hedged and unhedged Chinese onshore bonds are excellent risk diversifiers for DM bond investors, and Chinese onshore bonds are also a good risk-diversifier and complementary to Chinese equity-centric portfolios. I trust you will find it insightful. Next week the China Investment Strategy team will take our second of the two-week summer break. We will resume our publication on Wednesday, September 1st. Best regards, Jing Sima, China Strategist Highlights Global investors have become increasingly interested in Chinese onshore equities and bonds as part of their multi-asset portfolios as Chinese onshore equities and bonds have been included in major global stock and bond indexes. In this report, we investigate the impact on global portfolios when adding onshore Chinese assets. Three assets (stocks, bonds and stock-bond combinations) and six home currencies (the USD, JPY, EUR, GBP, CAD and AUD) are included in our portfolio analysis. Chinese onshore equities have not been a good long-term, buy-and-hold asset for global equity investors due to extremely high volatility. To improve both the absolute and risk-adjusted returns of the onshore equity market, however, investors can apply an equal-weighted, five-factor smart-beta strategy or active sector/industry allocation strategies. Hedged Chinese onshore bonds are excellent risk diversifiers for DM bond investors, but higher absolute and risk-adjusted returns may be derived from unhedged bonds, thanks to the positive carry and negative correlation between the onshore Chinese bond index and CNY crosses. Chinese onshore bonds are also a good risk-diversifier and complementary to Chinese equity-centric portfolios, given the negative correlation between the performance of Chinese bonds and equities. Adding a stand-alone Chinese portfolio with equally weighted onshore bonds and equities to a typical 70-30 domestic equity-bond portfolio would significantly improve a non-USD investor’s risk-adjusted return. Global investors may access China’s onshore equity and bond markets through Stock Connect(s), Bond Connect and CIBM Direct. Risk management tools are also available via both onshore and offshore instruments. Feature In the past three decades, China’s financial markets have become the second largest in the world both in terms of equity capitalization and bonds outstanding. Pro-market financial reforms have made the onshore markets increasingly accessible to foreign investors (Appendix 1). As China’s domestic equities and bonds are gradually added to major global equity and bond indexes, the onshore markets have become too sizeable to be ignored by global investors. Chart 1China A Onshore Shares: Highly Volatile Driven By Policy Swings China A Onshore Shares: A Poor Long-Term Asset China A Onshore Shares: A Poor Long-Term Asset Gyrations in China’s equity market in July in response to regulatory changes imposed on various industries (internet, property, education, healthcare and capital markets), however, should be a reminder that volatility in this market is an ever-present aspect. The instability is driven by China’s profound cyclicality in credit, money and macroeconomic policies (Chart 1). Moreover, the unpredictability is exacerbated by periods of geopolitical tensions and domestic political events. We focus on the portfolio impact of adding onshore equities and bonds to global investors’ domestic portfolios with six different home currencies: the USD, euro (EUR), Japanese yen (JPY), British pound (GBP), Australian dollar (AUD) and Canadian dollar (CAD). We also address how to access the onshore markets and what risk management tools are available. Many global investors already have a significant home bias in their portfolios, therefore this report will look at replacing part of a domestic portfolio with Chinese onshore assets. Part 1. Are Chinese Onshore Equities A Good Alternative For Global Equity Investors? 1.1: Chinese Equities Have A Poor Long-Term Return-Risk Profile Chart I-1How Does China A Compare With Global Equities Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? The extremely volatile nature of the MSCI China A onshore equity index (referred to as ‘China A’ in this report) is not a recent phenomenon. Although the volatility in China A has moderated since 2015, the stocks in the index remain highly cyclical and closely correlated with China’s credit growth. China A has gone through two full boom-bust cycles since December 2000 and the third up-cycle started in 2019 is being challenged, as shown in Chart I-1 panel 1. On a rolling three-year basis, China A’s volatility has steadily declined since its peak in early 2015 and is currently comparable to other markets. Meanwhile, its correlation with the rest of the world has steadily risen, standing at around 60% with major equity markets (Chart I-1, bottom 3 panels). The change in correlation with global equity markets could be linked to the launch of the Shanghai Stock Connect and Shenzhen Stock Connect as well as a more market-based RMB exchange rate in the past six years.  Compared with domestic equities for investors in the US, euro area, Japan, UK, Canada and Australia, however, China’s A-shares’ unhedged return-risk profile did not become more attractive after the launch of the Shanghai Stock Connect. As illustrated in Table 1, China A’s underperformance has spanned the entire upcycle in global equities starting in March 2009. It was only in the early years following China’s entrance into the WTO in 2001 that China A-shares performed better than their peers in Japan and the euro area. Table 1Return-Risk Profiles: China A Onshore Index vs Global Equity Indexes and CNY Crosses Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? USD/CNY exchange rate volatility has increased since the 2015 de-pegging from the US dollar, but remains at very low level compared with other CNY crosses. The People’s Bank of China (PBoC) primarily manages the RMB against the dollar by targeting a daily USD/CNY fixing rate, while allowing market forces to drive the RMB value against a basket of currencies in the China Foreign Exchange Trade System (CFETS) index. Chart I-2Correlations Between China A And DM Currencies Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Interestingly, even though CNY crosses with the euro, GBP, JPY, AUD and CAD have much higher volatility, the volatility in unhedged China A-shares in each of those currencies is similar to or lower than that in USD. For example, from December 2014 to July 2021, AUD/CNY had an annualized volatility of 8.8%, much higher than the 4.5% of the USD/CNY, yet the unhedged China A-share's volatility in AUD was 21%, lower than the 24% in USD. The reason lies in correlation, as shown Chart I-2. While China A-shares in CNY have a positive correlation with USD/CNY and JPY/CNY (i.e. China A-share prices tend to rise when China’s currency appreciates against the US dollar and Japanese yen), they have falling and negative correlations with the other four currencies. For equity investors in the US and Japan, exposure to the CNY would increase potential volatility to their home-currency portfolios, but the opposite would be true for investors in the euro area, the UK, Australia and Canada. In addition, Chinese onshore equity correlations with DM equities and EM-ex China equities were low, but have increased since 2015, making onshore shares less attractive for global equity investors looking to diversify. Bottom Line: Chinese onshore shares are a poor long-term asset for global equity investors. 1.2: Factor Strategies Work Well In The Onshore Market Despite Chinese equities’ poor long-term performance, applying a factor strategy to Chinese onshore stocks can create impressive results. In a GAA Special Report on smart-beta strategies for MSCI DM and EM markets, we concluded that a simple, equally weighted five-factor strategy would smooth out the cyclicality of individual factors and outperform the broad market. These five factors are value, equal weight (i.e. size), quality, momentum and minimum volatility, as defined and calculated by MSCI (see Box 1). When we apply the same methodology to the MSCI China A onshore market, the result is even more impressive as shown in Chart I-3. Box 1MSCI Factor Indices Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart I-3Factor Performance: China A Vs Global Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Since December 2004, the value and small cap factors  have outperformed the broad  benchmark by about 11%  and 47%, respectively, in the China A universe, despite sharp corrections since December 2016  for small cap  and Oct 2018 for value. In contrast, in the global universe, value and small cap have underperformed the global benchmark by 24% and 7%, respectively, in the same time frame (Chart I-3, panels 2 and 6.) This confirms anecdotal evidence that the onshore equity market was less efficient than its global peer, although efficiency has improved. Momentum is a consistent factor for global markets. A GAA Special Report on momentum strategy shows that momentum works better in markets with higher individuality where self-attribution and self-confidence are more pervasive, according to Hofstede’s Cultural Dimension theory. This behavioral aspect is confirmed by the performance of momentum in China’s onshore market: in the early years, momentum did not work well, but strengthened after both Shanghai and Shenzhen shares were accessible to foreign investors via the two Stock Connects and mainland institutional investors became more prevalent (Chart I-3, panel 4) Quality is the most consistent factor for global markets because investors reward companies with solid fundamentals. As shown in (Chart I-3, panel 3), this factor has worked even better in the China A market than in the global universe. The fact that good fundamentals have generated superior equity return repels the “myth” that the China A market is a “casino” driven by individual investors, who totally ignore company fundamentals. The minimum volatility factor works in a similar fashion in the onshore Chinese market as in the global markets. Chart I-4Onshore Equity Market Can Be Improved By Smart-Beta Strategies Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Factor timing can hardly generate consistent outperformance. BCA’s GAA team advocates equally weighting the five time-tested factors for the MSCI global universe. This approach also applies to China’s onshore market (Chart I-3, panel 1). Since all the factor indexes became available in August 2013, the equally weighted, five-factor portfolio has outperformed the benchmark by about 20% in total with similar volatility. On a rolling one- and three-year basis, this strategy also performs better than the benchmark (Chart I-4). Some investors may prefer a more active and quantitative approach; they should refer to CIS’s Special Report on factor investing in the A-share market. The CIS report recommends that global investors should opt for industry groups with above-median return on equity (ROE) and below-median ex-post beta when investing in the onshore market. ROE is a quality factor in MSCI (see Box 1 above) and below-median beta is a variation of low volatility. Bottom Line: Factor strategies can improve the return and risk profiles of China’s onshore equity market. Part 2. Chinese Onshore Bonds Chinese onshore bonds have attracted global investors because they offer much higher yields than DM government bonds (Chart II-1). At the same time, as shown in Chart II-2, Chinese onshore bond yields have low to negative correlations with major government bond yields. Thus, the onshore bonds offer potential risk diversification for global bond portfolios. Chart II-1Chinese Bonds Offer Higher Yields Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart II-2Chinese Yields Have Low Correlation With DM Bond Yields Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? For foreign DM government bonds, the conventional wisdom is to hedge foreign currency exposure because currency fluctuations outweigh bond volatility. A GAA Special Report shows that hedged foreign bonds have favorable return-risk profiles compared with domestic bonds in major DM countries. For EM local currency debt (based on the JP Morgan GBI-EM Global Diversified Local Currency Debt Index), USD investors should hedge their EM FX exposure while non-USD DM investors should not hedge. However, non-USD investors should avoid EM local currency debt if their objective is to maximize risk-adjusted return on the long-term horizon. Do Chinese bonds share the same traits as the EM aggregate? Our analysis suggests that Chinese bonds have historically provided better risk-adjusted returns to USD-based bond investors, hedged and unhedged. Thus, allocating a portion of the US Treasury portfolio to Chinese onshore bonds would improve a US bond portfolio’s return-risk profile. The Bloomberg Barclays (BB) China Treasury and Policy Bank Bond Index is used for the analysis. The index has a history starting in January 2004, even though it was included in BB's three flagship bond indexes only in April 2019.  On a hedged basis, Chinese onshore bonds deliver similar returns to global bonds as shown in Chart II-3. This is not surprising because interest-rate parity implies that the expected return on domestic assets equals the exchange-rate adjusted return on foreign currency assets, given foreign exchange market equilibrium. Unhedged returns, however, have outperformed both local and foreign government bonds for bond investors in the US, Japan, UK and the euro area since 2004 (Chart II-4). Carry was negative for USD-, GBP- and euro-based investors before the Global Financial Crisis, but has become positive since that time. The CNY has appreciated in general, albeit with greater movement against the non-USD crosses.  Chart II-3Chinese Bond Performance In A Global Context Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart II-4Carry And Spot CNY Exchange Rate Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Unhedged Chinese bonds have much higher absolute returns and also much higher volatility when compared with hedged bonds. How do Chinese onshore bonds fare on a risk-adjusted return basis? Table 2 compares the risk-return profiles of hedged and unhedged Chinese bonds with local and hedged foreign DM bonds in two periods: one from January 2004 and the other from July 2017 when the Bond Connect was launched. Table 2Return-Risk Profiles: Chinese Onshore Bond Index Vs DM Local Bond Indexes Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Several observations from Table 2: In local currency terms, Chinese bonds have the best risk-adjusted return and the second lowest volatility – only higher than Japanese government bonds (JGBs) – both from January 2004 and from July 2017. Since the start of Bond Connect, the risk-adjusted return of Chinese bonds in CNY has strengthened significantly with higher return and lower volatility. In contrast, there has been a deterioration in DM local bonds and their corresponding hedged foreign government bonds’ return/risk profiles.   In the past four years, Chinese bonds have outperformed all DM local bonds when unhedged, both in terms of absolute return and risk-adjusted return. When compared with a hedged foreign government bond, however, the absolute return advantage has been offset by much higher FX volatility. Still, euro- and JPY-based bond investors enjoy higher risk-adjusted returns from unhedged Chinese bonds than their respective hedged foreign DM government bonds. However, GBP-based investors would be better off with hedged non-UK government bonds. For USD-based bond investors, unhedged Chinese bonds would only be slightly inferior to hedged non-US government bonds. On a hedged basis, Chinese bonds have lower returns and less volatility than local bonds (with the exception of Japan), but they have higher risk-adjusted returns than local bonds in all but the euro area. When compared with hedged foreign bonds, euro- and USD-based investors would do slightly better with the Chinese bonds while JPY- and GBP-based investors would earn slightly more with other DM government bonds. How much should a bond investor replace local bonds with Chinese ones? For illustration, Chart II-5 plots the efficient frontiers for bond investors in the US, euro area, Japan and the UK when hedged Chinese bonds are added to their respective domestic bond portfolios. This addition would reduce portfolio volatility for all domestic bond portfolios, regardless of time frame. This is especially impressive for JGB investors because JGBs already have the lowest volatility among DM bonds. Moreover, returns would be improved for USD- and JPY-based investors when Chinese bonds are gradually included in domestic bond portfolios up to the risk-minimizing point.  Chart II-5Adding Hedged Chinese Bonds Reduces Volatility For All DM Domestic Bond Portfolios* Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? For GBP- and euro-based investors, however, adding hedged Chinese bonds would reduce absolute returns, but significantly improve risk-adjusted returns for GBP-based bond investors. Interestingly, even though euro zone local bonds have had superior risk-adjusted returns to hedged Chinese bonds since 2017, their risk-adjusted returns would still increase by about 18% when 50% of their local-bond portfolio is allocated to Chinese bonds. What is more striking is how unhedged Chinese bonds impact the return/risk profiles of global investors’ domestic bond portfolios. Unlike DM foreign bonds, which have inferior risk-adjusted returns when foreign currency exposure is not hedged, unhedged Chinese onshore bonds actually enhance a domestic bond investor’s absolute and risk-adjusted returns, as shown in Chart II-6. This is because of Chinese bonds’ superior risk-adjusted return measured in CNY (Table 2), negative correlations with CNY crosses (Chart II-7) and low to negative correlations with DM government bonds (Chart II-2). Chart II-6Adding Unhedged Chinese Bonds Enhances Absolute and Risk-Adjusted Returns For All DM Domestic Bond Portfolios* Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? For US bond investors who seek to maximize risk-adjusted return, the domestic Treasury portfolio would be improved significantly if about 40-50% of their holding were allocated to unhedged Chinese bonds. In comparison, the ratios would be lower for bond investors in the euro area, Japan and the UK. The key message is that global investors do not need to hedge the RMB exposure when investing in the Chinese onshore bond market. Chart II-7Chinese Bond Correlation With DM Currencies Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart II-8Chinese Yuan Still Has Upside Potential Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? We still have a favorable cyclical outlook for the CNY against the US dollar, supporting the case not to hedge the currency. The CNY is at about one standard deviation below fair value even though the gap has been narrowing since mid-2020 (Chart II-8). We expect the CNY to keep appreciating in the coming years barring major disruptive geopolitical/political events. China’s relatively strong productivity growth should continue to support the currency’s rising fair value. On a cyclical basis, given that the US Fed is firmly staying behind the curve (capping the upside in real bond yields in the US), the differential in real interest rates between China and other major economies should remain favorable for the RMB.  Bottom line: In a search-for-yield environment, the return-risk profiles of dedicated DM government bond portfolios may be enhanced by adding some exposure to Chinese onshore bonds on an unhedged basis. Part 3. Chinese Onshore Assets For Global Multi-Asset Portfolios Chinese onshore stocks on their own are not suitable for long-term, buy-and-hold strategic investments due to extremely high volatility, and the positive and rising correlation with global stocks and with CNY crosses. Chinese bonds, on the other hand, have an attractive risk-return profile with very low volatility, low correlation with global bonds, and negative correlation with CNY crosses. The negative correlation between Chinese stocks and bonds means that a mixed portfolio of the two assets would provide good diversification (Chart III-1). Chart III-1Chinese Onshore Assets Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart III-2Chinese Multi-Asset Portfolio Correlation With Global Multi-Asset Portfolios Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Investors may have different stock-bond allocations based on their return-risk objectives and constraints. For illustration, we constructed a stand-alone Chinese multi-asset portfolio by equally weighting onshore stocks and bonds. The correlations of this portfolio with six DM domestic 70-30 stock-bond portfolios have varied over time and by different countries, as shown in Chart III-2. Our Chinese-asset portfolio has a relatively high correlation with US and Japanese assets, but a low correlation with European assets, and almost no correlation with Australian and Canadian assets. Accordingly, the diversification effects are much stronger for GBP-, euro-, AUD- and CAD-based investors than for USD- and JPY-based investors, as shown in Chart III-3. Chart III-3Chinese Multi-Asset Portfolio Should Be Treated As A Standalone Asset By Non-US Asset Allocators Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart III-3 shows how the risk-return profile of a standard 70-30 stock-bond portfolio in the US, UK, Japan, euro area, Australia and Canada may be improved by adding some exposure to a 50-50 Chinese stock-bond portfolio. Even though this equally weighted Chinese onshore asset portfolio has unimpressive returns, when added to a domestic stock-bond portfolio there is an improvement in the return-risk profile of all non-USD-based portfolios. The optimal allocation to the stand-alone Chinese onshore portfolio varies with different home currencies, objectives and time periods, as shown in Table 3. Table 3Chinese Assets Improve Global Multi-Asset Portolios' Return-Risk Profiles Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Bottom Line: Unhedged Chinese onshore stocks and bonds may be treated as a stand-alone asset for global asset allocators, especially non-US ones. Adding a simple 50-50 Chinese stock-bond portfolio may boost the return/risk profile of global multi-asset portfolios. Part 4. Operational Q&A Many foreign investors believe that China’s onshore markets are hard to access. However, regulatory changes in the past 10 years, partially since Stock Connect was launched in 2014, have made it simpler from an operational point-of-view to buy and sell Chinese onshore equities and bonds. Below we answer some questions that international investors may have about market access. Q: Are there any access or quota restrictions for offshore investors to invest in China A-shares via Stock Connect? Historically, access to China’s mainland equity market by offshore investors was restricted through investment quotas and local currency controls. Since 2014, with the launch of Stock Connect, offshore investors no longer have access or repatriation restrictions. Stock Connect allows offshore investors to trade selected A-share stocks listed on the Shanghai (SSE) and Shenzhen (SZSE) Stock Exchanges through offshore brokers. Although not all A-shares listed on the SSE or SZSE can be invested in through Stock Connect, eligible stocks include almost all large- and medium-cap A-shares.1 Note that the Shanghai-Hong Kong (SH-HK) Stock Connect and the Shenzhen-Hong Kong (SZ-HK) Stock Connect complement each other, but they have a dual-channel, independent operation mechanism with two distinct Connect operations. Therefore, their shares cannot be cross-traded. Q: How to purchase China’s A-Shares via Stock Connect? Offshore investors need a Hong Kong or international broker (see MMA strong="">< strong="">GO strong="">> on Bloomberg for a list of Offshore brokers for Stock Connect northbound trading), through whom they buy A-shares. Brokers instruct Hong Kong Exchange’s (HKEX) participants to conduct northbound trades on the SSE or SZSE. Hong Kong Exchange’s subsidiary (a SSE or SZSE participant) also takes instructions to conduct trades on the SSE or SZSE stock exchanges. Clearing and settlement services of A-shares executed through Stock Connect are provided by the Hong Kong Securities Clearing Company (HKSCC), a solely-owned subsidiary of the HKEX, through clearing links established with the China Securities Depository and Clearing Corporation Limited (ChinaClear). The shares of offshore investors are held in an onshore omnibus securities account registered under the HKSCC. Q: Is margin trading or short selling allowed for Stock Connect northbound trading stocks? Yes, most eligible Stock Connect northbound trading A-shares are permitted for margin trading or short selling. Nowadays, more than 80% of the total eligible Stock Connect northbound trading stocks in the SSE and more than 70% of that in the SZSE are permitted for margin trading and short selling. HKEX provides a list of eligible equities for margin trading and short selling in a timely manner.2 Q: Are there other ways to tactically manage exposure to China’s A-shares? There are offshore ETFs that investors can use to hedge their exposure to Chinese equities (Table 4). For example, Direxion Daily CSI 300 China A Share Bear 1X ETF listed on the New York Stock Exchange (NYEX) provides 100% of the inverse exposure of the performance for the CSI 300 index. This ETF may be used to hedge offshore investors’ exposure to domestic China A- shares. Table 4ETFs That Can Be Used To Hedge Investors’ Exposure To Chinese Equities Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Q: Describe the main differences between Bond Connect and CIBM Direct. How do overseas investors hedge their currency exposure when investing in China’s onshore bond market? Bond Connect and China Interbank Bond Market (CIBM) Direct are the official channels for offshore investors to invest in China's onshore bond market except for Qualified Foreign Institutional Investors (QFII) and RMB Qualified Foreign Institutional Investors (RQFII). Around 680 foreign institutional investors have entered China’s interbank bond market since Bond Connect’s launch in July 2017.3 Here are some differences between CIBM Direct and Bond Connect: Bond Connect is based offshore, which gives overseas investors easy and quota-free access to China’s onshore interbank bond market through offshore trade platforms. Bond Connect permits investors to open accounts, trade, and settle transactions in the offshore market whereas CIBM Direct stipulates the process must be completed in the onshore market. CIBM Direct offers greater access to opportunities in the onshore market because it has access to a wider range of products and hedge tools, such as repos, interest rate swaps, bond lending and bond forwards. In comparison, the only Bond Connect products are bonds traded in China’s inter-bank bond market, and hedge tools are limited. In terms of currency hedging, both CIBM Direct and Bond Connect allow FX hedge tools such as forwards, swaps and options to help investors hedge their exposure to CNY (Chinese yuan traded in the onshore market). CIBM Direct trades in CNY rather than CNH (CNH is Chinese yuan traded in the offshore market) and allows investors to hold onshore balances in CNY. Bond Connect, however, does not allow investors to hold CNY balances. Under Bond Connect, investors are required to exchange CNY into CNH for any excess cash from trading or coupon payments, which can be a currency risk when funds are repatriated. However, offshore investors can hedge their FX exposure with FX Settlement Banks by engaging in various FX trades and FX hedge tools that match their bond position. FX Settlement Banks are banks in Hong Kong approved by the China Foreign Exchange Trade System (CFETS) to access the FX market of CIBM as RMB participation banks. Offshore FX Settlement Banks may square positions in either offshore or onshore FX markets. Investors should contact their Hong Kong custodians, which will appoint an FX Settlement Bank for FX conversion and hedging. Q: Is there another currency hedge mechanism for investors’ CNY exposure?  CNY exposure can be hedged using the usual instruments, such as CNH-forwards or CNY-non deliverable forwards (NDF). However, the CNH-forward has CNH basis risk, which arises from the differences between CNY and CNH spot rates. Investors may consider short CNY currency ETFs listed on the offshore market, such as the WisdomTree Chinese Yuan Strategy Fund (CYB) on the NYEX. CYB offers exposure to the overnight Chinese yuan and uses both short- and long-forward currency contracts for both CNH and CNY to manage its expectations for the currency. It seeks to achieve total returns reflective of money market rates in China available to foreign investors and of changes in the value of the yuan versus the dollar. Xiaoli Tang Associate Vice President, Global Asset Allocation xiaoliT@bcaresearch.com Qingyun Xu, CFA Associate Editor, China Investment Strategy qingyunx@bcaresearch.com   Appendix 1: The Evolution of The Chinese Onshore Markets China’s onshore equity and bond markets have grown dramatically in the past two decades. The equity market is the second largest in the world with more than 4,400 listed companies; the combined market capitalization of the Shanghai and Shenzhen stock exchanges has reached USD12.2 trillion (Chart A1). China’s bond market also is ranked second globally, after the US, with amounts outstanding at USD18.6 trillion (Chart A2). Chart A1China’s Stock Market Has Grown Sharply In The Past Two Decades China's Stock Market Has Grown Sharply In The Past Two Decades China's Stock Market Has Grown Sharply In The Past Two Decades Chart A2China’s Onshore Bond Market Is Second Largest In World Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Thanks to China’s financial market liberalization since the early 2000s, foreign investors can now access China's onshore stock and bond markets to include China A-shares and onshore bonds in portfolios. Various tools are available, including QFII, RQFII, Stock Connect, CIBM Direct and Bond Connect (Diagram 1). Since the launch of Stock Connect in late 2014, the cumulative net northbound flows to the Shanghai and Shenzhen exchanges have been more than RMB1.2 trillion (Chart A3, top panel). The cumulative net capital inflows through CIBM Direct and Bond Connect have reached more than RMB3.5 trillion since these mechanisms were introduced in 2016 and 2017, respectively (Chart A4, bottom panel).  Diagram 1China’s Financial Market Liberalization Roadmap Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart A3Net Inflows To China’s Onshore Markets Through Stock And Bond Connect Net Inflows To China's Onshore Markets Through Stock And Bond Connect Net Inflows To China's Onshore Markets Through Stock And Bond Connect Chart A4Growing Foreign Holdings Of China’s Onshore Equities And Bonds Growing Foreign Holdings Of China's Onshore Equities And Bonds Growing Foreign Holdings Of China's Onshore Equities And Bonds Although foreign investors’ holding of RMB-denominated assets increased significantly in recent years, their share of the total onshore market is still small, highlighting the potential for more capital inflows to China’s onshore market (Chart A4). Following the inclusion of China A-shares in global equity indexes, bond indexes have followed suit and Chinese government bonds are now offered in the world’s three major bond indices. Bloomberg Barclays Global Aggregate Index (BBGA) was the first to include Chinese government bonds in April 2019, followed by the JP Morgan Government Bond-Emerging Market Index (GBI-EM) in February 2020 and finally FTSE Russell’s World Government Bond Index (WGBI) in October 2021.   Footnotes 1The list of eligible A-shares for Shanghai and Shenzhen Connect can be accessed via the HK Exchange 2List of eligible equities for margin trading and short selling 3List of approved investors under Bond Connect Market/Sector Recommendations Cyclical Investment Stance

Highlights The chaotic US withdrawal from Afghanistan is symbolic – the US is conducting a strategic pivot to Asia Pacific to confront China. US-Iran negotiations are the linchpin of this pivot. If they fail, war risk will revive in the Middle East and the US will remain entangled in the region. At the moment, there is no deal, so investors should brace for a geopolitical risk premium in oil prices. That is, as long as global demand holds up despite COVID-19, and as long as the OPEC 2.0 cartel remains disciplined. We think they will in the short run. The US and Iran still have fundamental reasons to agree to a deal. If they do, the US will regain global room for maneuver while China’s and Russia’s window of opportunity will close. The implication is that markets face near-term oil supply risks – and long-term geopolitical risks due to Great Power rivalry in Eastern Europe and East Asia. Feature Events in Afghanistan have little macroeconomic significance but the geopolitical changes underway are profound and should be viewed through the lens of our second key view for 2021: the US strategic pivot to Asia. Chart 1The US Pivot To Asia Runs Through Iran Not Afghanistan The US Pivot To Asia Runs Through Iran Not Afghanistan The US Pivot To Asia Runs Through Iran Not Afghanistan As we go to press the Taliban is reconquering swathes of Afghanistan while US armed forces evacuate embassy staff and civilians. The chaotic scenes are reminiscent of the US’s humiliating flight from Saigon, Vietnam in 1975. As with Vietnam, the immediate image is one of American weakness but the reality over the long run is likely to be different. Over the past decade we have chronicled the US’s efforts to disentangle itself from wars of choice in the Middle East and South Asia. In accordance with US grand strategy, Washington is refocusing its attention on its rivalries with Russia and especially China, the only power capable of supplanting the US as a global leader (Chart 1). The US has struggled to conduct this “pivot to Asia” over the past decade but the underlying trajectory is clear: while trying to manage its strategic interests in the Middle East through naval power, the US will need to devote greater resources and attention to shoring up its economic and military ties in Asia Pacific (Map 1). The Middle East still plays a critical role – notably through China’s energy import needs – but primarily via the Persian Gulf. Map 1The US Seeks Balance In Middle East In Order To Pivot To Asia And Confront China Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China Thus the critical geopolitical risks today stem from Iran and the Middle East on one hand, and China on the other. They do not stem from the US’s belated and messy exit from Afghanistan, which has limited market relevance outside of South Asia. First, however, we will address the political impact in the United States. US Political Implications Chart 2Americans Agree With Biden And Trump On Exit From Afghanistan Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China American popular opinion has long turned against the “forever wars” in Iraq and Afghanistan, which cumulatively have cost $6.4 trillion and about 7,000 American troops dead1 (Chart 2). Three presidents, from two political parties, campaigned and won election on the basis of winding down these wars. The only presidential candidate since Republicans George W. Bush and John McCain who took a hawkish stance for persistent military engagement, Hillary Clinton, nearly lost the Democratic nomination and did lose the general election to a Republican, President Trump, who had reversed his party’s stance to advocate strategic withdrawal. War hawks have been sidelined in both parties. This is notable even if it were not the case that the current President Biden, whose son Beau fought in Afghanistan, had opposed the troop surge there under Obama. True, Biden will use drones, surgical strikes, and limited troop rotations to manage the aftermath in Afghanistan, both militarily and politically. Americans are still concerned about terrorism in general and any sign of a resurgent terrorist threat to the US homeland will be politically potent (Chart 3). But neither Biden nor the US can roll back the Taliban’s latest gains or achieve anything in Afghanistan that has not been achieved over the past twenty years.   Chart 3American Public Cares About Terrorism, Not Afghanistan Per Se Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China True, Biden will suffer a political black eye from Afghanistan. His approval rating has already fallen to 49.6%, slipping beneath 50% for the first time, in the face of the Delta variant of COVID-19 and the Afghan debacle. In both cases his early optimistic statements have now become liabilities. Biden is also 79 years old, which will make the 2024 campaign questionable, and he faces mounting problems in other areas, from lax border security and immigration enforcement to rising domestic crime. Nevertheless, Biden still has sufficient political capital to push through one or both of his major domestic legislative proposals by the end of the year, despite thin majorities in both the House and Senate. Afghanistan will not affect that, for three reasons: 1. The US economy is likely to continue to recover despite hiccups due to the lingering pandemic, since the vaccines so far are effective. The labor market is recovering and business capex and government support are robust. Setbacks, such as volatile consumer confidence, will help Biden pass bills designed to shore up the economy. 2. The public fundamentally agrees with Biden (and Trump) on military withdrawal, as mentioned. Voters will only turn against him if a major attack reinforces an image of weakness on terrorism. A major attack based in Afghanistan is not nearly as likely to succeed as it was prior to the September 11, 2001 attacks. But Biden also faces an imminent increase in tensions in the Middle East that could result in attacks on the US or its allies, or other events that reinforce any image of foreign policy failure. 3. Biden has broad popular support for his infrastructure deal, which also has bipartisan buy-in, with 19 Republican Senators already having voted for it. Further, the Democratic Party has a special fast-track mechanism for passing his social spending agenda, though conviction levels must be modest on this $3.5 trillion bill, which is controversial and will have to be winnowed to pass on a partisan vote in the Senate. If we are correct that Afghanistan will not derail Biden’s legislative efforts then it will not fundamentally affect US fiscal policy or the global macro outlook. Note, however, that a failure of Biden’s bills would be significant for both domestic and global economy and financial markets as it would suggest that US fiscal policy is dysfunctional even under single party rule and would thus help to usher back in a disinflationary context. Might Afghanistan affect the midterm elections and hence the US policy setup post-2022? Not decisively. Republicans are more likely than not to retake at least the House of Representatives regardless. This is a cyclical aspect of US politics driven by voter turnout and other factors. Democrats are partly shielded in public opinion due to the Trump administration’s attempts to pull out of foreign wars. But surely a black eye on terrorism or foreign policy would not help. Similarly, a major failure to manage the Middle East, South Asia, and the pivot to Asia Pacific would marginally hurt the Democrats in 2024, but that is a long way off. Geopolitical Implications The Taliban’s reconquest of Afghanistan has very little if any direct significance for global financial markets. Pakistan and India are the two major markets most likely to be directly affected – and their own geopolitical tensions will escalate as a result – yet both equity markets have been outperforming over the course of the Taliban’s military gains (Chart 4). Afghanistan’s impacts are indirect at best. However, the US withdrawal connects with major geopolitical currents, with both macro and market significance. Afghanistan often marks the tendency of empires to overreach. Russia’s failure in Afghanistan contributed to the collapse of the Soviet Union, though Russia’s command economy was unsustainable anyway. British failures in Afghanistan in the nineteenth and twentieth centuries did not lead to the British empire’s decline – that was due to the world wars – but Afghanistan did accentuate its limitations. Since 9/11 and the US’s wars in Iraq and Afghanistan, the US public’s economic malaise, political polarization, and loss of faith in public institutions have gotten worse. In turn, political divisions have impeded the government’s ability to respond cogently to financial and economic crisis, the resurgence of Russia, the rise of China, nuclear proliferation, constitutional controversies, and the COVID-19 pandemic. Once again Afghanistan marked imperial overreach. It is natural for investors to be concerned about the stability of the United States. And yet the US’s global power has recently stabilized (Chart 5). The US survived the 2020 stress test and innovated new vaccines for the pandemic. It is passing laws to upgrade its domestic technological, manufacturing, and infrastructural base and confronting its global rivals. Chart 4If Indo-Pak Markets Shrug Off Taliban Wins, So Can You If Indo-Pak Markets Shrug Off Taliban Wins, So Can You If Indo-Pak Markets Shrug Off Taliban Wins, So Can You Chart 5US Geopolitical Power Is Stabilizing Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China Chart 6US Not Shrinking From Global Role US Not Shrinking From Global Role US Not Shrinking From Global Role The US is not retreating from its global role, judging by defense spending or trade balances (Chart 6). While the desire to phase out wars could theoretically open the way to defense cuts, the reality is that the great power confrontation with China and Russia will demand continued large defense spending. The US also continues to run large trade deficits, due to its shortage of domestic savings, which gives it influence as a consumer and provider of dollar liquidity across the world. The critical geopolitical problem is Iran, where events have reached a critical juncture: To create a semblance of a balance of power in the Middle East, the US needs an understanding with Iran, which is locked in a struggle with Saudi Arabia over the vulnerable buffer state of Iraq. President Biden was not able to rejoin the 2015 détente with Iran prior to the inauguration of the new president, Ebrahim Raisi, who is a hawk and whose confrontational policies will lead to an escalation of Middle Eastern geopolitical risk in the short term – and, if no US-Iran deal is reached, over the long term. Iran recognizes the US’s war-weariness, as demonstrated by withdrawals from Iraq and Afghanistan. It was also exposed to economic sanctions after the US’s 2018-19 abrogation of the 2015 nuclear deal – it cannot trust the US to hold to a deal across administrations. Still, both the US and Iran face substantial strategic forces pressuring them to conclude a deal. The US needs to pivot to Asia while Iran needs to improve its economy and reduce social unrest prior to its looming leadership succession. But the time frame for negotiation is uncertain. Any failure to agree would revive the risk of a major war that would keep the US entangled in the region. Thus the pivot to Asia could be disrupted again, with major consequences for global politics, not because of Afghanistan but because of a failure to cut a deal with Iran. If the US succeeds in reducing its commitments to the Middle East and South Asia, the window of opportunity that China and Russia have enjoyed since 2001 will close. They will face a United States that has greater room for maneuver on a global scale. This is a threat to their own spheres of influence. But neither Beijing nor Moscow has an interest in a nuclear-armed Iran, so a US-Iran deal is still possible. Unless and until the US and Iran normalize relations, the Middle East is exposed to heightened geopolitical risk and hence oil supply risk. Global oil spare capacity is sufficient to swallow small disturbances but not major risks to stability, such as in Iraq or the Strait of Hormuz. Investment Takeaways Chart 7Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Back in 2001, the combination of American war spending, and conflict in the Middle East, combined with China’s massive economic opening after joining the WTO, led to a falling US dollar and an oil bull market. Today the US’s massive budget deficits and current account deficits present a structural headwind to the US dollar. Yet the greenback has remained resilient this year. While the pandemic will fade as long as vaccines continue to be effective, China’s potential growth is slowing even as it faces an unprecedented confrontation with the US and its allies. Until the US and Iran normalize relations, geopolitics will tend to threaten Middle Eastern oil supply and put upward pressure on oil prices. However, if the US manages the pivot to Asia, China will face more resolute opposition in its sphere of influence, which will tend to strengthen the dollar. The dollar and oil still tend to move in opposite directions. These geopolitical trends will be influential in determining which direction prevails (Chart 7). Thus geopolitics poses an upward risk to oil prices for now.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Please see Crawford, Neta, "United States Budgetary Costs and Obligations of Post 9/11 Wars Through FY 2020: $6.4 trillion", Watson Institute, Brown University.

Highlights A critical aspect of the diffusion of global geopolitical power – “multipolarity” – is the structural rise of India. India will gain influence in the coming five years as a growing importer of goods, services, oil, and capital. Trade with China is a positive factor in Sino-Indian relations but it will not be enough to offset the build-up of strategic tensions. Indo-Russian relations will also wane. India’s slow transition to green energy will give it greater sway in the Middle East but will not remove its vulnerability if the region destabilizes anew over Iran. Sino-Indian tensions have already affected capital flows, with the US building on its position as a major foreign investor. Feature Chart 1Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil India’s geopolitical power pales in comparison to that of the China-Pakistan alliance (Chart 1). India is traditionally an independent and “non-aligned” power that has managed conflicts with its neighbors by influencing either Russia or America to display a pro-India tilt. This strategy has held India in good stead as it helps create the illusion of a “balance of power” in the South Asian region. Structural changes are now afoot: Sino-Pakistani assertiveness toward India continues. But in a break from the past India’s Modi-led Bhartiya Janata Party (BJP) has been constrained to adopt a far more assertive stance itself. Russo-Indian relations face new headwinds. Russia has been a close historical partner of India. But Russia under President Vladimir Putin has courted closer ties with China, while the US has tried to warm up with India since President Bush. Under Presidents Trump and Biden, the US is taking a more confrontational approach to Russia and China and will continue to court India. Against this backdrop the key question is this: In a multipolar world, how will India’s relations with the Great Powers evolve over the next five years? Will the alliances of the early 2000s stay the same or will they change? And if they change, what will it mean for global investors? In this special report we provide a helicopter view of India’s relations with key countries. We do so by examining India’s trade and capital flows with the world. A country’s power to a large extent is a function not only of its population and military strength but also of the business interests it represents. India today is the second largest arms importer globally (guns), fifth largest recipient of global FDI flows (capital) and third largest importer of energy (oil). Looking at the trajectory of these business relations, we quantify the magnitude and sources of India’s geopolitical power over the next five years and its investment implications. Trade: India’s Imports Not Enough To Offset China Tensions “The 11th Law of Power - Learn to Keep People Dependent on You. To maintain your independence, you must always be needed and wanted. The more you are relied on, the more freedom you have.” – Robert Greene, The 48 Laws of Power1 A small and closed economy in the 1980s, India today is large and open. Since India lacked industrial capabilities, and was energy-deficient to start with, its import needs grew manifold over this period. India’s current account deficit has increased by nine times from 1980 to 2019. The magnitude of India’s appetite for imports is such that its current account deficit is the fifth largest in the world today (Chart 2). Chart 2India Is The Fifth Largest Importer Of Goods And Services The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Given its lack of domestic energy and industrial capabilities, India’s role as a client of the world will only become more pronounced as it grows. In fact, India appears all set to become the third largest importer of goods and services globally over the next five years (Chart 3). Chart 3India Will Become The Third Largest Net Importer, After US And UK, By 2026 The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Global history suggests that the client is king. The rise and fall of empires have been driven by the strength of their economies and militaries. Great powers import lots of goods and resources – and tend to export arms. The UK’s geopolitical decline over the nineteenth century, and America’s rise over the twentieth, were linked to their respective status as importers within the global economy. India’s rise as a large global importer will prove to be a key source of diplomatic leverage over the next five years. For example, India’s high appetite for imports from China will give India much-needed leverage in bilateral relations. Also, India’s slow transition to green energy continued reliance on oil will strengthen its bargaining power vis-à-vis oil producers. But these trends also bring challenges. Structurally, Sino-Indian tensions are rising and trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. China: India’s Growing Might As A Consumer Increases Leverage Vis-à-Vis China China’s rising assertiveness in South Asia and India’s own inclination to adopt an assertive foreign policy stance will lead to structurally higher geopolitical tensions in the region. So, is a full-blooded confrontation between the two nigh? No. First, Sino-Indian wars have always been constrained by geography: they are separated by the Himalayas, which help to keep their territorial disputes contained, driving them toward proxy battles rather than direct and total war. Second, India, Pakistan, and China are nuclear-armed powers which means that war is constrained by the principle of mutually assured destruction. This principle is not absolute – world history is filled with tragedy. There are huge structural tensions lurking in the combination of China’s Eurasian strategy and growing Sino-Indian naval competition that will keep Sino-Indian geopolitical risks elevated. Nevertheless, the bar to a large-scale war remains high. In the meantime, India’s growing might as a consumer could act as a much-needed deterrent to conflict. The last two decades saw America’s share in Chinese exports decline from a peak of 21% to 17% today. With US-China relations expected to remain fraught under Biden and with the US looking to revive its strategic anchor in the Pacific and shore up its domestic manufacturing strength, China’s trade relations with America will continue to deteriorate regardless of which party holds the White House. Against such a backdrop, China will try to build stronger trading ties with countries like India whose share in China’s exports has been growing (Chart 4). After excluding Hong Kong, India today is the eighth-largest exporting destination for China. While it only accounts for 3% of China’s exports, this ratio is comparable to that of larger exporting partners like Vietnam (4% share in China’s exports), South Korea (4%), Germany (3%), Netherlands (3%), and the UK (3%). In other words, China’s need for India is underrated and growing. There are two problems with Sino-Indian trade going forward. First, the strategic tensions mentioned above could prevent trade ties from improving. Over the past decade, Sino-Indian maritime and territorial disputes have escalated while Sino-Indian trade has merely grown in line with that of other emerging markets (Chart 5). China’s rising import dependency has led it to develop both a navy and an overland Eurasian strategy. The Eurasian strategy threatens India’s security in border areas of South Asia, while India’s own naval rise and alliances heighten China’s maritime supply insecurity. These trends may or may not prevent trade from living up to its potential, but they could result in strategic conflict regardless. Chart 4Amongst Top Chinese Export Clients, India’s Importance Has Increased The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 5India’s Imports From China Have Broadly Grown In Line With Peers India's Imports From China Have Broadly Grown In Line With Peers India's Imports From China Have Broadly Grown In Line With Peers Second, the trade relationship itself is imbalanced. India imports heavily from China but sells little into China. China is responsible for more than a third of India’s trade deficit. At the same time, India increasingly shares the western world’s concern about network security in a world where cheap Chinese hardware could become integral to the digital economy. If Sino-Indian diplomacy cannot redress trade imbalances, then trade will generate new geopolitical tensions rather than resolve other ones. One should expect China to court India in the context of rising American and western strategic pressure. Yet China has failed to do so. Why? Because China’s economic transition – falling export orientation and declining potential GDP – is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s own economic difficulties – the need to create jobs for a growing population – are generating an opposing wave of nationalism. Thus, while Sino-Indian trade will discourage conflict on the margin, it may not be enough to prevent it over the long run. Oil: As India Lags On Green Transition, Its Significance As An Oil Consumer Will Rise Whilst renewable energy’s share of India’s energy mix is expected to grow, the pace will be slow. Moreover, India’s increased reliance on green energy sources over the next decade will come at the expense of coal and not oil (Chart 6). Consequently, India’s reliance on oil for its energy needs is expected to stay meaningful. Chart 6India’s Reliance On Oil Will Persist For The Next Decade And Beyond The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 7India’s Importance As An Oil Client Has Been Rising The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil The International Energy Agency (IEA) forecasts that India’s net dependence on imported oil for its overall oil needs will increase from 75% today to above 90% by 2040. But India’s relative importance as an oil client will also grow as most large oil consumers will be able to transition to green energy faster than India. In fact, data pertaining to the last decade confirms that this trend is already underway. India’s share of the global oil trade has been rising (Chart 7). In particular, India has taken advantage of Iraq’s rise as a producer after the second Gulf War and has marginally increased imports from Saudi Arabia (Chart 8). Chart 8India’s Importance As A Client Has Been Rising For Top Oil Exporters The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Iran is the country most likely to gain from this dynamic in the coming years – if the US and Iran strike a deal to curb Iran’s nuclear program in exchange for the US lifting economic sanctions. India has maintained stable imports from the Middle East over the past decade despite nominally eliminating imports of oil from Iran (Chart 9). Chart 9India Has Maintained Stable Imports From The Middle East The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil However, while India will have greater bargaining power between OPEC and non-OPEC suppliers, dependency on the unstable Middle East is always a geopolitical liability. If the US and Iran fail to arrive at a deal, a regional conflict is likely, in which case India’s slow green transition and vulnerability to supply disruptions will become a costly liability. Bottom Line: India’s growing importance to both Chinese manufacturers and global oil producers will give it leverage in trade negotiations. However, ultimately, national security will trump economics when it comes to China, while India will remain extremely vulnerable to instability in the Middle East. Guns: Indo-Russian Relations Weaken “When the war broke out [between India & Pakistan in 1971], the Soviet Union cast aside all pretentions of neutrality and non-partisanship… the Russians were in no hurry to terminate the fighting since their interest was better served by the continuation of hostilities leading to an India victory … The factors that decisively determined the outcome of the war were: first, Soviet military assistance to India; secondly the USSR’s role in the UN Security council; and thirdly, Russia strategy to prevent a direct Chinese intervention in the war.” – Zubeida Mustafa, "The USSR and the Indo-Pakistan War"2 The true origins of Russia’s pro-India tilt can be traced back to 1971. The former Soviet Union’s support for India played a critical role in helping India win the Indo-Pakistan war of 1971. Half a century later the Indo-Russia relationship persists, but its intensity has declined and will continue declining over the next few years. We see three reasons: America’s withdrawal from Iraq and Afghanistan will allow the US to focus more intently on its rivalry with China and Russia – a dynamic that is reinforcing China’s and Russia’s move closer together. Meanwhile India’s relationship with the US continues to improve. The China-Pakistan alliance continues to strengthen. Beyond cooperation on China’s ambitious Belt and Road Initiative, Pakistan shares a deep relationship with China based on defense and trade (Chart 10). Hence India is distrustful of closer Russo-Chinese relations. In light of this strategic re-alignment, Russia may see value in developing a closer defense relationship with China. Trading relations between Russia and India are minimal even today. Hence unlike in the case of China, there exists no backstop on weakening of Russo-Indian relations. Less than 1.5% of India’s merchandise imports come from Russia and less than 1% of India’s exports go to Russia. Russia’s share of Indian oil imports has grown in recent years but only to 1.4% of total. Meanwhile the US share of India’s imports has catapulted to 5.7% since the US became an exporter. Any removal of Iran sanctions will come at the cost of other Middle Eastern exporters, not these two alternatives to the risky Persian Gulf, but Russia’s share is still small. Now the backbone of Indo-Russia relations has been their arms trade. However, India’s reliance on Russia for arms could decline over the next five years. India today is Russia’s largest arms client accounting for 23% of its arms sales (Chart 10). However, second in line is China which accounts for 18% of Russia’s arms sales. Given that Russia’s share in global arms exports has been declining (Chart 11), Russia will be keen to reverse or at least halt this trend. Russia can do so most easily by selling more arms to India or to China. Even as China appears to be increasingly focused on developing indigenous arms production capabilities, for reasons of strategy, China appears like a better client for Russia to bank on for the next decade. After all, in 1989, when western countries imposed an arms embargo against China in response to events at Tiananmen Square, Russia became the prime supplier of arms to China. Chart 10India Is A Key Client For Russia, As Is China The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil By contrast, for reasons of strategy India appears like a less promising client to bank on for Russia. India’s import demand for arms has been declining while China’s demand is increasing (Chart 12). India under the Modi-led Bhartiya Janata Party (BJP) has been reducing its reliance on imported arms. Last month, for example, the Indian Ministry of Defense (MoD) said that it has set aside 64% of the defense capital budget for acquisitions from domestic companies.3 This is an increase of 6% over last year, which was the first time such a distinction between domestic and foreign defense expenditure was made. Whilst it will take years for India to develop its domestic arms production capabilities, India’s inward tilt is worrying for traditional suppliers like Russia. Chart 11Among Top Arms Exporters, Russia Is Losing Market Share The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 12India’s Appetite For Arms Imports Is Falling The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Moreover, Russia is aware that the situation is rife for US-India arms trade to strengthen given that India is starting to display a pro-US tilt. Groundwork for a sound defense relationship with India has already been laid out by the US as evinced by: Foundational agreements: India and the US signed the Communications, Compatibility, and Security Agreement (COMCASA) in 2018 and the Basic Exchange and Cooperation Agreement (BECA) in 2020. Sanction exemptions: The US had applied sanctions on Turkey under the Countering America's Adversaries Through Sanctions Act (CAATSA) for Ankara’s purchase of Russia’s S-400 missile defense system in 2020. The US has threatened India with CAATSA sanctions for buying S-400 missile defense systems from Russia but has not applied these sanctions to India (at least not yet). Not applying CAATSA sanctions to India allows the US to strengthen its strategic relations with India that can help further the American goal of creating a counter to China in Asia. Bottom Line: India-Russia relations will remain amicable, but this relationship is bound to fade over the next five years as the US counters China and Russia. Limited backstops exist for Indo-Russia ties. Economic ties between India and Russia are minimal, as India is cutting back on arms imports and only marginally increasing oil imports. Capital: China Investment Down, US Investment Up “America has no permanent friends or enemies, only interests.” – Henry Kissinger, Former US Secretary of State India’s economic growth rates could be higher if it did not have to deal with the paradox of plentiful savings alongside capital scarcity. Even as Indian households are known to be thrifty, only a limited portion of their savings is available for being borrowed by small firms. Almost a quarter of bank deposits are blocked in government securities. More than a third of adjusted net bank credit must be made available for government-directed lending. With what is left, banks prefer lending the residual funds to large top-rated corporates. It is against this backdrop that foreign direct investment (FDI) flows provide much needed succor to Indian corporates, particularly capital-guzzling start-ups. FDI inflows into India have become a key source of funding for Indian corporates over the last decade with annual FDI flows often exceeding new bank credit. Correspondingly, for FDI investors, India provides the promise of high returns on investment in an emerging market that offers political stability. India emerged as the fifth largest FDI destination globally in 2020. Amongst suppliers of FDI into India (excluding tax havens like Cayman Islands), the US and China have been top contributors. Whilst China has been a leading investor into the Indian start-up space, geopolitical tensions have translated into regulatory barriers that prevent Chinese funds from investing in India. Separately, as Indo-US relations improve, the symbiotic relationship between capital-rich US funds and capital-hungry Indian start-ups should strengthen. In fact, in 2020 itself, Chinese private equity (PE) and venture capital (VC) investments into India shrank whilst American investments into India doubled, according to Venture Intelligence (Chart 13). Distinct from Chinese funds’ restrained ability to invest in Indian firms, Indian tech start-ups could potentially benefit from reduced global investor appetite in Chinese tech stocks owing to China’s regulatory crackdown and breakup with the United States. China’s foreign policy assertiveness and domestic policy uncertainty may lead to a reallocation of FDI flows away from China and into India. China (including Hong Kong) has been a top host country for FDI, attracting 4x times more funds than India (Chart 14). However, India’s ability to absorb these reallocated funds over the next five years will be a function of sectoral competencies. For instance, India’s information and communications technology (ICT) sector appears best positioned to benefit from this trend. But the same may not be the case for sectors like manufacturing that traditionally attract large FDI flows in China yet are relatively underdeveloped in India. On the goods’ front, given that India’s comparative advantage lies in the production of capital-light, labor-light and medium-tech intensive products, pharmaceuticals and chemicals could be two other industries that attract FDI flows in India. Chart 13Chinese PE/VC Investments Into India In 2020 Slowed Significantly The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 14China Has Been A Top Host Country For FDI, Attracting 4x More Flows Than India The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Bottom Line: Whilst trade between India and China has not been affected much by geopolitical tensions, capital flows have been. Given that the US historically has been a top FDI contributor in India, and given improving Indo-US relations, FDI investment into India from the US appears set to rise steadily over the next five years, particularly into the ICT sector. Investment Conclusions China-India geopolitical tensions are here to stay and will be a recurring feature of South Asia’s geopolitical landscape. However, a growing trade relationship could discourage conflict, especially if it becomes more balanced. It may not be enough to prevent conflict forever but it is an important constraint to acknowledge. India’s current account deficit will remain vulnerable to swings in oil prices, but it may be able to manage its energy bill better as its bargaining power relative to oil suppliers improves. The problem then will become energy insecurity, particularly if the US and Iran fail to normalize relations. As India and Russia explore new alignments with USA and China respectively, the historic Indo-Russia relationship will weaken. It will not collapse entirely because Russia provides a small but growing alternative to Mideast oil. US-India business interests may deepen as India considers joint ventures with American arms manufacturers and American funds court India’s capital-hungry information and communications technology sector. Against this backdrop we reiterate our constructive strategic view on India. However, for the next 12 months, we remain worried about near-term geopolitical and macro headwinds that India must confront.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 (Viking Press, 1998). 2 Mustafa, Zubeida. "The USSR and the Indo-Pakistan War, 1971" Pakistan Horizon 25, No. 1 (1972): 45-52. 3 Ajai Shukla, "Local procurement for defence to see 6% hike this year: Govt to Parliament" Business Standard, July 2021.