Emerging Markets

Special Report

Highlights As US and China’s grand strategies collide, expect major and minor geopolitical earthquakes whose epicenter will now lie in South Asia and the Indian Ocean basin. Another tectonic change will drive South Asia’s emergence as a new geopolitical battle ground - South Asia is now heavily weaponized. All key players operating in this theater are nuclear powers. South Asia’s democratic traditions are well-known but notable institutional and social fault lines exist. These could trigger major geopolitical events in Afghanistan, Pakistan and in pockets of India too. We are bullish on India strategically but bearish tactically. Dangerous transitions are underway to India’s east and west. Within India, key elections are approaching, and it is possible that growth may disappoint. For reasons of geopolitics, we are strategically bullish on Bangladesh but strategically bearish on Pakistan and Sri Lanka. We are booking gains of 9% on our long rare earths basket and 1% on our long GBP-CZK trade. Feature Over the 1900s, East Asia and the Middle East emerged as two key geopolitical focal points on the world map. Global hegemons flexed their muscles and clashed in these two theaters. Meanwhile South Asia was a geopolitical backstage at best. The majority of South Asia was a British colony until the second half of the twentieth century. After WWII it struggled with the difficulties of independence and mostly missed out on the prosperity of East Asia and the Pacific. But will the twenty-first century be any different? Absolutely so. We expect the current century to be marked by major and minor geopolitical earthquakes in which South Asia and the Indian Ocean basin will play a major part. This seismic change is likely to be the result of several tectonic forces: Population: A quarter of the world’s people live in South Asia today and this share will keep growing for the next four decades. India will be the most populous country in the world by 2027 and will account for about a fifth of global population. Supply: China’s growth model has left it heavily dependent on imports of raw materials from abroad. It is clashing with the West over markets and supply chains. Beijing is building supply lines overland while developing a navy to try to secure its maritime interests. These interests increasingly overlap with India’s, creating economic competition and security concerns over vital sea lines of communication. Access: Whilst the Himalayas and Tibetan plateau have historically prevented China from expanding its influence in South Asia, China’s alliance with Pakistan is strengthening. Physical channels like the China Pakistan Economic Corridor (CPEC), and other linkages under the Belt and Road Initiative, now provide China a foot in the South Asian door like never before (Map 1). Weapons: The second half of the twentieth century saw China, India, and Pakistan acquire nuclear arms. Consequently, South Asia today is one of the most weaponized geographies globally (Map 1). Map 1South Asia To Emerge As A Key Geopolitical Theater In The 21st Century With the South Asian economy ever developing, and US-China confrontation here to stay, we expect China to make its presence felt in South Asia over the coming decades. The US’s recent withdrawal from Afghanistan, and the failure of democratization in Myanmar, are but two symptoms of a grand strategic change by which China seeks to prevent US encirclement and Indo-American cooperation develops to counter China. Throw in the abiding interests of all these powers in the Middle East and it becomes clear that South Asia and the Indian Ocean basin writ large will become increasingly important over the coming decades. The Lay Of The Land - India Is The Center Of Gravity Chart 1South Asia Managed Rare Feat Of ‘Steady’ Growth South Asia stands out amongst developing regions of the world for its large and young population. In recent decades, South Asia has also managed to grow its economy steadily, surpassing Sub-Saharan Africa and rivaling the Middle East (Chart 1). While South Asia’s growth rates have not been as miraculous as East Asia post World War II, its growth engine has managed to hum slowly but surely. India and Bangladesh have been the star performers on the economic growth front (Chart 2). Despite decent growth rates, the South Asian region is characterized by very low per capita incomes due to large population. On per capita incomes, Sri Lanka leads whilst Pakistan finds itself at the other end of the spectrum (Chart 3). Chart 2India And Bangladesh Have Been Star Performers Chart 3Per Capita Incomes In South Asia Have Grown, But Remain Low Chart 4India Accounts For About 80% Of South Asia’s GDP South Asia constitutes eight nations. However only four are material from an investment perspective: India, Pakistan, Sri Lanka, and Bangladesh. India is the center of gravity as it offers the most liquid scrips and accounts for 80% of the region’s GDP (Chart 4). In addition: India accounts for 101 of the 110 companies from South Asia listed on MSCI’s equity indices. MSCI India’s market capitalization is about $1 trillion. In fact, India’s equity market could soon become larger than that of the UK and join the world’s top-five club.1 The combined market cap of MSCI Bangladesh, Sri Lanka, and Pakistan amounts to only about $6 billion. Liquidity is a constraint that investors must contend with whilst investing in these three countries in South Asia. Pakistan is the home of 220 million – set to grow to 300 million by 2040. It lags its neighbors on economic growth and governance but has nuclear weapons and a 650,000-strong military. Bottom Line: India is the center of gravity for the regional economy and financial markets in South Asia. Sri Lanka and Bangladesh are small but are developing. Pakistan is the laggard, but is militarily strong, which raises political and geopolitical risks. South Asia: Major Consumer, Minor Producer Chart 5Manufacturing Capabilities Of South Asian Economies Are Weak South Asia’s defining economic characteristic is that it is a major consumer. This feature contrasts with the region’s East Asian cousins, which worked up economic miracles based on their manufacturing capabilities. South Asia’s appetite to consume is partly driven by population and partly driven by the fact that this region’s economies have an unusually underdeveloped manufacturing base (Chart 5). It’s no surprise that all countries in South Asia (with the sole exception of Afghanistan) are set to have a current account deficit over the next five years (Charts 6A and 6B). Chart 6ASouth Asian Economies Tend To Be Net Importers Chart 6BSouth Asian Economies Tend To Be Net Importers India is set to become the third largest global importer of goods and services (after the US and UK) over the next five years. Its rise as a large client state of the world will be both a blessing and a curse, as increased business leverage will coincide with geopolitical insecurity. Structurally, Sino-Indian tensions are rising and growing bilateral trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. Either way, India and its region become more important to the rest of the world over time. Whilst the structure of South Asia’s economy is relatively rudimentary, it is worth noting that Bangladesh and Sri Lanka present an exception. Bangladesh has embarked on a path of manufacturing-oriented development via labor-intensive production. Sri Lanka has a well-developed services sector (Chart 7). In particular: Bangladesh: Within South Asia, Bangladesh’s manufacturing sector stands out as being better developed than regional peers. More than 95% of Bangladesh’s exports are manufactured goods –a level that is comparable to China (Chart 8). China’s share in the global apparel and footwear market has been systematically declining and Bangladesh is one of the countries that has benefited most from this shift. Bangladesh’s share in global apparel and footwear exports to the US as well as EU has been rising steadily and today stands at 4.5% and 13% respectively.2 Chart 7Bangladesh’s And Sri Lanka’s Economies Are Relatively Modern Chart 8Bangladesh Has The Most Developed Exports Franchise In South Asia Sri Lanka: Whilst Sri Lanka social complexities are lower and per capita incomes are higher as compared to peers in South Asia, its transition from a long civil war to a focus on economic development recently suffered a body blow, first owing to terrorist attacks in 2019 and then owing to the pandemic. The economic predicament was then worsened by its government’s hasty transition to organic farming which hit domestic food production. Geopolitically it is worth noting that China is one of the largest lenders to Sri Lanka. Whilst Sri Lanka’s central bank may be able to convince markets of the nation’s ability to meet debt obligations for now, its foreign exchange reserves position remains precarious and public debt levels remain high. Sri Lanka’s vulnerable finances are likely to only increase Sri Lanka’s reliance on capital-rich China. Despite Democracy, South Asia Has Political Tinderboxes Another factor that sets South Asia apart from developing regions like Africa, the Middle East, and Central Asia is the region’s democratic moorings. India and Sri Lanka lead the region on this front, although the last decade may have seen minor setbacks to the quality of democracy in both countries (Chart 9). Pockets of South Asia are socially and politically unstable, characterized by religious or communal strife, terrorist activity, and even the occasional coup d'état. Risk Of Social Conflict Most Elevated In Pakistan And Afghanistan India’s demographic dividend is real, but its benefits should not be overstated. For instance, India’s northern region is a demographic tinderbox. It is younger than the rest of the country, yet per capita incomes are lower, youth underemployment is higher, and society is more heterogeneous. The rise of nationalism in India is an important consequence and could engender potential social unrest. Chart 9India’s Democracy Strongest, But May Have Had Some Setbacks Chart 10South Asia Is Young And Will Age Slowly   Chart 11Social Complexities Are High In Afghanistan & Pakistan A similar problem confronts South Asia as a whole. Pakistan and Afghanistan are younger than India by a wide margin (Chart 10). But both countries are economically backward and have either poor or non-existent democratic traditions. Lots of poor youths and inadequate political valves to release social tensions make for an explosive combination. These countries are highly vulnerable to social conflict that could cause political instability at home or across the region via terrorism (Chart 11). The Gatsby Effect Most Prominent In Pakistan While various regions struggle with inequality, South Asia has less of a problem that way (Chart 12). However South Asia is characterized by very low levels of social mobility as compared to peer regions. This can partially be attributed to two centuries of colonial rule as well as to endemic traditions of social stratification. Chart 12Gatsby Effect: Social Mobility Is Lowest In Pakistan Within South Asia it is worth noting that social mobility is the lowest in Pakistan and highest in Sri Lanka. Chart 13Military’s Influence Most Elevated In Pakistan And Nepal Too Military Influential In Pakistan (And Nepal) Events that transpired over January 2020 in the US showed that even the oldest constitutional democracy in the world is not immune to a breakdown of civil-military relations. South Asia has seen the occasional coup d'état, one reason for the political tinderboxes highlighted above. Obviously, Myanmar is the worst – it saw its nascent democratization snuffed out just last year. But other countries in the region could also struggle to maintain civilian order in the coming decades. The military’s influence is outsized in Pakistan as well as Nepal (Chart 13). India maintains high levels of defense spending but has a strong tradition of civilian control (Chart 14). Chart 14Pakistan’s Military Budget Is Most Generous, India A Close Second South Asia: A New Global Battle Ground Historically global hegemons have sought to assert their dominance by staking claim over coastal regions in Europe and Asia. Over the past two centuries Asia has emerged as a geopolitical theater second only to Europe. Naval and coastal conflicts have emerged from the rise of Japan (the Russo-Japanese War) and the Cold War (the Korean War & the Vietnam War). Today the rise of China is the destabilizing factor. The “frozen conflicts” of the Cold War are thawing in Taiwan, South Korea, and elsewhere. China is pursuing territorial disputes around its entire periphery, including notably in the East and South China Seas but also South Asia. Meanwhile the US, fearful of China, is struggling to strike a deal with Iran and shift its focus from the Middle East to reviving its Pacific strategic presence. A budding US-China competition is creating conditions for a new cold war or a series of “proxy battles” in Asia. Over the next few decades, we expect disputes to continue. But the focal points are likely to cover South Asia too. In specific, landlocked regions in South Asia are likely to see rising tensions in the twenty-first century (Map 2). Also as mentioned above, China’s naval expansion and the US’s attempt to form a “quadrilateral” alliance with India, Japan, and Australia will generate tensions and potentially conflict. European allies are also becoming more active in Asia as a result of US alliances as well as owing to Europe’s independent need for secure supply lines. Map 2China’s Interest In Landlocked Regions Of South Asia Is Rising While border clashes between India and China will ebb and flow, Indo-Chinese confrontations along India’s eastern border will become a structural theme. Arguably, Sino-Indian rivalries pre-date the twenty-first century. But in a world in which the Asian giants are increasingly economically and technologically developed, Sino-Indian confrontations are likely to persist and result in major geopolitical events. Consider: China is adopting nationalism and an assertive foreign policy to cope with rising socioeconomic pressures on the Communist Party as potential GDP growth slows. China is developing a navy as well as a stronger alliance with Pakistan, which includes greater lines of communication. North India is a key constituency for the political party in power in India today (i.e., the Bhartiya Janata Party or BJP) and this geography harbors especially unfavorable views of Pakistan (Chart 15). Thus, there is a risk that the India of today could respond far more decisively or aggressively to threats or even minor disputes. More broadly, nationalism is rising in India as well as China. India is shedding its historical stance of neutrality and aligning with the US, which fuels China’s distrust (Chart 16). Chart 15Northern India Views Pakistan Even More Unfavorably Than Rest Of India Chart 16India Has Aligned With The QUAD To Counter The Sino-Pak Alliance Turning attention to India’s western border, clashes between India and Pakistan relating to landlocked areas in Kashmir will also be a recurring theme. Whilst India currently has a ceasefire agreement in place with Pakistan, peace between the two countries cannot possibly be expected to last. This is mainly because: Kashmir: Core problems between the two countries, like India’s control over Kashmir and Pakistan’s use of militant proxies, remain unaddressed. India’s unexpected decision in 2019 to abrogate article 370 of the Indian constitution has reinforced Pakistan’s attention on Kashmir. Sino-Pak Alliance: Pakistan accounted for 38% of China’s arms exports over 2016-20. Pakistan accounts for the lion’s share of Chinese investments made in South Asia (Chart 17). Sino-India rivalries will spill into the Indo-Pak relationship (and vice versa). Revival Of Taliban: The US withdrawal from Afghanistan has revived Taliban rule in that country. Taliban’s rise will resuscitate a range of dormant terrorist movements in Afghanistan as well as in Pakistan. India has a long history of being targeted. South Asia today is very different from what it looked like for most of the post-WWII era: it is heavily weaponized. India, Pakistan, and China became nuclear powers in the second half of the twentieth century and have been steadily building their nuclear stockpiles ever since (Chart 18). North Korea’s growing arsenal is theoretically able to target India, while Iran (more friendly toward India) may also obtain nuclear weapons. Chart 17China And Pakistan: Joined At The Hip? Chart 18South Asia: The New Epicenter For Nuclear Activity While nuclear arms create a powerful incentive for nations to avoid total war, they can also create unmitigated fear and uncertainty during incidents of major strategic tension. This is especially true when countries have not yet worked out a mode of living with each other, as with the US and USSR in the early days of the Cold War. Investment Takeaways For investors with an investment horizon exceeding 12 months, we highlight that India presents a long-term buying opportunity for two key reasons: China’s Internal And External Troubles Will Benefit India: As long as US and China do not reengage in a major way, global corporations will fall under pressure to diversify from China and the US will pursue closer relations with India. China faces an array of challenges across its periphery, whereas India need only focus on the South Asian sphere. India Is Rising As A Global Consumer: As long as a major Middle East war and oil shock is avoided (not a negligible risk), India should see more benefits than costs from its growing importance as a client of the world. However, over the next 12 months we worry that India is priced for perfection. India currently trades at a punchy premium relative to emerging markets (Table 1) at a time of when both geopolitical and macroeconomic headwinds are at play. In particular: Table 1We Are Bearish On India Tactically, But Bullish On India & Bangladesh Strategically Major Transitions Are Dangerous: Recent developments in South Asia have added to geopolitical risks for India. The assumption of power by Taliban in Afghanistan will activate latent terrorist forces that could target India. Pakistan’s chronic instability combined with the change of power in Afghanistan could set off an escalation in Indo-Pakistani tensions, sooner rather than later. On India’s eastern front, China’s need to distract its population from a souring economy could trigger a clash between China and India. Down south, China’s rising influence over crisis-hit Sri Lanka is notable and could potentially engender security risks for India. Chart 19Politics Can Trump Economics In Run Up To General Elections Growth Slowing, Elections Approaching: We worry that India’s growth engine may throw up a downside surprise over the next 12 months owing to poor jobs growth and poor investment growth. History suggests that politics often trumps economics in the run up to general elections (Chart 19). Hence there is a real risk that policy decisions will be voter-friendly but not market-friendly over 2022. As both India and Pakistan are gearing up for elections in the coming years, major military showdown or saber rattling should not be ruled out. Both countries may engineer a rally around the flag effect to bump up their pandemic-battered approval. Tension with China may escalate as Xi Jinping extends his term in power next year and seeks to enforce red lines in China’s eastern and western borders. Globally what are the key geopolitical factors that could lead to India’s underperformance in the short run? We highlight a checklist here: China Stimulates: The near-term clash between markets and policymakers in China should eventually give way to meaningful fiscal stimulus by Chinese authorities. This buoys China as well as emerging markets that depend on China for their growth. However, even if China flounders, India may not continue to outperform. The correlation between MSCI India and China equities has been positive. Fed Tightens Quickly: A faster-than-expected taper and tightening guidance could cause those emerging markets that are richly priced like India to correct. A Crisis Over Iran’s Nuclear Program: If the US is unable to return to diplomacy, tensions in the Middle East will rise and stoke oil prices. This will affect India adversely, given global price pressures and India’s high dependence on oil imports. Conversely, if these developments fail to materialize then that would lower our conviction regarding India’s underperformance in the short run. In summary, we are bullish India strategically but bearish tactically. As regards the three other investable markets in South Asia: We are bearish on Pakistan and Sri Lanka on a strategic time horizon. Whilst both nations’ rising alignment with China could be an advantage ceteris paribus, ironically their deteriorating finances are driving their proximity to capital-rich China (Chart 20). To boot, Sri Lanka’s ability to pay its way out of its economic crisis on its own steam is worsening. This is evident from its rising debt to GDP ratio (Chart 21). Chart 20Pakistan And Sri Lanka Running Low On Reserves Pakistan faces elevated risks of internal social conflict, must deal with a rapidly changing external environment, has a weak democracy and an unusually influential military. Sri Lanka’s social risks are low, but its economic crisis appears likely to persist. The fact that both markets have been characterized by a high degree of volatility in earnings in the recent past implies that even a cyclical “Buy” case for either of these markets is fraught with risks (Table 1). The outlook for Bangladesh is better. Exports account for 15% of GDP and the US and Europe account for around 70% of its exports. Strong fiscal stimulus in these developed markets should augur well for this frontier market. Additionally, Bangladesh is characterized by moderate social risks, reasonably strong democracy scores and low levels of influence from the military. Its healthy public finances (Chart 21) and the fact that it shares no border with China creates the potential to leverage a symbiotic relationship with China. Chart 21Sri Lanka’s Debt Now Exceeds Its GDP But there is a catch. Bangladesh as a market has a low market cap and hence offers low levels of liquidity (Table 1). We thus urge investors to avoid making cyclical investment calls on this South Asian market. However, from a long-term perspective we highlight our strategic bullish view on Bangladesh given supportive geopolitical factors. Watch out for an upcoming report from our Emerging Markets Strategy team, that will delve into the macroeconomic aspects of Bangladesh.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Abhishek Vishnoi and Swetha Gopinath, "India's stock market on track to overtake UK in terms of m-cap: Report" Business Standard, October 2021. 2 Arianna Rossi, Christian Viegelahn, and David Williams, "The post-COVID-19 garment industry in Asia" Research Brief, International Labour Organization, July 2021. Open Trades & Positions

Highlights The surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Chart 2Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Chart 4… But The Nominal USD Value Rises Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Chart 8   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations

Highlights As US inflation proves to be not-so-transitory, US interest rate expectations will rise. Slowing Chinese domestic demand and rising US interest rate expectations will support the US dollar. The net impact from China’s slowdown and higher US interest rate expectations on mainstream EM will be currency depreciation. Rising mainstream EM nominal and real (inflation-adjusted) interest rates do not often lead to domestic currency appreciation A strengthening dollar vis-à-vis EM currencies is bad news for EM fixed-income markets – both local currency bonds and credit markets. Feature This report discusses EM local currency (domestic) bonds and US dollar bonds (credit markets). To begin with, we reiterate our main macro themes since January this year: (1) a slowdown in China and (2) rising US inflationary pressures and higher US bond yields. These macro themes will create tailwinds for the US dollar, at least for the next several months. A strengthening dollar is bad news for EM fixed-income markets. China’s Slowdown China’s slowdown will continue to unfold. China’s credit (TSF1 excluding equity) growth has slowed further in September (Chart 1, top panel). Similarly, household mortgages are also decelerating sharply (Chart 1, bottom panel). Chart 1China's Money And Credit Are Decelerating Chart 2Curtailed Financing For Property Developers = Less Construction Activity     China's ever-important property market and construction activity will contract in the months ahead. Property sales were down by 20% in September from a year ago. Property developers in recent years have been relying on pre-construction sales as a major source of financing. With pre-sales drying up and borrowing restrained by both government regulations and creditors’ unwillingness to lend, property developers will be unable to sustain the current pace of construction and completion (Chart 2). Chart 3Red Flags For EM ex-TMT Stocks For the same reason, property developers have curtailed their purchases of land. Land sales have been a major source of local government revenues – it is estimated to account for 45% of local government revenues including managed (off-balance sheet) funds. The upshot will be that local governments will be unable to ramp up their infrastructure spending to offset shrinking property construction. Altogether, these will have negative implications for the mainland’s industrial economy and raw materials. Notably, global material stocks have rolled over decisively even though CRB Raw Materials price index has yet to peak (Chart 3, top panel). Global industrial stocks in general and machinery stocks in particular have also relapsed. Finally, Chinese non-TMT share prices have dropped by 20% from their February high and EM ex-TMT equity prices have formed a head-and-shoulder pattern, which often precedes a major gap down (Chart 3, bottom panel). These equity market signals are foreshadowing a slowdown in China’s “old economy”. Bottom Line: The shockwaves emanating from the slowdown in China will hinder growth in Asia and commodity-producing economies in the rest of EM. This is positive for the US dollar because among major economic blocks, the US economy is the least exposed to the mainland economy. US Interest Rates Will Be Repriced US bond yields will continue marching higher, supporting the US dollar. The reasons for higher bond yields are as follows: Investors and commentators can differ on their assessment of the US inflation outlook. However, one thing that we should all agree on is that uncertainty over the US inflation outlook is extraordinarily high. Heightened uncertainty requires a higher risk premium in bonds, i.e., a wider bond term premium. Surprisingly, until August, the term premium on US bonds was very subdued (Chart 4). In brief, the US bond term premium will rise to reflect uncertainty around the inflation outlook, which will push bond yields higher. US wages hold the key to the inflation outlook. We believe that wage growth will surprise to the upside as many companies have strong order books but are struggling to hire. As people gradually return to the labor force, employers have a once in a decade chance to attract qualified employees. Hence, companies will likely compete with one another by offering higher wages to attract the most qualified candidates. The job quit rate is the highest it has been since the early 2000s. This rate also points to higher wages (Chart 5). Chart 4High Inflation Uncertainty Heralds Higher Bond Term Premium And Yields Chart 5US Wage Growth Will Accelerate   Three factors that had suppressed US bond yields will likely be reversing: US commercial banks have been major buyers of US Treasurys and agency securities; the US Treasury has depleted its account at the Fed due to the debt ceiling but will now begin issuing more bonds to fill in this account; the Fed has been purchasing $80 billion of US government bonds each month; however, the Fed is preparing to taper and therefore reduce these purchases. Chart 6US Banks Have Been Buying Bonds En Masse US commercial banks’ holdings of US government and agency securities has risen to 19% of their total assets – on par with their early 1990s all-time high (Chart 6, top panel). In turn, the share of loans and leases has fallen to an all-time low (Chart 6, middle panel). As US banks begin to expand their lending, they will likely reduce the pace of their buying of US Treasurys. This along with the US Treasury issuing more paper to increase its depleted Treasury General Account at the Fed (Chart 6, bottom panel) and the Fed’s tapering will likely push up US bond yields. Current shortages are the result of excessive demand, rather than producers operating below capacity.2 The fact is that the supply/shipment of goods is booming, at least from Asia/China to the US. This will prove to be inflationary, and therefore lead to higher bond yields. Chinese shipments to the US continue to thrive – in September, export values were up by 30.5% from a year ago (Chart 7, top panel). Given that US import prices from China are rising at an annual rate of 3.8%, China’s export volume to the US has grown to about 26.7% from last September when it was already booming. Consistently, inbound containers unloaded at the Long Beach and LA ports have surged to all-time highs (Chart 7, bottom panel). Hence, US ports are not operating below capacity, it is excessive demand for goods that has created these bottlenecks. Finally, concerning semiconductors, shortages are due to excessive demand not a failure to produce. Global semiconductor production has been growing rapidly over the past two years. A silver lining is that a capitalistic system will eventually expand production and meet demand. Although we broadly agree with this expectation, it will take a couple of years for this to take place. In the interim, we can expect to see higher prices, at least for goods, and rising inflation expectations. Bottom Line: As US inflation proves to be not-so-transitory, US interest rate expectations will rise, which will support the US dollar. The broad-trade weighted US dollar has been correlated with US TIPS yields (Chart 8). Chart 7Shipments From Asia To The US Have Been Booming Chart 8High US Rates Will Support The Dollar   EM Domestic Bonds Chart 9EM Inflation Has Been Spiking EM domestic bond yields have been rising as inflation in EM ex-China, Korea, Taiwan (herein referred as mainstream EM) has been surging (Chart 9). Even if commodity prices roll over, EM interest rate expectations will likely continue rising for now because of higher US bond yields and EM currency weakness. Many clients have been asking whether rising mainstream EM policy rates and local bond yields will support EM currencies. We do not think so. In high-yielding interest rate markets such as Brazil, Mexico, South Africa, Russia and Turkey, neither short- nor long-term rates have been positively correlated with the value of their currencies (Chart 10 and 11). Chart 10Higher Bond Yields Do Not Lead To Currency Appreciation In Brazil And Mexico Chart 11Higher Bond Yields Do Not Lead To Currency Appreciation In Russia And South Africa Chart 12Higher EM Inflation-Adjusted Bond Yields Do Not Lead To EM Currency Appreciation Further, in these markets real (inflation-adjusted) rates also have not been positively correlated with their currencies (Chart 12). As illustrated in Charts 11, 12 and 13, there has been no positive correlation between both EM nominal and real (inflation-adjusted) interest rates and their currencies. Rather, there has often been a negative correlation. The basis is that exchange rates drive interest rate expectations, not vice versa. Currency depreciation leads to higher inflation expectations and rising interest rates. Conversely, exchange rate appreciation dampens inflation expectations paving the way for declining interest rates. Bottom Line: The net impact China’s slowdown and higher US interest rate expectations on mainstream EM domestic bonds will be currency depreciation with little room for their central banks to cut rates. As a result, local bonds’ risk-reward factor remains an unattractive tradeoff. EM Credit Markets As we laid out in A Primer on EM USD Bonds report  on April 29, EM exchange rates and their business cycle are the key drivers of EM sovereign and corporate credit spreads. If EM currencies drop, EM sovereign and corporate credit spreads will widen (Chart 13). The basis is that foreign currency debt servicing will become more expensive as EM currencies depreciate. As EM growth disappoints, EM credit spreads will widen too (Chart 14). Chart 13EM Credit Spreads And EM Currencies Chart 14EM Profit Expectations And EM Corporate Spreads   In addition, the continuous carnage in Chinese offshore corporate bonds will heighten odds of a material selloff in this EM credit. Chinese property companies’ USD bonds make up a more than half of China’s offshore USD corporate bond index and a large part of the EM corporate bond index. Poor performance of the EM corporate bond index could trigger outflows from this asset class. Investment Recommendations Slowing Chinese domestic demand and rising US interest rate expectations will support the US dollar. As the interest rate differential between China and the US narrows, the CNY will likely experience a modest setback versus the greenback (Chart 15). Even small RMB weakness could produce a non-trivial depreciation in EM exchange rates. The latter is negative for EM local currency bonds and EM credit markets. Absolute-return investors should stay on the sidelines of EM domestic bonds. For dedicated investors in this asset class, our recommended overweights are Mexico, Russia, Korea, India, China, Korea, Malaysia and Chile. EM credit markets will continue to underperform their US counterparts (Chart 16). Credit investors should continue underweighting EM credit versus their US counterparts, a strategy we have been recommending since March 25, 2021. Chart 15CNY/USD And The Interest Rate Differential Chart 16EM Credit Markets Are Underperforming Their US Peers   Finally, EM ex-TMT share prices correlate with inverted EM USD corporate bond yields (Chart 17). Higher EM corporate bond yields (shown inverted in Chart 17) entail lower EM ex-TMT share prices. Chart 17High EM USD Bond Yields Herald Lower Share Prices In turn, China’s TMT stocks remain vulnerable as we have argued in past reports. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Total Social Financing. 2 We made a similar case for Chinese electricity shortages in last week’s report. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Special Report

Dear Client, Owing to BCA’s Annual Investment Conference next week, there will be no report on Wednesday, October 20. We will return to our regular publication schedule on Wednesday, October 27. Please note that there will be a China Outlook panel discussion at 9 AM on Thursday, October 21. We hope you will join us for the event. Best regards, Jing Sima China Strategist   Highlights In the next six to nine months, the long-end of the yield curve will likely drop as investors start to price in weaker-than-expected economic growth amid measured stimulus. China’s 10-year government bond yields are set to structurally shift to a lower bound as domestic demand decelerates along with the nation’s total population. Policymakers will favor lower borrowing costs to reduce stress due to high debt levels among companies, central and local governments, and households. National savings are not a constraint for a country to lower domestic bond yields. China will continue to open domestic financial markets to global investors. The country’s large foreign exchange reserves limit the risk to its internal markets from extreme volatility in foreign fund flows. Feature In the past two decades policy rates in advanced economies have been brought close to zero and bond yields have dropped to extremely low levels. The yields on China’s government bonds, however, have remained well above their peers in advanced economies and in neighboring countries (Chart 1). Chart 1China's Government Bond Yields Far Above Other Major Economies Moreover, despite China’s growth slowing from double to mid-single digits, yields on China’s 10-year government bonds have remained at around 2006 levels. China’s working-age population continues to decline and its total population is estimated to start falling in the next five years. China’s demographic headwinds, combined with high leverage in the private sector at around 220% of GDP, will cap the upside in yields. In this report we share our views on China’s short rates and long-term bond yields on a cyclical basis (next six to nine months) and in the next five years. The Cyclical Outlook The yield curve will likely flatten with China’s long-term government bond yields dropping more than short-term rates in next six to nine months. This will occur in the expectation of a further growth slowdown in at least the next two quarters. Meanwhile, the downside is limited on the short-end of the curve, given it is more sensitive to the PBoC’s guidance and monetary authorities will ease policy only gradually. Stimulus in the next two quarters may also disappoint. Credit growth will bottom in Q4 this year, but the rebound will be modest. Stronger issuance in local government bonds in the next two quarters will be offset by sluggish bank loan impulse. Chinese policymakers will refrain from using stimulus for the property market as a counter-cyclical policy tool to revive the economy. Restrictions will be maintained on bank lending to the real estate sector including mortgages and these controls will limit the rebound in credit expansion. Furthermore, infrastructure investment will improve modestly in the next two quarters, but local governments remain under pressure to deleverage, which will limit their incentive and capacity to spend. Chart 2Stimulus In 2018/19 Was Very Measured We maintain our view that the current policy backdrop is shaping up to resemble that of H2 2018 and 2019. At that time, even though the central bank maintained an accommodative monetary policy stance and kept liquidity conditions ample, the size of the stimulus was measured and the economy was lackluster (Chart 2). Recent liquidity injections by the PBoC through open market operations should not be viewed as monetary easing because they represent the bank’s efforts to keep policy rates steady, at best (Chart 3). The central bank provided the interbank system with substantial financing to avoid liquidity crunches following the May 2019 Baoshang Bank takeover and the November 2020 Yongcheng Coal company debt default (Chart 4). In both cases, 10-year bond yields did not fall by as much as short rates, reflecting investors’ expectations that the liquidity injections and resulting drop in short rates were not long-lasting. Chart 3Recent PBoC Liquidity Injections Intended To Keep Policy Rates Steady Chart 4APBoC Also Injected Liquidity After Previous High-Profile Defaults Chart 4BPBoC Also Injected Liquidity After Previous High-Profile Defaults Our view on China’s bond yields will not change with the liftoff of US Fed policy rates,  even if the Fed hikes rates earlier and by more than anticipated. The Fed’s policy has little bearing on China’s long-dated yields, which are driven by domestic business cycles and monetary policy (Chart 5). Concerning the exchange rate, we believe that the RMB will modestly depreciate in the next six to nine months, given that the China-US nominal and real interest rate differentials will narrow (Chart 6). While some depreciation in the currency is modestly reflationary for China’s exporters, it will not be enough to offset weaknesses in domestic demand. Chart 5Domestic Economic Fundamentals Drive Yields On China's Government Bonds Chart 6China-US Rate Differentials Are Set To Narrow Chart 7Pipeline Inflationary Pressures in China Remain Elevated Inflation remains a risk to our cyclical view on the 10-year bond yield. While the economy is weakening, pipeline inflationary pressures remain elevated (Chart 7).  We do not foresee that the PBoC will change its modestly dovish policy stance because of inflationary pressures stemming from supply-side bottlenecks. However, supply constraints will not abate soon and consequently, pipeline inflationary pressures and producer price inflation may not subside in the next six months. Thus, fixed-income investors may start to price in higher inflation, which could prevent long-duration bond yields from declining by much. Bottom Line: In the coming months, the long-end of the yield curve will likely drop as investors start to price in weaker-than-expected economic growth and very measured stimulus. The short-end of the curve will have limited downside potential because there is only a slim chance of aggressive monetary easing. Bond Yields Are On A Structural Downtrend Bond yields in China will likely downshift in the next three to five years. Our secular outlook for government bond yields is based on the country’s demographic trends, inflation, productivity growth and debt levels. While China’s long-term bond yields have persistently averaged below nominal GDP growth, in the past decade the gap has significantly narrowed as economic growth slowed while yields remained within a tight range (Chart 8).  This contrasts with other manufacturing and export-oriented Asian economies where interest rates have moved to a lower range in proportion with economic growth rates (Chart 9). Chart 8China's Economic Growth Has Downshifted But Yields Have Not... Chart 9...In Contrast With Other Asian Manufacturing-Based Economies China’s long-dated bond yields will also downshift in the next three to five years given the nation’s declining long-term potential output growth, based on the following: Chart 10Wages Have Risen In China A shrinking workforce can be inflationary due to higher labor costs and we expect Chinese workers’ compensation will continue to increase in the next five years (Chart 10). However, wage inflation will likely be offset by labor productivity, which has remained robust. The nation’s unit-labor cost (ULC), measured by the wages paid for each employee to produce one unit of output, has been flat to slightly down in the past decade despite strong wage growth (Chart 11). Similarly, ULC has sagged in Japan and is muted in South Korea (countries with shrinking labor forces) due to fast-growing labor productivity. This contrasts with the US, where ULC has risen even though the labor force has expanded in the past 10 years (Chart 12) China’s labor productivity will not likely undergo a significant decline in the next five years, particularly if China successfully maintains the manufacturing sector’s share in its aggregate economy, because productivity growth in this sector is usually higher than in others. Chart 11ULC Has Been Relatively Flat Chart 12ULC Muted In Asian Economies Compared With US   Meanwhile, China’s total population will shrink within the next five years, which will likely bring powerful disinflationary forces that will more than offset price increases created by labor shortages. Disinflation will cap the upside in interest rates/bond yields. Chart 13Japan's Household Consumption Share Fell Sharply When Total Population Started Shrinking A shrinking total population can significantly reduce demand, as evidenced in Japan in the past two decades. Japan’s working-age population started falling in the early 1990s, but the country’s household consumption share in GDP fell sharply after its total population peaked in 2010 and the urban population growth started contracting (Chart 13). In other words, Japan’s rapidly falling demand more than offset a muted increase in wage growth. China’s housing demand may have already peaked and the decline will gather speed in the next five years (Chart 14). Long-term growth in household consumption moves in tandem with housing and, therefore, will also downshift in the coming years (Chart 15). In the next five years or longer, China’s de-carbonization efforts will require shutting down production of many old economy enterprises.  Policymakers may keep low interest rates to accommodate such a transformation. Furthermore, amid the geopolitical confrontation with the US, Beijing will need lower interest rates to support the manufacturing sector and to undertake an industrial upgrade. Chart 14China's Demand For Housing Is On A Structural Downshift... Chart 15...Along With Consumption The main risk to our view is that China’s total factor productivity1 growth could accelerate to more than offset a declining total population. This would boost real per capita income and result in higher potential growth in the economy. In this scenario, long-duration bond yields could climb.  However, total factor productivity growth will need to outpace the rate of a shrinking labor pool and capital formation to prop up growth in the aggregate economy (Chart 16A and 16B). This is a daunting mission that Japan and South Korea, where productivity growth has been on par with China, have failed to accomplish. Chart 16AChina's Neighbors Have Not Accelerated Their Productivity Gains To Structurally Boost Economic Growth Chart 16BChina's Neighbors Have Not Accelerated Their Productivity Gains To Structurally Boost Economic Growth Chart 17China Cannot Drastically Improve Its Productivity Growth In The Next Five Years It is unrealistic to expect that China will drastically improve its productivity growth.  Productivity level is much higher now than it was 10-20 years ago when China’s manufacturing sector accounted for more than 40% of GDP (Chart 17). Even though China’s manufacturing share in the economy will stabilize and even increase from the current 27% of the economy, it cannot boost the sector drastically, particularly because its export market share cannot expand much further due to rising geopolitical tensions. In short, sectors of the economy where productivity gains have been most rapid – manufacturing sector including exports that drove China’s productivity in the past 20 years - cannot fully offset the deceleration in other growth drivers going forward. The service sector will grow, but it is much more difficult to achieve fast productivity gains in the service sector. All in all, productivity and economic growth will moderate as China’s growth model shifts from capital-intensive infrastructure and real estate to services. Bottom Line: In the next five years, China’s 10-year government bond yields are more likely to structurally move to a lower bound as final demand falls along with the nation’s total population. Savings, Debt And Interest Rates China’s national savings rate is one of the highest in the world, but it will drop as the population ages. Thus, some economists may argue that a structural decline in the national savings rate will lead to higher interest rates in the long run. Chart 18Lower Savings Rates Do Not Necessarily Herald Higher Interest Rates However, there is no empirical evidence that national savings drive interest rates. There has not been an inverse relationship between national savings rates and government bond yields in either Japan or the US, as illustrated in the middle and bottom panels of Chart 18.  There are more periods of positive rather than negative correlation between savings rates and bond yields. Note that China’s national savings rate and its interest rates also are not inversely related; a rising saving rate does not lead to lower interest rates and vice versa (Chart 18, top panel). This empirical evidence is in line with special reports published by BCA’s Emerging Markets Strategy that concluded the following: Banks cannot and do not lend out or intermediate national or households “savings.” In an economy with banks, one does not need to save in the form of a deposit in a bank in order for a bank to lend money to another entity. In any economy, new money originates by commercial banks “out of thin air” when they lend to or buy assets from non-banks. Hence, there is little relationship between national savings (flow concept in economics) and money supply growth (a flow variable too) (Chart 19). The term “savings” in macroeconomics denotes an increase in the economy’s capital stock, not deposits at banks. China’s banking system has an enormous amount of deposits, created by the banks “out of thin air” and not from households’ savings. The above factors explain why Japan’s government bond yields and national savings rate have been falling since 1990 (Chart 18 on Page 12, bottom panel). A lack of demand for borrowing was not why bond yields fell. A reason why China’s bond yields will likely be in a secular decline is that commercial banks will purchase government and corporate bonds en masse as they have done in the past 10 years (Chart 20). To do so, commercial banks will not use existing deposits, but rather they will create new deposits/money “out of thin air.” Chart 19There Is Little Relationship Between National Savings And Money Growth Chart 20China's Commercial Banks Will Continue To Purchase Government And Corporate Bonds The same is true for the banks’ purchases of corporate bonds. In China, commercial banks own about 75% of government (including local government) bonds and 20% of onshore corporate bonds. To avoid a spike in bond yields, Chinese regulators could relax the limitations on commercial banks to purchase government and corporate bonds. The upshot will be a lack of crowding out and no upward pressure on bond yields despite a large bond issuance. Chart 21China's Debt-To-GDP Ratio And Service Costs Have More Than Doubled In The Past 10 Years What are the implications of high indebtedness on interest rates? China’s domestic debt-to-GDP ratio has jumped from 120% of GDP in 2008 to 260% (Chart 21, top panel). This includes local currency borrowing by/debt of government, enterprises and households. Critically, the debt-service ratio2 for enterprises and households has more than doubled from 10% of disposable income in 2008 to over 20% (Chart 21, bottom panel). China cannot afford much higher interest rates because enterprises and households will struggle and will not be able to service their debts. Mortgage rates in China are at around 5.5%, the one-year prime lending rate for companies is 3.85% and onshore corporate bond yields are 3.7%. These are not particularly low borrowing costs given both high indebtedness and the outlook for structurally slower economic growth. Onshore borrowing costs may be brought down further in the years ahead to rule out debt distress among households, enterprises and local governments. Since 2015 and prior to the pandemic, China’s debt-service ratio has been mostly flat despite a rising debt-to-GDP ratio.3 This has been achieved through declining interest rates. In the next five years policymakers will likely maintain a stable debt-to-GDP ratio. Hence, lower bond yields are all but inevitable to decrease the debt-servicing burden. In addition, China’s “common prosperity” policy means larger government spending/deficits. However, to cap the government debt-to-GDP ratio, bond yields should be kept down. This is another reason why China’s will opt for lower interest rates/bond yields. Bottom Line: The high level of debt among local governments, companies and households means that borrowing costs in China will be reduced in the years ahead. National savings are not a constraint in any country for commercial banks to expand credit and/or to buy bonds. China will encourage its banks to buy government and corporate bonds to trim yields amid continuous heavy bond issuance. Will China’s Financial Opening Continue? In the current environment which geopolitical tensions are rising between China and the West, many global investors are concerned whether China will impose tighter capital controls and even seize foreign assets. Despite these challenges, China has continued to make progress opening its domestic markets. The nation seems to be sticking to its key policy goals of attracting foreign capital and internationalizing the RMB; both aspects require open access and repatriation of foreign capital. In addition, the share of foreign holdings in onshore securities is very low and thus, poses limited risk to China’s onshore financial markets during global economic or geopolitical crises. China’s current exposure to foreign capital flows is much smaller than its Asian neighbors during the 1997 Asian Financial Crisis, as well as Russia during the geopolitical standoff in 2014-2016 following the capture of Crimea.4 Despite years of easing access to financial markets, foreign ownership (mostly concentrated in government bonds) remains at only around 3-4% of China’s entire onshore bond market. Furthermore, unlike other Asian economies in 1997-98, China has large foreign exchange reserves to buffer shocks from foreign fund flows. In recent years its capital control mechanism has also been successful in preventing implicit capital outflows and stabilizing the RMB exchange rate. We expect Chinese policymakers to feel confident in continuing their financial opening because they have the capability and sufficient funds to safeguard the economy against retrenchments by global investors. Bottom Line: China will continue to open its domestic financial markets, albeit gradually, to global investors. The country’s domestic financial markets have limited exposure to the extreme volatility of foreign capital flows. Investment Conclusions Chart 22The RMB Still Has Upside Structurally, But Will Modestly Depreciate On A Cyclical Basis We are constructive on China’s government bonds, both cyclically and structurally. In the next six to nine months, the yield curve will likely flatten, with long-duration bond yields dropping faster than the short-end. China’s 10-year government bond yield will structurally shift to a lower range in the next five years, driven by the impact of falling population on domestic demand, and the country’s rising debt levels and debt-servicing costs. Although the RMB still has upside structural potential, in the next 6 to 12 months the currency will likely modestly depreciate against the US dollar (Chart 22).   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1Total Factor Productivity (TFP) is a measure of productive efficiency,  determining how much output can be produced from a certain amount of inputs. 2Defined by BIS as the ratio of interest payments plus amortizations to income. 3Despite a rising debt load, debt-servicing costs were contained due to (1) LGFV debt swap as new provincial government bonds had lower yields than LGFV bonds and (2) a large decline in the prime lending rate and mortgage rates. 4Foreign investors held more than 40% of local currency bonds in Indonesia, and over 20% in Malaysia. Foreign ownership accounted for 26% of Russia’s local currency bonds in 2014. Market/Sector Recommendations Cyclical Investment Stance