The COVID-19 pandemic has escalated a long-simmering battle between the US and China, two of the principle drivers of financial globalisation
Author: Alex Katsomitros
July 6, 2020
If fact is the primary casualty when struggle is said, then the identical goes for capital mobility when pandemics strike. This turned evident on May 11, when US President Donald Trump ordered the federal pension fund – the world’s fifth-largest pension fund – to cease investing in Chinese equities. The transfer got here in response to what the US Government perceived as persistent Chinese aggression – COVID-19 simply being the straw that broke the camel’s again. “The function of the Chinese Government in purposely not disclosing what was occurring throughout the COVID-19 outbreak has fuelled a whole lot of [anti-Chinese-Government] sentiment,” Charles Calomiris, a professor of financial establishments at Columbia Business School, informed World Finance.
After an extended interval of integration, segmentation, pushed by geopolitical turbulence, is turning into the norm
It was not the primary time that the Federal Retirement Thrift Investment Board, which represents the pursuits of round 5.5 million federal staff by its $600bn Thrift Savings Plan, had been pressed to avoid Chinese property. Last November, the board rebuffed the same request by US lawmakers on the grounds of lacking out on funding alternatives. Trump’s order put paid to the board’s plan to shift its $40bn worldwide fund from the MSCI World Index, which focuses on developed markets, to the MSCI All Country World Index, which incorporates Chinese shares. Although the fund shouldn’t be legally obliged to obey, it has little leeway this time, because the US Government goals to interchange nearly all of its administrators.
Although largely symbolic, the ban highlighted a primary fact about international financial markets: after an extended interval of integration that began within the 1970s with the collapse of the Bretton Woods system, segmentation, pushed by geopolitical turbulence, is turning into the norm. The period of financial globalisation reached its peak in 2007 when international cross-border capital flows reached a report $12.7trn (see Fig 1). The shock of the credit score crunch and the following eurozone disaster halted unbridled capital mobility. Within 10 years, capital flows had dropped to $5.9trn, pushed by a pointy lower in cross-border lending.
In a working paper revealed this spring, researchers from the French asset supervisor Amundi argued that financial globalisation shouldn’t be a linear course of, however as an alternative evolves in cycles. Following a interval of abrasion of financial borders between the late 19th century and the First World War, reasonable integration took maintain till the 1970s, when fierce globalisation kicked off with the dismantling of limitations to capital mobility.
According to Marie Brière, Head of Amundi’s Investor Research Centre and one of many authors of the paper, we’ve been going by a section of financial deglobalisation because the Great Financial Crisis (GFC), and the pandemic will solely speed up this pattern. She informed World Finance: “It is unlikely that we are going to return to a interval of no market integration, just like the Bretton Woods one. What might occur, and we’re already seeing it, goes again to a interval of extra reasonable integration.” One facet impact is that contagion might turn into extra probably when issues go awry. “When there may be absolute market segmentation or, quite the opposite, full market integration, there may be little threat of contagion,” Brière mentioned. “But if there’s a reasonable diploma of market integration, as within the 1880-1914 interval, the danger is larger.”
Segmentation is partly pushed by geopolitical developments. The US-China commerce struggle, Brexit, turbulence in Hong Kong and a extra insular EU had already halted commerce liberalisation earlier than the pandemic, erecting new limitations in financial markets. According to the UN Conference on Trade and Development (UNCTAD), overseas direct funding (FDI) dropped by one p.c final yr to $1.39trn, its lowest stage since 2010 (see Fig 2). The pandemic has additional disrupted international commerce, exposing the vulnerability of ‘simply in time’ manufacturing and worldwide provide chains.
Emerging markets, which have benefitted from an enormous influx of overseas capital over the previous few many years, are actually bearing the brunt of the disaster. Through each day monitoring of non-resident portfolio flows, the Institute of International Finance (IIF) revealed that rising markets noticed the biggest capital outflow in historical past in Q1 2020, regardless of the Federal Reserve taking swift motion to assist a lot of them by dollar-denominated swap traces.
Jonathan Fortun, an economist on the IIF, informed World Finance: “The COVID-19 shock has resulted in a pronounced sudden cease in capital flows to rising markets. While we count on a restoration of flows to rising markets within the second half of 2020, we don’t consider that the pickup might be robust sufficient to carry a few return to 2019 ranges.” The organisation forecasts that non-resident capital flows to those markets will attain $444bn in 2020 in contrast with $937bn final yr, marking a brand new low because the GFC. Calomiris added: “The mixture of greenback appreciation, international recession and [a] enormous build-up of leverage in dollar-denominated debt is an existential risk for rising markets.”
Barriers to success
Looser financial ties are mirrored within the decline of cross-border listings, notably within the US. Historically, overseas companies have listed on US exchanges to entry extra liquid markets, with the spillover impact spurring capital inflows and advances in financial integration of their house nations.
In a current working paper for the National Bureau of Economic Research, teachers Craig Doidge, Andrew Karolyi and René Stulz claimed that the valuation hole for companies from developed markets elevated by 31 p.c after the GFC – a mark of a pointy reversal in financial globalisation – whereas the hole for companies from rising markets (excluding China) stayed secure. However, the propensity of non-US companies from each developed and rising markets to cross-list within the US has decreased, a improvement that the authors interpret as one other signal that financial globalisation is in retreat.
The pandemic has additional disrupted international commerce, exposing the vulnerability of ‘simply in time’ manufacturing and worldwide provide chains
Last yr, the amount and worth of cross-border preliminary public choices (IPOs) world wide dropped by 17 p.c and 35 p.c respectively compared with 2018 ranges. As Karolyi defined to World Finance: “For some companies, the advantages of a US itemizing might have diminished as a result of they have been capable of safe sufficient financing for their operations domestically or by different means than an providing related to a US itemizing. For different companies, it could be that funding wants for progress dried up as a result of they noticed a slowdown of their progress.”
In the banking sector, the financial turbulence that adopted the GFC and the sovereign debt disaster curtailed cross-border lending for greater than a decade, with overseas claims on superior economies dropping from round $16trn to $12trn between 2007 and 2015. According to McKinsey’s The New Dynamics of Financial Globalisation report, the introduction of Basel III – a patchy regulatory framework for the banking sector – not directly hit cross-border lending by forcing banks to promote overseas property in a bid to shrink their stability sheets and meet excessive capital necessities.
Brière believes nationwide regulation has additionally performed a task: “Just after the subprime disaster, we noticed a type of ‘quasi-nationalisation’ on account of authorities interventions within the banking sector aiming to cut back cross-border lending.” That pattern began reversing in 2018, based on a report by the Bank for International Settlements, with excellent mortgage progress approaching 2008 ranges final yr, pushed by a rise in worldwide lending by European banks. However, the present pandemic might reverse these features. As Brière defined: “In the brief run, we might see extra concentrate on home funding, as within the earlier disaster.”
A brand new chilly struggle
The COVID-19 pandemic has escalated a long-simmering battle between the US and China, two of the principle drivers of financial globalisation. Some concern that the ban on the federal pension fund was simply the primary shot in a extra open confrontation. David Dollar, a former US Treasury emissary to China and at the moment a senior fellow on the Brookings Institution’s John L Thornton China Centre, informed World Finance: “There is a threat of a financial struggle… If the tensions have been to escalate to severe measures, similar to slicing off China’s state-owned industrial banks from the US financial system, the results can be laborious to foretell, however virtually actually recessionary for the world, as these are among the many largest international banks.”
Suggestions that the US would possibly demand financial compensation from China for the financial injury wrought by the pandemic have added gas to the flames, with Trump describing the COVID-19 outbreak as an assault just like Pearl Harbour and 9/11. Shehzad Qazi, Managing Director at China Beige Book International, an impartial supplier of information on the Chinese economic system, informed World Finance: “If relations proceed to deteriorate, notably over Hong Kong, we might see the US testing the waters with banking sanctions. If the US makes strikes to chop China or Chinese entities off from US greenback entry, this could be a severe escalation.” Some fear China might retaliate by promoting a bit of its US Treasury holdings, however Dollar believes such a transfer can be counterproductive: “China purchased these for its personal functions of trade fee administration. Selling them en masse would are inclined to make China’s forex rise, which isn’t to its benefit in the intervening time.”
Geopolitical tensions are undermining investor confidence, with many worrying concerning the capacity to repatriate funds
Even earlier than the pandemic, the US was more and more cautious of Chinese inroads into its markets. Since 2017, US authorities have blocked a number of takeover bids from Chinese rivals on nationwide safety grounds. This, based on the Rhodium Group, led to a pointy decline in Chinese direct funding into the US between 2016 and 2019, falling from $45bn to simply $5bn. A working example is the commerce ban the US Government has imposed on Chinese telecoms powerhouse Huawei, stopping it from shopping for or utilizing applied sciences owned by corporations working within the US. In mid-May, the US Government prolonged a nationwide emergency declaration that targets Huawei and different Chinese companies, proscribing the corporate’s entry to Google’s providers and halting its plans to develop its semiconductor chips through a partnership with the Taiwan Semiconductor Manufacturing Company. The US Government has additionally pressed allies to observe comparable insurance policies.
Running out of inventory
Inevitably, financial warfare is spilling over into the inventory trade. US listings of Chinese corporations – a marker of financial integration between the 2 nations – had been rising for twenty years, culminating in Alibaba’s itemizing on the New York Stock Exchange (NYSE) in 2014, the largest IPO in historical past on the time. This pattern raised eyebrows, although, notably amongst US rivals complaining that Chinese companies weren’t topic to the identical rigorous disclosure guidelines. The argument resurfaced in April when Luckin Coffee, a China-based espresso firm listed on the NASDAQ, disclosed that round $310m of its 2019 gross sales had been “fabricated”. In May, the US Senate handed a invoice that would block some Chinese corporations from US exchanges, whereas former Trump aide Steve Bannon has known as for all Chinese corporations to be delisted.
“It would take deft negotiation between US and Chinese regulators to discover a sensible compromise,” Dollar mentioned. “[That] appears not possible within the present atmosphere, so most likely the US will observe by with the just lately handed Senate invoice that ends with delisting all Chinese corporations.” Sceptics, nonetheless, downplay the opportunity of drastic motion. “There might be no delisting of Chinese companies, at the least [not] anytime quickly,” Qazi mentioned. “The laws requires all corporations on US exchanges – not simply Chinese companies – to stick to US compliance laws, similar to opening themselves to [Public Company Accounting Oversight Board] audits. It’s true this principally calls out the largest nationwide actor that refuses to stick to these requirements, China, however companies have three years to start complying with the brand new legislation.”
The EU is scrutinising its financial ties with China, even when its objections are expressed in additional diplomatic language
Karolyi believes Chinese corporations record within the US as a result of the advantages – similar to entry to international traders and liquid markets, international model consciousness and the power to boost capital on higher phrases – exceed the prices and reporting burdens again house. However, as he defined to World Finance, this will likely quickly change: “The geopolitical tensions that come up from the US-China commerce struggle and past might very effectively be placing a damper on these advantages and rising the prices and burdens. So, I count on quite a few these cross-listed Chinese companies might very effectively rethink their capital market methods and provoke a delisting and deregistration from US markets.”
China’s largest chipmaker, the Semiconductor Manufacturing International Corporation, introduced it was delisting from the NYSE final May, citing “low buying and selling quantity and excessive prices”, whereas Alibaba has reportedly been contemplating a secondary itemizing in Hong Kong. Qazi mentioned: “Any Chinese companies that preemptively delist can be slicing their nostril off to spite their face as a result of solely a handful of the very largest Chinese corporations might efficiently elevate the identical kind of funding elsewhere.”
The EU can be scrutinising its financial ties with China, even when its objections are expressed in additional diplomatic language. Alarmed by a collection of Chinese takeover bids for EU corporations, the European Commission is exploring the opportunity of blocking Chinese funding on nationwide safety grounds. Margrethe Vestager, the fee’s govt vp, has urged member states to purchase strategic stakes in corporations which might be extra weak to takeovers because of the pandemic and its damaging affect on share costs. Brière mentioned: “Europe is extra open to Chinese funding than the US, however given the shifting political atmosphere, we may even see it place extra scrutiny on Chinese funding.”
A street to salvation
Strained relations with the West come at an important time for China’s financial system. The Chinese Government has been attempting to open up the nation’s $45trn financial providers trade to enhance competitiveness and appeal to overseas capital in a market lengthy dominated by native state-run gamers. Chinese authorities have regularly dismantled limitations to overseas traders accessing the nation’s $13bn onshore bond market, whereas Chinese bonds have been included within the Bloomberg Barclays Global-Aggregate Total Return Index final yr.
According to information held by China’s largest bond market clearinghouse, the Central Depository and Clearing Corporation, overseas traders held Chinese bonds price CNY 1.95trn ($275.5bn) on the finish of February, a big chunk of which have been authorities bonds. The Chinese Government has additionally relaxed guidelines on overseas inventory possession as a part of a commerce take care of the US. The nation is anticipated to allow overseas traders to amass life insurance coverage suppliers, futures and mutual fund corporations, in addition to native banks. A hyperlink between the Shanghai and London inventory exchanges was established final yr by the Shanghai-London Stock Connect scheme, which permits companies listed on one of many two bourses to concern, record and commerce depositary receipts on the opposite.
Perhaps the outbreak of SARS-CoV-2 will speed up long-brewing traits, similar to a inexperienced revolution within the investor group
Chinese banks have boosted their share of world cross-border lending – due, in giant, to China’s formidable Belt and Road Initiative – with the variety of worldwide claims rising by 11 p.c each year since 2016. Dollar believes their enlargement makes US sanctions much less efficient: “The most important draw back of a severe motion like sanctioning China’s massive industrial banks is that these are deeply built-in globally. Constraining them may have unpredictable results, particularly in creating areas similar to Africa, South-East Asia and Latin America, the place these banks are very energetic. China will surely retaliate by preserving US establishments out of its newly opened financial providers markets.”
Lower capital flows because of the COVID-19 pandemic might stall China’s plans, nonetheless. Recent disruptions in Hong Kong are anticipated to hamper the nation’s capacity to draw capital from European and US institutional traders. Geopolitical tensions are additionally undermining investor confidence, with many worrying concerning the capacity to repatriate funds on account of US sanctions or different limitations. Many harbour doubts concerning the fee of change, too. Qazi mentioned: “Relatively little has been finished up to now to open up the Chinese financial system to overseas companies, and what has been finished has been finished far too late. Foreign banks won’t be able to compete with Chinese banks even with Beijing opening that sector, given their entrenched positions. Deteriorating relations between China and the remainder of the world gained’t assist out what little motion we’ve seen up to now.”
Even if the height of financial globalisation is over, there isn’t a going again to the period of closed borders. Less than 10 years after the GFC, overseas traders owned greater than 1 / 4 of equities and near a 3rd of bonds globally. In the US, the center of the worldwide financial system, overseas property and liabilities scaled by GDP elevated from 48.three p.c in 1980 to 324 p.c in 2017. According to Brière, although, traders ought to be ready for an period of financial protectionism and contagion: “They must look for alternate options past typical diversification methods. For instance, sector diversification tends to work higher than nation diversification in crises.”
Perhaps the outbreak of SARS-CoV-2 will speed up long-brewing traits, similar to a inexperienced revolution within the investor group. An Amundi examine highlighting the affect of COVID-19 on the exchange-traded fund market confirmed surging outflows from typical fairness funds, whereas funds with environmental, social and company governance (ESG) agendas have been far more resilient. “Even earlier than the pandemic, we’ve been observing a shift of institutional and retail traders in direction of sustainable funding and ESG merchandise,” Brière mentioned. “The pandemic has strengthened this pattern.”