Morgan Stanley's James Lord is explaining why China's transformation to a current account deficit nation could be the biggest "turning point" for the world in 2019:
This year investors are likely to witness a number of major turning points. Our 2019 Global Strategy Outlook called for the USD bull market to reverse, EM assets to outperform and the US economy to slow versus the rest of the world. We’ve added another big transition to the list: China’s economy should slip into its first annual current account deficit since 1993.
Unlike that year, when China saw a normal cyclical C/A deficit in an emerging economy, this shift to a ‘saving short’ economy is structural. My colleague Robin Xing reckons that the aging population will consume more and save less, driving the deficit to US$50 billion in 2019 and as high as US$430 billion by 2030. The flip side is that China’s capital inflows will have to ramp up significantly as a result, which is where the opportunity lies. All this is consistent with our long-term thesis of China transitioning to high-income status.
In truth, China’s current account has been deteriorating for a while. In 2007, it was in surplus to the tune of 10% of GDP but moved close to balance by 2018. A shift to a deficit in 2019 is just another step along the road. Yet a move into the red still matters. From now on, China’s internal resources will no longer be sufficient to fund its desired growth, and we think that the shortfall will encourage further gradual opening up of the economy. In future, foreign investors will be chipping in more than ever before.
Where could they step up? Foreigners own 8% of the Chinese government bond market, 2.6% of equities and less than 2% of corporate bonds. These numbers are tiny compared to elsewhere (e.g., 35-40% foreign equity ownership in Taiwan and Korea), but if we’re right, they’re about to rise significantly.
For government bonds, inflows could reach US$80-100 billion this year and as much as US$120 billion annually over 2020-30, on average. This compares with US$35 billion per annum over 2015-18. My colleague Min Dai has been discussing the implications of China’s inclusion in global bond indices for some time, and Bloomberg recently confirmed that China will join the Global Aggregate index in April. Entry into the GBI-EM and WGBI indices might not be far behind. Asset managers would face a high bar to justify excluding Chinese bonds once they are part of the Aggregate index.
We think that the weight of CNY in global FX reserves will rise too, from 2.5% (excluding China’s reserves) to 5-10% over the next 5-10 years, bringing around US$40 billion a year of inflows. This view tends to generate plenty of debate. Many investors see little prospect of the renminbi taking a greater share of reserve assets without full currency convertibility and capital mobility. We agree that without deep reforms, CNY will struggle to raise its share significantly. However, this share is tiny relative to China’s economic importance, and a modest increase is not unrealistic.
What about equities? My colleagues Laura Wang and Jonathan Garner expect 2019 to be a record year, with US$70-125 billion of inflows. Again, index inclusion is a major theme, with China entering the FTSE Russell from June and MSCI likely to raise the A-share inclusion factor for the EM index in May. The team expects flows to normalise between US$100-220 billion over the next ten years, with foreign ownership hitting 10%.
FDI should remain resilient too, funding around half the expected deficit. Robin and team are not great believers in the offshoring argument and think that the authorities will open up more sectors to foreign involvement. But considering that China has been a large recipient of FDI for a while, the future may not look significantly different from the past. It is the fixed income and equity flows that are on the cusp of a major turning point.
What’s the takeaway? First, take a look at Hong Kong Exchange & Clearing (0388.HK), the gateway to the Stock and Bond Connect programmes that access mainland China’s markets. The exchange clips a coupon on the back of every transaction. Second, with ample financing for the current account we think that CNY will rally. We see USDCNY at 6.55 by end-2019 and 6.30 by end-2020 with gradual trade-weighted gains over the long term. Cyclically, a trade deal and the stabilisation in China growth should help too.
As China’s demand for foreign capital picks up, it will simultaneously fall in the rest of the world, so this doesn’t have to end badly for other deficit economies. But the process may not be smooth for all, and it will come down to which countries benefit from China’s higher future imports.