The End of EM (part II)

Part 2: The Rise of the Xi Doctrine using Belts and Roads

Our previous blog reviewed the “Deng Era” which covered Deng’s opening of the Chinese economy to its current status as the 2nd largest economy in the world. In that period, China transformed from a closed, inward looking agrarian economy (remember “eat all your food on your plate, dear - there are starving kids in China!”) to a global powerhouse impacting world politics and dramatically altering global manufacturing. As well, the rise of China helped create a new investment asset class called emerging markets or EM (with DM or developed markets its core counterpart). This near 40Y trend came to an end when President Xi assumed the Chinese presidency in 2016. Xi slowly diverged from the Deng doctrine (open up, capture manufacturing share, copy the West) and constructed a new Xi Doctrine: share the boom, stress self reliance and re-assert China’s rightful and historical place among the world’s super powers (crystalized by XI’s signature Belt and Road Initiative aka “BRI”) which had broad implications for world politics, global manufacturing and EM investing. Let’s discuss the key points.

Arriving in 1977, previous Chinese leader Deng Xiaoping pursued a tactically neutral geopolitical strategy. At that stage, China was simply too weak economically to assert its interests. Hence China for decades pursued ambivalence about global geopolitics in public while seeking global economic advantages behind the scenes. China’s unique economic advantages (huge low cost skilled workforce, excellent logistics and embedded entrepreneurial culture) are difficult to replicate anywhere at China’s price point. These advantages helped China reach effectively developed market status by the 2010s.

Conversely, arriving in 2016, President Xi inherited a vastly different China than Deng. China was now an economic powerhouse, unchallenged in manufacturing (in low value added products) and much more confident on the world stage. Thus Xi began pursuing a more assertive foreign policy to reassert China’s interests and establish its super power status. From 25i’s perspective, China was no longer an “emerging market” economically but rather a developed country like the US, Japan and the EU and had, under Xi, begun to act like one.

Core to this super power strategy was Xi’s signature policy, the BRI. Effectively, the BRI was China’s plan to move up the economic value chain (produce planes and semiconductors and not plastic toys), spread the economic boom’s benefits amongst all citizens (ie higher wages for an aerospace engineer vs a shoe factory workers), increase self-reliance (ie. reduce all imports and any reliance on any country or company) and create a sphere of influence (especially to counter US presence in Philippines, Japan, Korea, Australia and Pacific islands). The BRI helped achieve this objective via three means: relocation, infrastructure build and cheap financing. To start, the Chinese government encouraged Chinese agencies and companies to move low value factories to poorer countries (like Vietnam and Bangladesh). Secondly, Chinese companies built the infrastructure in these low income countries (using Chinese supplied debt) to support the move (and provide business to the Chinese entities). Finally, Chinese agencies and banks (all government owned) provided cheap funding for Chinese companies to move into areas like robotics, aerospace, semiconductors and green tech. So effectively Xi was willing to forego a 40Y global competitive advantage, compete forcefully in products the G20 actually care about and geopolitically, move from a passive global strategy to a dominant regional one. This new economic and political friction creates a new operational calculus for global multinationals with high exposure to China.

So what does this all mean for EM? This discussion seems a lot about China only. That is true but as we discussed in part 1, a bet on EM is effectively a bet on China given its size in the EM index (over 40% and more than 50% if one “includes” Taiwan). And if our thesis is correct, then the outlook for China has changed from the past 40Y and thus the outlook for EM has changed. China is no longer the fast growing, manufacturing market share gaining machine but rather a developed market more inline with the US, Japan and the EU. China is classified by index providers as emerging for technical reasons (closed capital account, etc) rather than economic. This view makes intuitive sense as countries with 2nd largest economies in world status, superior military, world class tech industries and even their own space station don’t really fit the typical investor definition of “emerging”. So for all intensive purposes China is “developed” and President Xi is pursuing a strategy along developed status parameters. But as we will see in part 3, the outlook for China (and hence EM) is very different than other DM countries given a very different political backdrop, especially in an ESG-focused investor world.

That difference, in 25’s view, is driving the End of EM as investors know it.

Thanks for reading.