If truth is the first casualty when war is declared, then the same goes for capital mobility when pandemics strike. This became evident on May 11, when US President Donald Trump ordered the federal pension fund – the world’s fifth-largest pension fund – to stop investing in Chinese equities. The move came in response to what the US Government perceived as persistent Chinese aggression – COVID-19 just being the straw that broke the camel’s back. “The role of the Chinese Government in purposely not disclosing what was going on during the COVID-19 outbreak has fuelled a lot of [anti-Chinese-Government] sentiment,” Charles Calomiris, a professor of financial institutions at Columbia Business School, told World Finance.
After a long period of integration, segmentation, driven by geopolitical turbulence, is becoming the norm
It was not the first time that the Federal Retirement Thrift Investment Board, which represents the interests of around 5.5 million federal employees through its $600bn Thrift Savings Plan, had been pressed to steer clear of Chinese assets. Last November, the board rebuffed a similar request by US lawmakers on the grounds of missing out on investment opportunities. Trump’s order put paid to the board’s plan to shift its $40bn international fund from the MSCI World Index, which focuses on developed markets, to the MSCI All Country World Index, which includes Chinese shares. Although the fund is not legally obliged to obey, it has little leeway this time, as the US Government aims to replace the majority of its directors.
Although largely symbolic, the ban highlighted a basic truth about global financial markets: after a long period of integration that started in the 1970s with the collapse of the Bretton Woods system, segmentation, driven by geopolitical turbulence, is becoming the norm. The era of financial globalisation reached its peak in 2007 when global cross-border capital flows reached a record $12.7trn (see Fig 1). The shock of the credit crunch and the ensuing eurozone crisis halted unbridled capital mobility. Within 10 years, capital flows had dropped to $5.9trn, driven by a sharp decrease in cross-border lending.
In a working paper published this spring, researchers from the French asset manager Amundi argued that financial globalisation is not a linear process, but instead evolves in cycles. Following a period of erosion of financial borders between the late 19th century and the First World War, moderate integration took hold until the 1970s, when fierce globalisation kicked off with the dismantling of barriers to capital mobility.
According to Marie Brière, Head of Amundi’s Investor Research Centre and one of the authors of the paper, we have been going through a phase of financial deglobalisation since the Great Financial Crisis (GFC), and the pandemic will only accelerate this trend. She told World Finance: “It is unlikely that we will go back to a period of no market integration, like the Bretton Woods one. What could happen, and we are already seeing it, is going back to a period of more moderate integration.” One side effect is that contagion may become more likely when things go awry. “When there is absolute market segmentation or, on the contrary, full market integration, there is little risk of contagion,” Brière said. “But if there is a moderate degree of market integration, as in the 1880-1914 period, the risk is higher.”
Segmentation is partly driven by geopolitical developments. The US-China trade war, Brexit, turbulence in Hong Kong and a more insular EU had already halted trade liberalisation before the pandemic, erecting new barriers in financial markets. According to the UN Conference on Trade and Development (UNCTAD), foreign direct investment (FDI) dropped by one percent last year to $1.39trn, its lowest level since 2010 (see Fig 2). The pandemic has further disrupted global trade, exposing the vulnerability of ‘just in time’ manufacturing and international supply chains.
Emerging markets, which have benefitted from a vast inflow of foreign capital over the past few decades, are now bearing the brunt of the crisis. Through daily tracking of non-resident portfolio flows, the Institute of International Finance (IIF) revealed that emerging markets saw the largest capital outflow in history in Q1 2020, despite the Federal Reserve taking swift action to support many of them through dollar-denominated swap lines.
Jonathan Fortun, an economist at the IIF, told World Finance: “The COVID-19 shock has resulted in a pronounced sudden stop in capital flows to emerging markets. While we expect a recovery of flows to emerging markets in the second half of 2020, we do not believe that the pickup will be strong enough to bring about a return to 2019 levels.” The organisation forecasts that non-resident capital flows to these markets will reach $444bn in 2020 compared with $937bn last year, marking a new low since the GFC. Calomiris added: “The combination of dollar appreciation, global recession and [a] huge build-up of leverage in dollar-denominated debt is an existential threat for emerging markets.”
Barriers to success
Looser financial ties are reflected in the decline of cross-border listings, particularly in the US. Historically, foreign firms have listed on US exchanges to access more liquid markets, with the spillover effect spurring capital inflows and advances in financial integration in their home countries.
In a recent working paper for the National Bureau of Economic Research, academics Craig Doidge, Andrew Karolyi and René Stulz claimed that the valuation gap for firms from developed markets increased by 31 percent after the GFC – a mark of a sharp reversal in financial globalisation – while the gap for firms from emerging markets (excluding China) stayed stable. However, the propensity of non-US firms from both developed and emerging markets to cross-list in the US has decreased, a development that the authors interpret as another sign that financial globalisation is in retreat.
The pandemic has further disrupted global trade, exposing the vulnerability of ‘just in time’ manufacturing and international supply chains
Last year, the volume and value of cross-border initial public offerings (IPOs) around the world dropped by 17 percent and 35 percent respectively when compared with 2018 levels. As Karolyi explained to World Finance: “For some firms, the benefits of a US listing may have diminished because they were able to secure adequate financing for their operations domestically or by other means than an offering associated with a US listing. For other firms, it may be that funding needs for growth dried up because they saw a slowdown in their growth.”
In the banking sector, the financial turbulence that followed the GFC and the sovereign debt crisis curtailed cross-border lending for more than a decade, with foreign claims on advanced economies dropping from around $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 – indirectly hit cross-border lending by forcing banks to sell foreign assets in a bid to shrink their balance sheets and meet high capital requirements.
Brière believes national regulation has also played a role: “Just after the subprime crisis, we saw a form of ‘quasi-nationalisation’ due to government interventions in the banking sector aiming to reduce cross-border lending.” That trend started reversing in 2018, according to a report by the Bank for International Settlements, with outstanding loan growth approaching 2008 levels last year, driven by an increase in international lending by European banks. However, the current pandemic may reverse these gains. As Brière explained: “In the short run, we could see more focus on domestic investment, as in the previous crisis.”
A new cold war
The COVID-19 pandemic has escalated a long-simmering conflict between the US and China, two of the main drivers of financial globalisation. Some fear that the ban on the federal pension fund was just the first shot in a more open confrontation. David Dollar, a former US Treasury emissary to China and currently a senior fellow at the Brookings Institution’s John L Thornton China Centre, told World Finance: “There is a risk of a financial war… If the tensions were to escalate to serious measures, such as cutting off China’s state-owned commercial banks from the US financial system, the effects would be hard to predict, but almost certainly recessionary for the world, as these are among the biggest global banks.”
Suggestions that the US might demand financial compensation from China for the economic damage wrought by the pandemic have added fuel to the flames, with Trump describing the COVID-19 outbreak as an attack similar to Pearl Harbour and 9/11. Shehzad Qazi, Managing Director at China Beige Book International, an independent provider of data on the Chinese economy, told World Finance: “If relations continue to deteriorate, particularly over Hong Kong, we could see the US testing the waters with banking sanctions. If the US makes moves to cut China or Chinese entities off from US dollar access, this would be a serious escalation.” Some worry China could retaliate by selling a chunk of its US Treasury holdings, but Dollar believes such a move would be counterproductive: “China bought those for its own purposes of exchange rate management. Selling them en masse would tend to make China’s currency rise, which is not to its advantage at the moment.”
Geopolitical tensions are undermining investor confidence, with many worrying about the ability to repatriate funds
Even before the pandemic, the US was increasingly wary of Chinese inroads into its markets. Since 2017, US authorities have blocked several takeover bids from Chinese rivals on national security grounds. This, according to the Rhodium Group, led to a sharp decline in Chinese direct investment into the US between 2016 and 2019, falling from $45bn to just $5bn. A case in point is the trade ban the US Government has imposed on Chinese telecoms powerhouse Huawei, preventing it from buying or using technologies owned by companies operating in the US. In mid-May, the US Government extended a national emergency declaration that targets Huawei and other Chinese firms, restricting the company’s access to Google’s services and halting its plans to develop its semiconductor chips via a partnership with the Taiwan Semiconductor Manufacturing Company. The US Government has also pressed allies to follow similar policies.
Running out of stock
Inevitably, financial warfare is spilling over into the stock exchange. US listings of Chinese companies – a marker of financial integration between the two countries – had been growing for two decades, culminating in Alibaba’s listing on the New York Stock Exchange (NYSE) in 2014, the biggest IPO in history at the time. This trend raised eyebrows, though, particularly among US competitors complaining that Chinese firms were not subject to the same rigorous disclosure rules. The argument resurfaced in April when Luckin Coffee, a China-based coffee company listed on the NASDAQ, disclosed that around $310m of its 2019 sales had been “fabricated”. In May, the US Senate passed a bill that could block some Chinese companies from US exchanges, while former Trump aide Steve Bannon has called for all Chinese companies to be delisted.
“It would take deft negotiation between US and Chinese regulators to find a practical compromise,” Dollar said. “[That] seems very unlikely in the current environment, so probably the US will follow through with the recently passed Senate bill that ends with delisting all Chinese companies.” Sceptics, however, downplay the possibility of drastic action. “There will be no delisting of Chinese firms, at least [not] anytime soon,” Qazi said. “The legislation requires all companies on US exchanges – not just Chinese firms – to adhere to US compliance regulations, such as opening themselves to [Public Company Accounting Oversight Board] audits. It’s true this basically calls out the biggest national actor that refuses to adhere to those standards, China, but firms have three years to begin complying with the new law.”
The EU is scrutinising its financial ties with China, even if its objections are expressed in more diplomatic language
Karolyi believes Chinese companies list in the US because the benefits – such as access to global investors and liquid markets, global brand awareness and the ability to raise capital on better terms – exceed the costs and reporting burdens back home. However, as he explained to World Finance, this may soon change: “The geopolitical tensions that arise from the US-China trade war and beyond may very well be putting a damper on those benefits and increasing the costs and burdens. So, I expect a number of these cross-listed Chinese firms may very well rethink their capital market strategies and initiate a delisting and deregistration from US markets.”
China’s biggest chipmaker, the Semiconductor Manufacturing International Corporation, announced it was delisting from the NYSE last May, citing “low trading volume and high costs”, while Alibaba has reportedly been considering a secondary listing in Hong Kong. Qazi said: “Any Chinese firms that preemptively delist would be cutting their nose off to spite their face because only a handful of the very largest Chinese companies could successfully raise the same type of funding elsewhere.”
The EU is also scrutinising its financial ties with China, even if its objections are expressed in more diplomatic language. Alarmed by a series of Chinese takeover bids for EU companies, the European Commission is exploring the possibility of blocking Chinese investment on national security grounds. Margrethe Vestager, the commission’s executive vice president, has urged member states to buy strategic stakes in companies that are more vulnerable to takeovers due to the pandemic and its negative impact on share prices. Brière said: “Europe is more open to Chinese investment than the US, but given the shifting political environment, we may see it place more scrutiny on Chinese investment.”
A road to salvation
Strained relations with the West come at a crucial time for China’s financial system. The Chinese Government has been trying to open up the country’s $45trn financial services industry to improve competitiveness and attract foreign capital in a market long dominated by local state-run players. Chinese authorities have gradually dismantled barriers to foreign investors accessing the country’s $13bn onshore bond market, while Chinese bonds were included in the Bloomberg Barclays Global-Aggregate Total Return Index last year.
According to data held by China’s biggest bond market clearinghouse, the Central Depository and Clearing Corporation, foreign investors held Chinese bonds worth CNY 1.95trn ($275.5bn) at the end of February, a large chunk of which were government bonds. The Chinese Government has also relaxed rules on foreign stock ownership as part of a trade deal with the US. The country is expected to permit foreign investors to acquire life insurance providers, futures and mutual fund companies, as well as local banks. A link between the Shanghai and London stock exchanges was established last year through the Shanghai-London Stock Connect scheme, which enables firms listed on one of the two bourses to issue, list and trade depositary receipts on the other.
Perhaps the outbreak of SARS-CoV-2 will accelerate long-brewing trends, such as a green revolution in the investor community
Chinese banks have boosted their share of global cross-border lending – due, in large, to China’s ambitious Belt and Road Initiative – with the number of international claims growing by 11 percent per annum since 2016. Dollar believes their expansion makes US sanctions less effective: “The main downside of a serious action like sanctioning China’s big commercial banks is that these are deeply integrated globally. Constraining them will have unpredictable effects, especially in developing regions such as Africa, South-East Asia and Latin America, where these banks are very active. China would certainly retaliate by keeping US institutions out of its newly opened financial services markets.”
Lower capital flows due to the COVID-19 pandemic may stall China’s plans, however. Recent disruptions in Hong Kong are expected to hamper the country’s ability to attract capital from European and US institutional investors. Geopolitical tensions are also undermining investor confidence, with many worrying about the ability to repatriate funds due to US sanctions or other barriers. Many harbour doubts about the rate of change, too. Qazi said: “Relatively little has been done to date to open up the Chinese financial system to foreign firms, and what has been done has been done far too late. Foreign banks will not be able to compete with Chinese banks even with Beijing opening that sector, given their entrenched positions. Deteriorating relations between China and the rest of the world won’t help out what little movement we have seen so far.”
Even if the peak of financial globalisation is over, there is no going back to the era of closed borders. Less than 10 years after the GFC, foreign investors owned more than a quarter of equities and close to a third of bonds globally. In the US, the heart of the global financial system, foreign assets and liabilities scaled by GDP increased from 48.3 percent in 1980 to 324 percent in 2017. According to Brière, though, investors should be prepared for an era of financial protectionism and contagion: “They will have to look for alternatives beyond typical diversification strategies. For example, sector diversification tends to work better than country diversification in crises.”
Perhaps the outbreak of SARS-CoV-2 will accelerate long-brewing trends, such as a green revolution in the investor community. An Amundi study highlighting the impact of COVID-19 on the exchange-traded fund market showed surging outflows from conventional equity funds, while funds with environmental, social and corporate governance (ESG) agendas were much more resilient. “Even before the pandemic, we have been observing a shift of institutional and retail investors towards sustainable investment and ESG products,” Brière said. “The pandemic has reinforced this trend.”