US-China relations worsen due to US Covid-19 policy and deflection of blame 

The creep towards a cold war between the US and China is inevitable, given that both are of a size that brings them into competition across trade, technology and territory, and neither has the will or resources to settle the rivalry decisively. The recent frostiness seen on multiple fronts is in line with our expectations. 

For investors in emerging markets, some of the negatives (eg increased China territorial friction with ASEAN rivals in the South China Sea, weaker China FX rate) might be offset by positives (eg another bout of US tariffs on China that accelerates both the transition of low-end manufacturing away from China to other, more geopolitically onside, low-cost locations like Vietnam, and reinvigorated implementation, from the Chinese side, of BRI projects in countries like Pakistan). 

But one area where the lack of coordination between the US and China has already played out is the global policy response to Covid-19 and the credibility of an international organisation tasked with that coordination, the WHO, that has been weakened (by both sides, arguably).

Another global policy challenge where this friction may act as an outright negative is on coordinated debt relief for poorer countries in EM (eg Ghana, Kenya, Nigeria, Tanzania, Zimbabwe in Africa or Pakistan in South Asia). 

China is a signatory of the 15 April G20 communique on the debt service suspension initiative for poorer countries; an unprecedented bilateral agreement that promises coordinated action. But the agreement is subject to well-worn implementation and compliance risks, which are more acute when two of the largest providers of bilateral debt are increasingly distrustful of each other:

1) China's lack of transparency over the full extent of its debt exposure via state-affiliated entities (an issue for Europe as much as the US) – one team of academics estimate that 50% of China's lending to emerging markets is not reported to the IMF or World Bank; 

2) The lens of the Belt and Road Initiative through which China may view debt relief (which may conflict with US priorities); and

3) China's willingness to participate in a multilateral approach over which it does not exert dominance.

Context of the US election in 2020, China party congress/presidential election in 2022/23

In the context of US President Trump's re-election bid (November 2020), which has unexpectedly been imperiled by a deficient response to Covid-19, rhetoric may be matched by more more meaningful action (eg new tariffs or sanctions). The rhetoric from the Trump administration has recently included blaming China for covering up Covid-19 (both its origin and its threat), compromising global organisations like the WHO (and therefore freezing its funding, where the US provides 22% and China 12%) and engaging in predatory lending and investment practices (eg in a warning repeated most recently to Israel on the need for more thorough scrutiny of Chinese inward investment). 

China President Xi has the benefit of a longer-term mandate (courtesy of the removal of term limits and an authoritarian political apparatus) and a sooner return to domestic social and economic normalcy after Covid-19 (regardless of the credibility of official data on infections). This likely makes for at least as much action as rhetoric; since the start of the year there has been friction between China and territorial rivals around the Nine-Dash Line in the South China Sea (Indonesia, Malaysia, Philippines, Vietnam) as well naval brushes with Japan and Taiwan. 

This is not to say that President Xi is impervious to unfavourable rhetoric from the US: to the degree that it infects either domestic opinion (the renewal of Xi's terms as party leader and president are due in October 2022 and March 2023, respectively) or international relations (eg with recipients of Chinese finance currently hoping for global debt relief and assistance), we expect at least a reciprocal rhetorical response.

Related reading

G20 endorses debt service suspension initiative for poorest countries, 16 April 2020

Geopolitics after Covid-19: US-China cold war, fragmented EU and GCC, 20 April 2020

Trump impeachment or election loss: what would it mean for emerging markets, 14 October 2019

Philippines: US to China rebalance continues, not cause for alarm, 12 February 2020

China's BRI: 2nd forum to stir an old debate, 22 April 2019

MSCI has spoken. The highlight is the potential ejection of Argentina and Turkey from the emerging market index.

While there are no shocks, the tyranny of benchmarks for active and passive institutional equity funds means we are all forced to pay attention; regardless of whether MSCI's criteria match the objectives of funds in the emerging or frontier market asset class its benchmarks are the most widely used.

The review reinforces our long-standing view that the emerging markets equity universe is split between the big 5 (China-HK, Taiwan, S Korea, India, and Brazil, which collectively account for over 75% of the index) and the very long tail of countries which makes up the rest. In other words, the boundary in this long tail between small emerging markets and frontier is arbitrary.

The details of the review

In its 2020 annual review of which countries are included in its emerging markets (EM), frontier markets (FM), and standalone indices, MSCI has made the following remarks:

• Argentina (0.11% weight in the EM index) and Turkey (0.43% of EM) are both potential candidates for downgrade from EM to FM or standalone at any time.

  • Argentina due to capital controls, introduced in September 2019, on locally listed stocks and, while all of Argentina's EM constituent stocks are listed overseas as ADRs, the flow of dividends may be impacted;

  • See Argentina creditor negotiations reach critical point and How to build exposure to disruptive EM tech and mitigate capital controls risk;

  • Turkey due to bans on short-selling (since October 2019) and stock lending (since February 2020);

  • See Turkey: The only chart that matters – interest rates and inflation.

  • A downgrade of Turkey to FM would create a headache for MSCI and the fund managers benchmarked to the FM index because Turkey’s average daily trading activity (close to US$2b over the last 6 months) would dwarf that of all the other markets in FM (Vietnam would be the next most active at $270m).

• Iceland (with a 5.24% weight) will be included in FM (from standalone) from May 2021.

  • In line with the consultation launched in August 2019 after capital controls were removed in March 2019;

  • See Iceland: Fully valued, slowing growth, FM anomaly for our views on the investment case.

• Nigeria, Lebanon, and Bangladesh are all potential candidates for downgrade from FM to standalone at any time.

  • Nigeria due to increasing dysfunction in its FX market; see Nigeria: Deep value or deep trouble?;

  • Lebanon due to capital controls since October 2019; see Lebanon restructuring plan: A long and winding road;

  • Bangladesh due to artificially high limit floor price-setting since March 2020); Bangladesh: Stock market to re-open on 17 May, 8 weeks after shutting.

• Kuwait will be included in the EM index (from FM) in November 2020.

  • As expected, following the delay announced in April 2020;

  • Approximately a 50bp weight in EM;

  • See Kuwait: MSCI EM delayed to Nov 2020 (from May), no change to fundamentals.

The evolution of EM and FM indices

[Note that these are estimates and may not accurately reflect the most recent daily update of weights, and the chart for frontier is for FM100, not FM.]

Recent budget announcements (Kenya and Mauritius in Africa, Bangladesh and Pakistan in Asia) highlight the strain caused by Covid-19 lockdowns on emerging market finances. While government spending is increasing to lessen the economic hardship, income is falling as economic activity declines. In this context, we think bank shareholders could once again find themselves in the firing line.

Banks are already exposed to the economic downturn through lower revenues, higher risk costs and tighter liquidity. In addition, regulators have adjusted loan contract terms in most markets so that borrowers may enjoy payment holidays or even lower interest rates.

Banks could face higher taxes and/or be asked to hold more sovereign debt

Tighter sovereign finances could result in two additional claims to which bank shareholders would be exposed. The first is that governments may raise taxes on the banking sector in order to plug fiscal gaps. While governments so far seem content with raising taxes on consumer staples such as telcos, tobacco and alcohol, past experience (such as the super taxes in Pakistan, or the debt repayment levy in Sri Lanka) suggest banks could also find themselves in the firing line.

Which banks could be most exposed to higher tax rates?

Comparing 2020f projected fiscal deficits with last year’s effective tax rates for our banking coverage highlights GCC markets along with Egypt as being potentially most at risk (ie names in the lower left quadrant of Figure 1 below).

Saudi Arabia recently hiked its VAT rate to 15% (from 5%), which could bring in additional revenues equivalent to 4% of GDP. Looking outside the GCC region, we note that Nigeria has already put in place measures to increase the tax burden on its banks via higher VAT (5% from 0% for online transactions, and 7.5% from 5% for other service fee income) and revocation of the tax-exempt status of government securities from 2022. Kenya in 2018 increased the excise duty charged on bank fees from 10% to 20%, which brought in KES8.3bn in receipts that year, equivalent to around 5% of the banking industry’s pre-tax profits. Another example is Egypt, which has introduced a less favourable tax regime for banks’ T-bill holdings. The chart below suggests that other tax-raising measures in these markets cannot be fully discounted.

Which banks will be asked to fund sovereign deficits?

A longer-term impact comes from increased reliance of bank funding by EM sovereigns. As well as crowding out private sector lending, banks carrying more government debt on their balance sheets make their risk profiles more closely intertwined. Even if such instruments carry zero risk-weights, particularly for the most indebted sovereigns, they are anything but, as the recent example of Lebanon spectacularly highlights.

We think banks in Oman and Sri Lanka could be increasingly called upon to carry more sovereign debt assets, particularly given that the likely increase in global sovereign issuance could lead international investors to become more discerning. We note that Sri Lanka banks are currently barred from holding USD sovereign debt, but they continue to invest in LKR-denominated government bonds.