A market renowned for surpluses will soon post its first current-account deficit in more than 25 years, opening new opportunities for international bond and equities investors.
As China's growth moderates and the country shifts from being a net saver to a capital importer, a debate has arisen on whether Beijing will open the world's second-largest economy to more foreign capital.
To finance the country's current-account deficit, China will need at least $210 billion of net foreign capital inflows per year from 2019 to 2030.
Consensus opinion doesn’t expect China to move in this direction. In this view, China may have cracked open its financial doors a bit wider, but they swing inward in what often amounts to symbolic reform.
Morgan Stanley’s economists and strategists have a different view. According to the recent report "The Transformation of China's Capital Flows," even after factoring benefits from a possible trade deal with the U.S., China will likely face a sustained period of current-account deficits, requiring the country’s leadership to embrace a larger role for foreign capital to keep its balance of payments in check. This shift will likely ignite a structural transformation that will intensify China’s integration with the rest of the global economy.
“Although this transformation will bring uncertainty, it also brings significant opportunities for foreign investors in China’s government bond market, equities and, eventually, the onshore corporate bond market,” says James Lord, the Head of Emerging Markets Fixed Income Strategy.
Shortfall, Not Shortcoming
This year, China is expected to see its first annual current-account shortfall—0.3% of GDP—since 1993. This time, however, the deficit may stick around. Due to the ongoing transition to a consumption-led economy and a decline in savings amid an aging population, China’s annual current-account deficit could reach as much as 1.6% of GDP—or $420 billion—by 2030.
Even so, by percentage, that projected shortfall is minuscule by emerging-markets standards. “The narrowing current-account surplus is in line with China's transition toward a consumption and service-led economy," says Chief China Economist Robin Xing.
China's Current-Account Surplus Narrowed Rapidly over the Past Decade
(% of GDP, 4Q Trailing Sum)
With a healthy external balance sheet—China’s net foreign asset position is the highest among emerging markets—rising competitiveness in the higher-value-added export space and improving productivity, China could maintain a modest current-account deficit over the medium term, without triggering external stability risks. However, the shortfall does mean China’s economy will need to compete for capital to fuel growth.
A Bonding Experience
To finance the country's current-account deficit, the report forecasts China will need at least $210 billion of net foreign capital inflows per year from 2019 to 2030.
“China has received limited levels of portfolio inflows over the past two decades and, as a consequence, foreign ownership of the domestic equity and bond markets has been very small," Lord says. “That is already changing."
Lord expects China’s share of global bond and equity indices to grow, which would drive a large increase in portfolio flows. In February, global equity index provider MSCI announced it would boost the weighting for China A-shares—stocks of Chinese companies incorporated on the mainland, quoted in renminbi, and listed in Shanghai and Shenzhen—in its Emerging Market Index to 3.3% by November, up from around 0.7% currently. The boost could drive historic inflows in 2019—$70 billion to $125 billion—and drive annual inflows to as much as $220 billion.
China’s bond market could also benefit. Lord forecasts an $80 billion to $100 billion inflow into China’s government bonds—a jump from an average $35 billion per year from 2015 to 2018. That figure could reach as high as $120 billion annually through 2030.
China's Bond Market Size Ranks as the World's Third Largest
(USD, Trn, Q2 2018)
Even in onshore Chinese corporate bonds, typically the last destination for foreign fixed-income investors, Morgan Stanley’s analysts forecast $300 billion to $400 billion of total inflows by 2030.
The report also notes that foreign direct investment inflows could reach $110 billion to $230 billion per year from 2019 to 2030, compared with a current annual average inflow of $126 billion over the past decade.
Exchange on the Rise
Global investors will need to track several factors if China further opens its financial markets, particularly since China assets have low correlation to global benchmarks, which could provide portfolio diversification.
In equities, the index weighting boost from MSCI should encourage gains, as should other efforts to make A-shares more available to foreign investors. Stabilization in China growth this year would also help to encourage gains. In fixed income, rising investor inflows from index inclusion, reserve manager diversification, disinflationary pressure and continued central bank easing could boost bond prices.
The report also notes that further opening of China’s financial markets should help to further internationalize its currency. “We think that renminbi-denominated assets could reach 5%-10% of global currency reserves over the next 10 years, surpassing the significance of the yen and pound,” says Lord.
To be sure, there is no guarantee that China’s authorities will open up financial markets to greater foreign investment. However, failure to do so would actually run counter to the economic forces driving the current-account deficit. The result could weaken China’s currency, which would make it more attractive for foreign investors to purchase assets in China.
For Morgan Stanley Research on China, ask your Morgan Stanley representative or Financial Advisor for the full report, “The Transformation of China's Capital Flows" (Feb 11, 2019). Plus, more Ideas from Morgan Stanley's thought leaders.