Wednesday, 17 April 2024

US-China trade war highlights shifting global terrain for financial services

5 min read

By Ellen Hardy

The US-China trade war may be inching towards a ceasefire, but the ramifications of this economic battle will continue to be felt around the world. As retaliatory restrictions have seen escalating horizontal affects, we take a look at how the war has impacted financial services now and into the future

  • The trade war has affected global trade volumes, however one major bank says that volumes of international payments have not decreased materially
  • Supply chains may be shifting away from China, but the domestic Chinese markets are continuing to grow and demand services to meet changing consumption
  • There is a strong incentive for a resolution to the trade war, which will include opportunities for foreign banks to gain a foothold in China’s domestic finance market

While it appears likely that the two global economic powerhouses will complete ‘phase one’ of  a deal to ease tensions in the trade war ahead of the APEC summit in Chile in mid-November, Carmen Chan, Deutsche Bank’s head of trade finance in Greater China, said that the economic retaliations have had a discernible effect on global trade.

“We have observed some decline in the trade volume between US and China from our clients, and that is happening in both directions. Simultaneously, we are also noticing a gradual increase in the flows through other trade corridors such as between China and ASEAN countries, and between China and Latin America,” she said.

In these corridors, countries such as Vietnam and Mexico appear to have been winners from their near neighbours’ involvement in the trade war. Mexico’s exports to the US totaled $346.5 billion in 2018, up 10.3% ($32.3 billion) from 2017, while Vietnamese exports have risen from around $176.6 billion in 2016 to $290.4 billion last year. Vietnam has seen a gross domestic product (GDP) gain from trade of 7.9%, ahead of Taiwan (2.1%) and Thailand (1.5%).

Citing Deutsche Bank’s China economist Yi Xiong, Chan noted that China appears to have changed its strategy towards the trade war, which began in March 2018, shifting from a focus on resolution to one of endurance.

“China is working on strengthening its economic resilience under the rising tariffs. That could be achieved by shifting trade flows, whether import or export, away from the US, and taking measures to boost domestic demands. It is quite obvious that China, over time, will strive to reduce its supply chains’ reliance on the US.”

The Chinese economy is growing at its slowest pace in nearly 30 years, but Chan takes the view that established industry players and financial institutions are well prepared to manage the economic impact.

“There is increased interest in looking at hedging tools that would mitigate any adverse impact caused by potential significant exchange rate fluctuations,” she added.

“The world economy is dynamic. A robust business plan and diversified income stream will help industry players to ride through any potential turmoil, be it the US-China trade dispute, heightened market volatility, or increased talk of a global recession.”

Indications from global firms operating in Asia

Faisal Ameen, head of Asia Pacific global transaction services for Bank of America (BOA), said that the difference between the 10-year bond and current three-month dollar rates earlier this year pointed to a lack of confidence in the long term outlook for global GDP growth.

However, he believes that it is now important to put the current trade war into a global context, noting that the estimated fall in trade from September 2018 to June 2019 was about $45 billion between the US and China, in a global market that saw a total trade of $17.5 trillion in 2017.

“Volumes of international payments has not decreased materially. A lot of labour-intensive, manually-produced goods have either shifted to lower cost countries or to automated production facilities through the use of robotics and automation in large factories to lower cost and improve efficiency. In the latter case, not as many replacement jobs are being created when some factors of production shift countries,” he stated.

For BOA, dollar clearing business has grown dramatically this calendar year, though some of the increase is due to internal strategy, as well as consequence of changing policies.

“We have seen the impact of the trade war through the rate reduction in the US, while China’s reaction was to devalue currency and expand liquidity in the domestic market. As a result domestic asset funding pricing has reduced significantly. That is specific to the China market, and as an outcome of the trade war,” he said.

Ameen said the bank isn’t making projections for the outcome of the trade war, but noted that a worst case scenario of no deal being reached would mean rising tariffs, significantly impacting volume of trade. More realistically, he believes that China has reason to support the economy for the longer term, and a strong incentive to strike a deal with US President Donald Trump rather than trying to wait it out until the outcome of the 2020 presidential election is known.

“There is a view that a deal reached in November will, to some extent, release the pullback in corporate investment,” he added. “Capital expenditure has all but stopped, so we will see some uptick. But the longer it takes for an agreement to be reached, the more it lessens the appetite for capital expenditure for many corporates.”

According to Ameen, a true resolution to the conflict will be seen if and when the US multinationals resume spending, because the global trade will follow as uncertainty is reduced. He also noted that China is not static in spite of shifting supply chains and that the country’s foreign direct investment remains very strong at over $100 billion.

“You have to view it with dual lens. There is a supply chain shift, but China’s markets will continue to grow. Just to satisfy Chinese market requirements, many companies will still have to increase capacity in China. In the longer term, the story is in shifting supply chains and changing consumption in China — low value moving out and middle market opening up,” noted Ameen.

Spotlight on payments and supply chain finance

Ameen believes that alongside the trade war, regulation across different markets is continuing to affect dollar clearing and supply chain finance. Recent US accounting standard changes and other regulatory changes mean that the ability to use supply chain as a methodology or mechanism to take assets off balance sheet is no longer available.

Many lenders are focusing on larger corporate clients and are reducing exposure to trade finance, which the Asian Development Bank estimates has increased the trade finance gap to around $1.4 trillion to $1.6 trillion, or 8% to 10% of the global merchandise trade.

Ameen says that BOA has found that supply chain financing has become a great way for its larger clients to develop much deeper supplier relationships with their customers by extending better financing terms to their suppliers than they would otherwise be able to achieve on their own.

“For the largest companies, financing costs remain very low,” he said. “In China, there is a lot more liquidity, hence returns and spreads have come down. While large companies have access to relatively cheap capital, the opposite is true for smaller companies, where costs are going up as Chinese institutions implement more stringent credit management policies.”

At BNY Mellon, Asia-Pacific managing director and regional head of relationship management Arnon Goldstein said that the trade dispute has dampened payment volumes as a by-product of an overall decline in regional and global trade volumes. But rather than dwelling on the negatives, he said that BNY is preferring to look at the opportunities available for innovation.

“We’re optimistic, particularly as trade and payment corridors flow. Broadly speaking, this is an extremely interesting period for transaction banking. We are starting to see the emergence of new payment infrastructures in Asia and globally,” he said.

Pointing to BNY’s origination of the industry’s first-ever real-time payment on The Clearing House’s Real-Time Payments network, Goldstein emphasised the role of technology in the transformation of the marketplace and in helping the financial services industry move out of these uncertain times.

While he labelled the opening of the domestic Chinese finance market a “developing situation,” he said that China nevertheless remains a strategically important market for transaction banking.

“Our focus has been in serving the cross-border requirements of our underlying bank and financial institution clients in China,” he added.

China remains a strong bet

The message from global banks is that they will continue to seek growth alongside their clients and partners in the Chinese market, for which there is still considerable opportunities. They are welcoming the decision to open up its $44 trillion domestic finance market to foreign investors by removing ownership and shareholder caps — although there may be more than trade compromise behind the decision.

Chinese banks are in the midst of a cash and creditworthiness crisis, with risk aversion spreading throughout the sector following the Chinese central bank’s takeover of the troubled Baoshang Bank — the first such case in nearly 20 years — in late May.

Although it may not all be smooth sailing despite the decision to allow foreign lenders to establish wholly-owned banks in China, as well as removing the requirement for prior approval to conduct businesses using the renminbi (RMB) being considered as positive first steps. Licences and other regulatory requirements could yet slow down new firms getting a foothold in a market already dominated by local players.

Eric Yip, general manager and head of the China division of The Bank of East Asia Limited, said it is a “positive initiative” taken by mainland authorities to open up the Chinese domestic financial market that will drive further reforms in the sector for both local and international firms.

“This will mean more business opportunities for foreign banks, who will be able to leverage their more advanced risk and business management knowhow,” he said. “On the other hand, intensified competition is expected to drive domestic banks to accelerate transformation and reform in areas such as risk pricing, asset management and operational controls.”

Though banks on the mainland may be championing the changes as a potential boon to the finance sector, fund managers have reported that the role of the US dollar in world trade flows and financial systems mean that the trade war’s lasting impact has been to dampen cash management returns after several years of strong growth.

Manpreet Gill, head of  fixed income, currencies, and commodities (FICC) strategy at Standard Chartered Private Bank in Singapore, said that there is still some appeal for fund managers to invest in the Chinese market, though enthusiasm has waned.

“We expect Chinese bond yields to be range bound from here. The benefit from significant foreign investor inflow from index inclusion may have largely run its course. However, growth-supportive domestic policy, a low global bond yield environment and a stable currency are likely to limit any rise in bond yields,” he said.

Market uncertainty from the trade war will mean less investment for some banks with a lot of exposure to negative or low interest rate markets, such as in Europe. In turn, these markets will open to increased disruption by low-cost fintech players who are less concerned with generating short term profits, and the major global banks will continue looking in to Asia.

“We have just upgraded emerging market local currency bonds to ‘Preferred’ within our global bonds asset allocation framework, and Chinese government bonds form a key component of this asset class,” added Gill.

Stalemate may become the new norm

The resounding view from the banking sector is that US tariffs will not continue forever, and that both the US and China have strong incentives to reach an agreement sooner rather than later.

Roland Rajah, director of the international economy program at the Lowy Institute, agreed that no matter the outcome of negotiations between the US and China, the economic and political landscape has changed.

“There’s definitely going to be more sand in the wheels of the free flow of capital between countries. We don’t know exactly where we’re going to end up on this front, but one can see that is the trajectory,” he noted.

Rajah, who prior to joining the think tank was a senior economist and country manager at the Asian Development Bank, said that the questions of long term material impact due to the change in political conditions remains to be seen.

“When we talk about the trade war, we’re normally talking about tariffs. But technology-related restriction has been a large part of the broader economic conflict between the United States and China,” he said.

“There have been some noises lately from the Trump administration about clamping down on Chinese companies listing in the United States, and possibly broader restrictions on investment flows into China. There are more leavers for the US government to pull in terms of stopping American firms from going into China if they think there’s a technology-related component.”

Rajah added that a number of regulatory issues, such as export controls and visa restrictions, are not even yet on the negotiating table.

“They are very much driven by national security in the United States — and they don’t look to be going away regardless of a deal.”

Ultimately, Rajah said that the trade war is something that can only be solved at a political level, and that is something that as fraught as it is unpredictable with a “wildcard” such as Donald Trump in office — and facing an election.

“My pessimistic view of how things might potentially settle down is that both sides will find that this is basically a stalemate,” he said.

“The US isn’t going to get everything that it wants, in terms of deep structural changes to the Chinese economy. China is not going to get everything it wants either in terms of the removal of tariffs, so I think a stalemate might be where we end up in the medium term.”

View From US

Audrey Kaplan, head of global equity strategy for Wells Fargo Investment Institute, believes that US banks are more insulated from the dispute than many other industries, with the S&P 500 Financials Sector revenue sourced primarily from domestic sources (80%) with only small revenue gains coming from China, which she said is likely less than 2%.

“The direct impact from the trade war on the financial sector has been minimal compared to other sectors. As it relates to the US-China trade dispute, and other trade disputes in progress globally due to the rise of nationalism, this relatively low overseas revenue exposure insulates the financial sector compared to the overall S&P 500 (60% domestic revenues),” she said.

While it is comparatively lower than sectors such as agriculture, finance has felt some effects from the trade war, both directly and indirectly. “We forecast that the impact may become larger as the US-China tariff dispute extends into 2020 and further impacts manufacturing companies in the domestic economy. For example, direct signs of economic stress may rise as lending slows.”

“We see signs that domestic commercial loan growth has been slowing since the summer as tariffs are suppressing growth,” she added. “We know historically that the deceleration in business inventory caused by economic and political uncertainty may further pressure commercial and industrial loan growth. This could weigh more heavily on the banking industry as we head into 2020.”

Meanwhile, Beijing has been relaxing foreign ownership rules in the financial sector. As recently as this October, China’s Securities Regulatory Commission released a time frame for removing limits to foreign stakes in futures companies, mutual fund management companies, and securities companies.

“This is a positive for the financial sector where companies have wanted to gain exposure to the growing Chinese affluent markets,” Kaplan added. “American financial service companies have desired to build out business exposure to the faster growing domestic Chinese marketplace.”

Trump administration officials have said that China’s pledge to open its markets to American financial services firms will see banks and credit card companies as the primary beneficiaries. Still, as recently as September, 81% of the banking, finance and insurance sector of the American Chamber of Commerce in China signaled that they would like a better business environment.

Kaplan noted that mutual fund management companies may be allowed full-ownership operation in the Chinese financials sector as soon as April 1, 2020 according to the reduced restrictions.

“This is one area that the dispute is already yielding a positive resolution by pressuring the Chinese government to speed up reforms already under discussion.”

Throughout the rounds of retaliatory tariffs and restrictions, service sectors have largely held up better than the trade in commodities. Any further impacts on growth in the US will have some flow-on effects on the services sector, which accounts for more than two-thirds of the country’s economic activity. In 2018, the finance and insurance sector represented 7.4% ($1.5 trillion) of US GDP.

Early data appears to show that the trade war is affecting the banking sector in ‘farm states’, the primarily Midwestern agricultural producers such as Iowa, Texas, and Nebraska. These states also form a substantial part of President Trump’s voter base.

Chairman of banking regulator Federal Deposit Insurance Corporation (FDIC) Jelena McWilliams recently admitted that there may be damage to the rural banking sector. “We may experience more delinquencies, which then become very difficult for those communities and our agriculture sector,” she said. “But down the road, we will have to see what the implications are.”

McWilliams, who was a Trump appointee, appears to have been playing down the impact. Figures from the St. Louis Federal Reserve Bank show that delinquencies on agriculture loans held by commercial banks have tripled since mid-2015 – the highest since the global financial crisis.

Still, according to the FDIC, the US banking sector saw an aggregate net income of $62.6 billion in the second quarter of 2019, an increase of 4.1% from a year earlier.

It remains to be seen how much the finance sector, and the economy in general, is being sheltered from the full effect of the trade war by Trump’s tax cuts, with data from the Reserve Bank of New York already showing that the tariff increases have wiped out the gain from his 2017 tax cuts for households.

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