Despite the effects of the pandemic over the past three years and China’s staunch adherence to a zero-Covid policy, the country has continued with its engagement in the world economy and global financial markets. When discussing China’s linkages to the world, there are three perspectives to consider: trade and investment; the spillover effect of its financial market into global markets; and RMB internationalization. 

Overseas Direct Investment

While the pace of China’s overseas direct investment (ODI) slowed during the pandemic in the short term, the long-term outlook is promising. Indeed, in 2021, China’s zero-Covid measures, including strict cross-border travel controls, substantial reduction of flights, and long quarantine requirements, had an impact on ODI. 

Significantly, the geographical distribution of China’s ODI is pivoting towards the Global South – Latin America, Asia and Africa. These regions offer ample opportunities in the energy and infrastructure sectors as host countries emerge from the economic downturn. 

By contrast, developed countries have imposed regulations on ODI flows from China, reflecting geopolitical uncertainties between the nation and the US and Europe. Therefore, focus on the Global South is likely to persist in the future, especially with the ongoing tech competition and escalating US-China conflicts. 

In the short term, the outlook for China’s ODI remains grim in 2023. Interest rate hikes in advanced countries have led to higher financing costs and currency volatilities in emerging markets, while China’s zero-Covid stance has translated into the postponement of ODI-related business trips. 

However, in the long run, China’s ODI has room to grow: the country’s share of global ODI is still disproportionately lower than its share of global GDP. Also, due to the current energy shortage and spike in food prices, China will prioritize security of energy and food supply through ODI investments in resource-rich countries. The ongoing supply chain relocation process outside China to circumvent US sanctions also indicates plentiful ODI opportunities. 

From the trade perspective, the view is that a complete China-decoupling is neither practical nor realistic. Although there may be some global value chain relocation to ASEAN and other regions, China retains its competitiveness as a global high-end manufacturing centre. 

The country’s advantages are multi-faceted: well-developed infrastructure, existing large-scale capital investment in manufacturing, the largest domestic market in the world, skilled labour and a large population of migrant workers, competitive engineers, and technology advantages compared with “nearshoring” competitors such as LATAM, ASEAN and India, etc.

Financial Market Linkages

China’s financial market links with the world have been strengthening over time, which begs the question: what is the significant impact of its financial markets on emerging markets such as Asia and LATAM? After all, China has a comparatively closed capital account. Analysis of higher frequency financial market (stock, bond and FX) data based on the Sign Restriction SVAR model points to the significant influence of Chinese stock and RMB movements on Asia and LATAM’s stock and FX markets. 

In normal times, China’s influence on LATAM and Asian equity markets rose to a level close to that of the US, although the relative impact of the US was stronger during periods of crisis. The RMB’s impact on other emerging market currencies has been rising over time, too. By contrast, China’s bond market remains a negligible player. 

When discussing the transmission channels of China’s financial markets, in terms of stock market spillover, worsening expectations of China’s economic outlook can have a significant impact on the outlook of LATAM and Asia due to trade and investment linkages, particularly commodity exports, which also impacts these regions’ stock markets. 

As for FX market spillover, the risk of currency (mis)management in China has the potential to trigger currency wars and beggar-thy-neighbour global dynamics, thus requiring LATAM and Asian countries to adjust exchange rates to maintain export competitiveness.

RMB Internationalization

RMB internationalization is the process of turning the Chinese currency into one that is widely used globally to invoice international trade (a unit of account), to settle payments in trade and financial transactions (a medium of exchange), and to denominate financial assets and serve as foreign reserve of central banks (a store of value). Simply speaking, it is about making RMB the next global currency, and China’s long-term strategy to create a stable international monetary environment for its own economic development and to enhance its spheres of political influence. 

Elements of RMB internationalization include RMB bank deposits outside of China, RMB-denominated bonds issued in offshore markets, the percentage of China’s trade settled in RMB, and the foreign exchange turnover share of the RMB, establishing offshore RMB markets, RMB swap lines, RMB share in countries’ foreign reserves, etc. According to SWIFT, the path of RMB internationalization can be divided into three phases: as usage for trade finance; for international investment; and, in the longer term, as reserve currency.

To facilitate RMB internationalization in the long term, China needs to relax its capital controls, allow more RMB convertibility, and undertake sweeping reform of its financial sector to achieve the required market depth. A freer flow of funds between onshore and offshore markets and a mature, broader and deeper domestic financial market would also give incentives for people outside China to use the currency. However, capital controls should be relaxed only after China’s financial system becomes mature and well-regulated. Otherwise, unchecked flows of hot money could destabilize financial and banking systems, leading to a financial crisis. 

RMB Internationalization should be regarded as a consequence of financial liberalization reform rather than a goal to be pursued independently. The internationalization of a currency usually goes hand-in-hand with the appreciation trend or at least a stable outlook to attract foreign institutions. Maintaining export competitiveness amid an appreciating RMB is also a challenge.

Dr Jinyue Dong, Senior China Economist, BBVA Research Asia