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How China Is Diverging from Emerging Markets

11 March 2022

8 min read

Adriaan du Toit| Director—Emerging Market Economic Research; Senior Economist—Africa

All indices change over time, and those of dynamic growth markets change quickest. China has become predominant in emerging markets (EM), and we believe it’s only a matter of time before its role in EM indices will change, too.

EM are constantly evolving, and the most important development since the 1990s has been China’s rise. After years of producing higher growth than its EM peers, China’s rate of economic ascent is moderating. Even so, China can still continue to catch up with developed markets (DM), though more slowly than before.

By contrast, the COVID-19 pandemic has hit EM ex-China hard. Many emerging economies are struggling to regain their growth momentum, trailing the more rapid rebound in DM. China is already the largest constituent of the MSCI EM Index at around one-third of the total, and based on current trends, that share could grow closer to 40% over the next five years.

Has China outgrown the EM index, and if it has, what could it mean both for EM generally and investors’ allocations? We think this important question should be viewed through four lenses: gross domestic product (GDP) per capita, policy frameworks, ESG criteria and China’s changing growth focus.

Measuring Convergence with Developed Markets

Growth in per-capita GDP is a key metric for EM progress relative to DM. Over the last three decades, China has made startling advances, with its share of world GDP growing from 2% in the 1980s to almost 20% today. It’s been an exceptional ascent relative to EM peers, but China’s growth rate is slowing now, and China still lags average per-capita GDP across DM (Display). This suggests that China is in a middle ground between DM and EM.

Relative to the G7* Average, China GDP per Capita Has Overtaken Other Emerging Markets

China’s Growth Momentum Has Slowed but Further Convergence with Developed Markets Is Likely

While EM GDP per capita relative to the G7 has faltered at the 30% level, China’s has broken through above 35%.

Historical and current analyses do not guarantee future results.
*G7 countries are Canada, France, Germany, Italy, Japan, the United Kingdom and the United States
Through December 31, 2021
Source: Haver Analytics, Maddison Project Database and AllianceBernstein (AB)

Two issues are currently preoccupying China’s policymakers.

First, even if China enters the high-income group of countries relatively quickly, can it keep growing fast enough in the longer term to avoid slipping back—or even becoming trapped in middle-income territory? Declining total-factor productivity has been a major reason for China’s recent growth slowdown, and it’s why China’s policymakers are focusing on a “dual circulation” strategy to rebalance economic development and shift to a sustainable high-quality growth path. This involves simultaneously promoting technological innovation and rebalancing away from investment-led growth to an economy fueled more by domestic consumption.

The second issue: China is a big, regionally diverse country. GDP per capita has soared at the national level, but regional disparities have been growing in recent years. Addressing this divergence is another priority for China’s government.

Policy Frameworks Highlight Status

As the largest emerging country, China has in many respects adopted a different philosophical and policy approach than its EM—and DM—peers.

The country’s monetary policy framework is a notable example. EM countries across Latin America, Africa and Eastern Europe have typically been forced to respond to COVID-19-related inflationary pressures with early, steep rate hikes. Asian EM countries and most DM countries have been slower to adopt tighter monetary policy. And while capital markets have already priced in DM rate hikes, in some cases these have yet to be implemented.

China stands apart from all these groups. Far from tightening, the People’s Bank of China (PBOC) has embarked on policy easing to stimulate growth and avert collapse in stressed sectors of the economy. Policymakers have the freedom to adopt this very different approach because of China’s success in growing and diversifying its economy.

China has experienced only mild headline Consumer Price Index inflation relative to the majority of EM and DM, and recent increases in its Producer Price Index inflation rates stem partly from the government’s environment-linked production restrictions, which are being relaxed.

So on a forward-looking basis, inflation isn’t a major concern for China—a very different situation than other EM and DM. These varying inflation dynamics are reflected in differing policy responses and investment opportunities (Display, below).

China’s Interest-Rate Trajectory Has Diverged from Both the US and Emerging Markets

10-Year Real Bond Yields

China’s 10-year bond yield has remained relatively high in the last two years while the US and EM average trended down.

Historical and current analyses do not guarantee future results.
Countries included in the EM average: Brazil, Colombia, Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Philippines, Poland, Russia, South Africa and Thailand
Through January 31, 2022
Source: Bloomberg, Haver Analytics and AllianceBernstein (AB)

Why such a divergent approach by China’s policymakers?

Chinese government policy dynamically balances different objectives, such as maintaining economic growth rates, ensuring financial stability and promoting green development. Right now, economic growth is a high priority to support “levelling up” poorer regions and achieving common prosperity.

And while China’s political system is centralized, the implementing of economic policy is decentralized across local governments and financial institutions. This model can facilitate rapid corrective actions by the central government if local authorities haven’t responded to policy directives as intended. This feature can also produce fluctuations in China’s economic cycle.

ESG Criteria Will Be Important Differentiators

Investors of all types are increasingly mindful of ESG factors. The rise of responsible investing is still in its early stages and looks set to take off globally in the years ahead. In 2021, 53% of inflows to EM fixed-income funds went into ESG funds, even though these funds represented only about 5% of the total universe (according to EPFR Informa Financial Intelligence and Bank of America).

DM have deeper financial resources to make the transition to sustainable business models and a greener future. EM have the opportunity to adopt the latest and greenest technologies in theory—perhaps with DM assistance aligned with the Just Transition Principles. However, in reality many are struggling. The poorest EM countries have been worst-hit by the COVID-19 pandemic and have been unable to make much progress in the green transition so far.

China stands apart from both groups. After years of industrialization that made it the world’s foremost manufacturing center, China faces formidable environmental challenges, and has clearly stated that these will take decades to fully address. Although China has made rapid energy efficiency gains so far, future progress will be tougher to achieve. Even so, the country has the will, technology and financial strength to complete the green transition, albeit at its own pace (Display, below). As investors progressively set greater store on ESG factors, we believe ESG adoption will be a further differentiator that sets China apart from both EM and DM.

China Has Made Rapid Progress in Its Green Transition

Significant Challenges Lie Ahead, but Goals Are Achievable

Energy consumption and CO2 emissions per GDP have fallen significantly and are projected to decrease further to 2030.

Historical and current analyses do not guarantee future results.
Through December 31, 2020, projections as at January 31, 2022
Projections based on AB estimated economic growth and Chinese government goals
Source: Wind and AllianceBernstein (AB)

China’s size and importance gives it a prominent role in the global green transition. Notably, it accounts for the largest share of world carbon emission at around 30% (much higher than the 10% of second-place US). At those emission levels, China must be an integral part of any solution to the climate change problem.

China plans for national carbon emissions to peak in 2030 and aims to achieve carbon neutrality by 2060. That will require an estimated RMB139 trillion in investment (according to China’s National Center for Climate Change Strategy and International Cooperation), the majority market-based. The PBOC is already active in creating tools to support bank lending for this massive decarbonization effort, highlighting China’s coordinated efforts to make a successful green transition.

China’s Changing Growth Focus Poses Questions for Emerging Markets

During its phase of rapid investment and export-led growth, China drove economic development across EM, particularly by importing commodities from EM producers. For example, China consumes more than 50% of global aluminium, copper and nickel output, according to the World Bureau of Metal Statistics.

But this growth model has led to an accumulation of structural issues, and China’s policymakers are intent on rebalancing the economy. Although the Chinese government has been calling for a transition from investment-driven to consumption-driven growth, actual rebalancing has so far been modest. As a result, China’s imbalance between consumption and investment still ranks among the largest in the world (Display, below).

China Aims to Rebalance toward Consumption-Led Growth

Progress Has Been Slow and Must Accelerate

Historical and current analyses do not guarantee future results.
Data through December 31, 2020
Source: Wind

On one hand, China’s rebalancing, along with potentially more moderate growth, could mean less impetus from China for EM growth rates. But on the other hand, China’s transition to a greener economy will itself require huge amounts of imported minerals, with the shift to electric vehicles and accompanying upgrades to electricity grids a notable example. And China’s leadership in several renewable technologies, particularly solar power, could also reduce costs for many EM economies.

Separate Exposure to China Is Timely

Given the extent of the divergence between China and EM ex-China, we believe it makes sense for investors to consider separate allocations to each. There are already many China-focused exchange-traded funds (ETFs)/collective funds, plus a smaller but growing number of EM ex-China ETFs/funds, and we believe the separate approach will likely become more popular over time.

Japan’s separation from the MSCI Asia indices in the late 1990s and early 2000s suggests that discrete allocations can work well. In this case, subsequent net portfolio flows to both regions remained consistently strong (and roughly proportionate), suggesting that neither Japan nor the rest of Asia were harmed by the spinoff.

A separate China allocation could benefit investors in several ways.

Breaking out the dominant market constituent would help investors focus on the full range of opportunities across EM ex-China, including the smaller markets of Latin America and EMEA. We also believe that segmentation would help investors better manage risks, resulting in more efficient portfolios. There are sizable sector differences between China and EM ex-China: EM ex-China has much greater exposure to tech hardware and semiconductors, banks and energy.* Political factors and economic cycles vary, too. For all these reasons, separate allocations would give investors greater control of their underlying exposures and portfolio risks.

China’s ascent gives it a unique status, both politically and economically. The current tragic events in Ukraine have highlighted multiple resource vulnerabilities across emerging markets, to which China is mostly immune. We think these factors will and should be reflected in investors’ asset allocations going forward.

*Source: FactSet, Goldman Sachs Global Investment Research, MSCI

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Author

Adriaan du Toit

Adriaan du Toit is a Senior Vice President and Senior Economist for Africa. He also leads AB's team of emerging-market economists. He joined AB in 2017 as a Sub-Saharan Africa economist. Prior to joining the firm, Du Toit was a Sub-Saharan Africa currency and rates strategist and director at Citigroup in Johannesburg, where he worked from 2013 to 2017. Between 2007 and 2013, he held three roles at Standard Bank in Johannesburg (rates analyst, head of Macro Research and fixed-income strategist). Du Toit started his career in 2004 as an economist at the South African Reserve Bank. He holds a BCom (Hons) in economics and an MCom in econometrics (cum laude), both from the University of Pretoria in South Africa, and an MSc in financial economics from the University of Oxford. Location: London

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