- Speaker #0
The European political agenda resumes after the interlude of the electoral campaign, and is unquestionably marked by another campaign, that of the snap general elections in France. The prospect of a populist victory would make the EU Commission's approach to trade with China even more delicate as the result of the anti-simsity investigation into imports of Chinese EVs came up. We'll benefit from Irina Topassery's insights into the position of China and its neighbour India which is climbing the global economic ladder at a breathtaking pace. I'm your host, Gilles Moëc, and you are listening to the Sound of Finance, an AXA IM podcast. What we found striking in the market reaction since the announcement of the anticipated French elections is that spreads have also widened in the Euro area periphery. Friday at close, the 10-year spread between Italy and Germany rose by 22 basis points from before the European elections, which is a bit less than what happened with the French spread, but that's not much. So we need a sense of perspective here, though. In the case of Italy, at 132 basis points, the spread is still much lower. than in 2019, before the pandemic struck. At the time, it was an average of 213 basis points. What likely happened was a sort of knee-jerk transmission following the usual hierarchy of the European bond markets. Very simply, if the risk premium rises on French sovereign bonds, which is the euro area's largest, best substitute to German bonds, then spreads readjust themselves down the implicit picking order. The situation would be different, of course, if there were an imminent existential threat to the functioning of the military union. But what matters most to the periphery at this stage is the continued disbursement of the next generation funds. And whatever the outcome of the early elections in France, it is hard to see how this aspect of EU policies will be put into question. Another issue, obviously, is the role of the European Central Bank should the pressure on the French and possibly the peripheral bond markets were to increase. At this stage, given the absolute level of yields, there is no need for the ECB to intervene. But a further widening cannot be excluded, of course, in case of complete fiscal paralysis in Paris, or if an administration decided to pursue a very spendthrift stance under the impetus of a new policy. The new intervention tool designed by the ECB, the TPI, implies some compliance with the European fiscal surveillance framework. This is where things could get thorny, given the unwillingness of populist parties usually to follow instructions from Brussels. But we're not there. Still, irrespective of the national elections outcome in France, European institutions need to restart after the European elections low. The results of the European Commission's anti-subsidy investigation into imports of Chinese electric vehicles would be the first item to check. Before we get into the nitty-gritty of this commission's investigation, let's simply state that the global mood music is not supportive of free trade. Protectionism will be a key in the looming US elections. The Peterson Institute has recently proceeded to estimate the macro impact of the generic 10% customs tariff which is advocated by Donald Trump. In the first approximation, this 10% generic tariff would cost roughly 1% of GDP to the US. When the authors from the Peterson Institute add the 60% special treatment for Chinese products, the cost rises to 1.8% of GDP. True, some domestic production in the US could substitute itself to Chinese imports, but this would however only have a limited offsetting impact on the purchasing power of US consumers, since these domestic producers would either come out with higher production costs than their foreign incumbents, or have a strong incentive to raise their profit margins. This explains why a customs duty triggers income transfers from consumers to the producers and the government. This is not a zero-sum game, however, since there is in any case a loss of economic efficiency. Some domestic producers can capture a rent equivalent to the difference between the new, higher price at the consumer level and the production costs. This rent is only imperfectly re-injected in the economy, as a significant share will be saved. This is one of the channels through which protectionism is socially regressive, even more so if it is supposed to fund the prolongation of tax cuts, which mostly benefited those at the upper end at the income scale in 2017. Besides, faced with higher costs, consumers will likely demand a rise in their nominal wage which will weigh on the profitability of the entirety of the domestic producers, including those who did not benefit from the protectionist tariff. Protectionism results in inefficient resource allocation. Yet, protectionism in the US is at least as much about a geopolitical rivalry with China than about the economy. The EU does not have a direct geopolitical conflict with China, but it is still difficult for the Europeans to navigate this de-globalization era. A de facto closure of the US market to Chinese producers in case of a 60% levy would incentivize them to look at Europe as an even more crucial market, flooding the EU with products which most national European governments consider as strategic. This would be even more damaging if the Chinese currency were to depreciate not just relative to the US dollar, but also to the Euro, which would make sense since Chinese products would face a higher tariff than European ones. Then the protectionist tendencies in Europe would be spurred further, and the spiral we described for the US could be found in the EU as well. Yet, European producers continue to adopt a complementary approach to Chinese supply, while often still relying on Chinese demand for their own products. This is a major difference with the US. A foreign issue for the European Commission is that European carmakers are relying on Chinese production for some of their own low-end electric vehicles for sale on their domestic market, or even some high-end ones, while collaboration with Chinese groups in battery production, including on European soil, is continuing. It is quite telling that the European Commission's investigation was launched ex officio, and not as the result of a complaint from an EU producer. A difficulty for the EC will lie in the fact that there is at least one European company among the top 15 recipients of subsidies from the Chinese government for developing battery-powered vehicles. Besides, they would have to consider the retaliation risks from China, with potentially significant adverse consequences for carmakers, in particular in Germany, for which the Chinese market remains critical. Ultimately, the Commission opted for a very targeted approach, tabling very granular countervailing measures specific to the various Chinese companies in scope and distinguishing between those which cooperated with the investigation from those who ignored the Commission's entreaties. The tariffs will range from 17 to 38%. European carmakers producing electric vehicles in China will face a 21 duty, as well as American carmakers. We are still within the realm of targeted measures, rather than the blanket approach, and this is only the beginning of a fairly long process which will give time to negotiate with China. Indeed, the final proposition will be made by the Commission only in November this year, opening to a vote by the European Council, for which a qualified majority of 15 countries representing 65% of the EU's population would be requested to overturn the Commission's offer. Unsurprisingly, the Chinese government's reaction was negative, as per Ministry of Commerce communique stating that, I quote, China is highly concerned and strongly dissatisfied. Yet, no tit-for-tat retaliation has come out so far. Last Thursday, a spokesman from the Chinese Ministry of Commerce mentioned the possibility for Beijing to bring the matter to the WTO, which given the long paralysis of this institution would have very little practical consequences. We continue to think that unlike the US-China's rivalry, there is still space for a decent trade relationship between the EU and China. An issue though for the EU is that given the pressure from populist policies, and not just in France, it needs to demonstrate that attachment to free trade can go hand in hand with a more muscular approach to bilateral relationships, while China needs an outlet for its production while its domestic engines of growth are stalled. This is a very, very fine line to tread. To find our own way, it's always useful, if not essential, to have the support of Irina Topa-Serry, our wizard on emerging markets. Hello, Irina. How are you?
- Speaker #1
Hello, Gilles. Thanks for having me. I'm fine.
- Speaker #0
Great. Okay, so a first question to you. Quite simply, how can China find a sort of workable strategy if domestic demand continues to be stuck and export markets are increasingly closing, at least the US, but also as we have just discussed, potentially Europe?
- Speaker #1
Now, there is no easy solution. And I have to say that China is kind of caught into a bad timing. Let's say kind of an unfortunate sequencing of events. As you were saying, you know, China is struggling today with its ailing property market. It's already been a couple of years now, and probably it'll still continue for some other years. And in that aspect, they will have kind of a gap in the GDP that needs to be covered. So their way of looking at it, right now is they aim to stabilize in a way the old driving forces. So they will on the short run replace this real estate investment with infrastructure or social housing construction, things that they know how to do. But they were definitely counting on roaring ahead with exports. It's been some time actually that Chinese authorities have identified the over-reliance of this old economic model of China based on external demand. And they actually even named this objective of achieving greater self-reliance. To be honest, it was starting already to be visible in terms of imports reliance, but it's fair to say that China remains very much dependent on foreign demand. And I think they know quite well, they look at past experience, they've seen Japan, they know, you know, it's difficult to sustain extreme export positions. And, you know, China today is the first exporter in the world. It has roughly 15 percentage world export share. It's the top trading partner of more than 120 countries globally, but it has failed to move up. on the value chain, like Japan did back in the 90s. So the timing is quite bad. And President Xi was identifying this, I quote him, new quality productive forces as the future of the economic model, and you name it, it's batteries, it's EVs, it's solar panels, which were quite well responding to the current global demand for energy transition. But it's exactly there where the current hostility of the international environment is concentrated as we speak. So I think we all have in mind the solar panels of the 90s and how that made China become the sole producer almost of the world of the solar panels. And I think on the Western side, we're quite worried that this will happen again on the electric vehicle, whether it is EV pure or hybrid or so on and so forth. And it's true China today is producing 70% of the... world electric vehicle vehicles in the world but it's mostly buying them domestically it's using it domestically whereas less than 15 percentage of the production is exported but they definitely count on exporting more and i think the current discussion hasn't changed much the needle because we actually see corporates purchasing car carrying vessel fleets so they do intend to export not because they think they're domestic market is not able to absorb, but because EU export markets are still quite attractive with better margins. I remind you that the local market is in a fierce competition and it's getting quite complicated. Prices have been falling today. You should know that most EVs today are priced below an internal combustion engine in China, which made its adoption quite great. So, in absence of those markets, you know, they can turn to others. They do it as we speak. They look at emerging markets. They're already quite big in terms of sales in Indonesia, Thailand, or Brazil, let's say. they look into Africa, Middle East and Eurasia. But again, here we talk about very low penetration, affordability is lower. So it's not quite there where they think they could find the end purchaser. To be honest, the only solution is the real one, is to aim at developing this domestic demand-driven economic model. They need to reform. and they need to start building the social safety net that allows consumers to look to the future in a more confident way. And to be honest, there's not much of that as we speak.
- Speaker #0
Yeah, indeed. And in a situation where public debt in China is rising quite fast, actually, the room for maneuver to do so is probably falling fast. But that's for another podcast. Now, It seems that the West is squarely obsessing about China. It used to be the US, but it's moving to Europe increasingly. And while we do that, aren't we missing a key development in the world economy, which is the emergence of India? And a very simple question, but I guess with a not-so-straightforward answer is, could India be China 2.0?
- Speaker #1
Well, we won't be able to miss it just because India is so big. You know, we're talking about the fifth largest economy in terms of nominal GDP terms. Actually, last year, India overtook UK's position. And if you look at the IMF projections, India is set to move above Germany and Japan. And it would become the third largest economy by 2027, 2028, which is virtually tomorrow. So India has already... You know, overtook China as the most populous nations of the world last year. We're talking about 1.4 million inhabitants, this huge young working age population, which will drive this economic growth. But I think it's quite interesting that as of next year, we're entering into a new era where Chinese projected growth is to fall below the EM average, meaning that China is a drag now for the EM average, will be at least as of next year. while India is expected to deliver the steady six and a half average growth in the next years. And, you know, China goes from, let's say, five percentage this year towards 3.3 percentage growth at the end of the decade. So Modi has been in power since 2014. He's been reelected as we speak. And, you know, the economy grew on average, let's say, just a tad below seven percentages if we exclude the 2020-2021, you know, COVID years. So... He quite well managed to develop a strong service sector, especially on the export side. Today, India has 8% of the global market share of services exports. Many FDIs have been attracted, certainly less than China, but more like, let's say, Brazil, which makes the country less vulnerable on external financing needs. Financial markets showed this great performance, whether it's equities. And as we speak, Indian bonds are about to be included in the EM local bond markets. But, but on PPP per capita GDP basis, India remains much poorer than many of its EM peers. We're talking about below $10,000 per capita, you know, Turkey, it's around 35,000 and China should be around $20,000. So, yes, 20, I think the figure was that I came across was 250 million people escaped poverty over the last decade, but poverty remains high 13% of the population still lives. below $2.15 per day. There were 40% back in 2004. You know, inequality is another issue. It actually kept rising in spite of strong growth. It's quite difficult to absorb this demographic growth into the labor force. This internal migration story of most emerging markets, you know, transitioning, converging, is slower in India where agricultural sector still accounts for a much larger share of employment and GDP. So just keep in mind, agriculture is around 16% of the value add and 45% of employment. So it's not going to be China. It's a different story.
- Speaker #0
Okay. Irina, is there something I did not ask you about this issue that you would be burning to say?
- Speaker #1
Well, no, I think the only thing about India, I wouldn't want to finish on a negative note. It's a great story, right? It's a great story. I think it will be focused on green industries, on services still. It's quite difficult today. And I think it's a valid question to ask, is there room for another China? I think it's sensible to ask. It has the story of it's difficult to replicate such an export-oriented. industrialization prices that we've seen in China and even other East Asian emerging markets. By now, manufacturing has become... much more capital intensive and less labor intensive. Globalization, as you said, it's not living its best days. And there is still this question of AI or tech, whether that can be a boost to productivity or a threat to employment substitution. And we haven't got the answer of this question yet. But just keep in mind that demography is always seen as a bliss, but it's quite challenging to absorb into a... The labor force, this young generation, just look at the projections by 2050. In order to maintain the current labor participation force, India has to absorb 330 million people. That's Turkey, Mexico and Vietnam all together. So yeah, Modi has a 2047 vision, which is that India achieves a developed economy status by the centenary of independence. That is a $30 trillion economy from $3.5 trillion now. That means an average nominal growth about 10%. So maybe it's too much, maybe it's not quite that. But what we know for sure is that we have several years in front of us where India will quite catch our attention and will be an interesting place to focus on.
- Speaker #0
So no China 2.0, but just India 1.0. And India 1.0 would definitely be anyway a powerful change to the way our world economy operates, right?
- Speaker #1
Indeed.
- Speaker #0
Thanks a lot, Irina, for your enlightening comments, as usual. And thank you all very much for listening. The Sound of Finance is an AXA IM podcast. I'm your host, Gilles Moëc, and I look forward to catching up with you next month for a new economic conversation. In the meantime… You can of course follow our weekly analysis in the Macrocast, the link to which is in the episode description. Be safe! This marketing communication does not constitute on the part of AXA investment managers a solicitation or investment, legal or tax advice. This material does not contain sufficient information to support an investment decision. The value of your investment can fall as well as rise and you may not get back the amount originally invested. Past performance is not a guide of future performance.
