Geopolitical risks for the economy and investments

The world has always been challenged by the dynamics of geopolitics. The nature and magnitude of associated conflicts may transition and manifest across varying contexts but, broadly speaking, geopolitical risk is ever present.

The fierce competition between the powerhouses of the East and West has been watched closely by many. The trade war between the US and China, characterised by tit-for-tat tariffs, continues to disrupt major global supply chains with greater levels of exposure to the two while threatening to hinder global economic growth, albeit the extent to which is difficult to determine. Numerous attempts to assess the impact and cost of the trade war between the US and China have been undertaken and recent research by the International Monetary Fund estimated the combined effect of the tariffs announced in 2018 and the recently announced tariffs this year could lower global GDP by 0.5% in 20201. However, not all market participants are worse off as a result of the disputes between the US and China. While the impact of the trade war has affected the financial markets, primarily through its effect on investor sentiment, more broadly there could be opportunities for some nations to benefit from a potential diversion of trade, particularly for economies who have the competitive capacity to replace US and Chinese firms2.

Chart 1: Trade gap between US and China (as of May 2019) 

Trade gap between US and China

Source: United States Census Bureau

The open rivalry and strategic competition comes as China makes progress towards achieving its major long- term goal in becoming a “moderately prosperous country” by 20203. As part of this strategy, China aims to become a “global innovation power in science and technology”4 along with several other goals relating to sustainability of its growth. Some of the actions China is alleged to have taken to achieve this, including allegations of inappropriate transfer of IP and technology, have raised concerns over national security for the US. This issue has been a driving force behind the protracted trade negotiations between the two countries with negotiations stalling on matters related to restrictions placed on some of China’s largest players in the tech industry. The tensions between the two nations are likely to remain while the possibility of a trade deal is still unknown.

Recently the People’s Bank of China (PBoC) let the yuan depreciate in its daily rate fixing, to be above the key USD/CNY 7 mark5. Key reasons for the RMB depreciation is suggested to be in support of growth in light of the impact of US tariffs on China. Recent measures by China to combat US tariffs through a devalued yuan has soured the outlook for a trade deal.

While China is caught in a challenging set of negotiations with the US, it is facing unrest within its own country. In 1997, when the UK handed Hong Kong over to China, a One Country, Two Systems Framework was established which set out civic freedoms and a high level of autonomy, including judicial independence. Recently proposed amendments to Hong Kong’s Fugitives Bill to allow extradition of fugitives not only to China, but to any jurisdiction in the world with which the territory has no existing formal agreement, has led to protests in the streets of Hong Kong over concerns and fears that the law could be abused by China for political or commercial reasons.

What began as a peaceful protest against an amendment to Hong Kong’s Fugitive Bill has now turned into the revival of a deeper rooted issue reminiscent of the 2014 Umbrella Movement. While it is an example of China’s assertion of power within its own borders, it too is a demonstration of a clash of political ideology and symbolic of the gradual reclaim of power that has long been vested in the West.

Changing geopolitical relationships is also clear in the pending UK exit from the European Union (EU). The outcome remains more uncertain yet following the resignation of May only months before the Brexit deadline. Oxford Economics’ modelling of the economic implications assumes the base case as the UK continuing its EU membership. In this model, all scenarios show a degree of trade destruction in which UK trade volumes decline as a share of GDP, reflecting the increased cost of trade between the regions, encouraging consumption of domestically produced goods instead. In the worst case scenario, compared to the base case, exports fall by as much as 8.8% and imports by up to 9.4%. The loss contributes to a 3.9% loss of GDP when factoring in events, such as a drop in labour productivity and foreign direct investment6.

Currently, the EU Single Market and Customs Union provides the deepest possible economic integration of a region and deviation from this standard involves economic costs7. While this is occurring, some EU countries are still recovering from the crises of recent years. While the Bank of England’s Financial Stability Report affirmed that UK Banks are deemed resilient enough to withstand a disorderly no-deal Brexit, even given the added strains of trade tensions and an economic downturn, it is still expected that a range of UK assets will be negatively affected8. The European Central Banks Financial Stability Review maintained a more cautious tone citing signs of vulnerability across the credit market spectrum9.

The rise of widespread geopolitical issues comes at a time when the world economy is slowing. The uncertain impact of potential US tariffs and the course of the UK’s pending divorce from the EU continues to introduce greater levels of volatility into the markets. Consumer confidence and financial sentiment has dampened alongside the growing risks to the current economic expansion. Central banks are treading cautiously, but are mindful of the already low interest rates and the high levels of debt. As the IMF highlights in its most recent report, failure of nations to cooperatively address sources of dissatisfaction would further destabilise a slowing world economy10.

1. IMF, 2019 https://www.imf.org/external/np/g20/pdf/2019/060519.pdf
2. United Nations, 2019 https://unctad.org/en/pages/newsdetails.aspx?OriginalVersionID=1989
3. World Bank, 2019 https://www.worldbank.org/en/country/china/overview
4. Office of the United States Trade Representative, 2019 https://ustr.gov/sites/default/files/enforcement/301Investigations/301%20Draft%20Exec%20Summary%203.22.ustrfinal.pdf
5. The People’s Bank of China, 2019  http://www.pbc.gov.cn/en/3688110/3688172/3871642/index.html
6. Oxford Economics, 2019 https://www.oxfordeconomics.com/brexit
7. European Network for Economic and Fiscal Policy Research, 2017 https://www.ifo.de/DocDL/EconPol_Policy_Report_04_2017_Brexit.pdf
8. Bank of England, 2019 https://www.bankofengland.co.uk/financial-stability-report/2019/july-2019
9. European Central Bank, 2019 https://www.ecb.europa.eu/pub/financial-stability/fsr/html/ecb.fsr201905~266e856634.en.html#toc3
10. International Monetary Fund, 2019 https://www.imf.org/en/Publications/WEO/Issues/2019/01/11/weo-update-january-2019


Next up: US China trade war – where to next?
  

How did the US China trade dispute start, what happens next and what are the implications for Australia.

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This article was prepared by BT, a part of Westpac Banking Corporation ABN 33 007 457 141 AFSL and Australian Credit Licence 233714 (Westpac). This information is current as at 15 July 2019.  This article provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such. This information does not take into account your personal objectives, financial situation or needs and so you should consider its appropriateness, having regard to these factors before acting on it. This information may contain material provided by third parties derived from sources believed to be accurate at its issue date. While such material is published with necessary permission, no company in the Westpac Group accepts any responsibility for the accuracy or completeness of, or endorses any such material. Except where contrary to law, we intend by this notice to exclude liability for this material.