The Impact Of Brexit On China

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Includes: CHN, CN, CXSE, FCA, FXI, FXP, GCH, GXC, JFC, MCHI, PGJ, TDF, XPP, YANG, YAO, YINN, YXI
by: Red Pulse

Summary

Trade with UK and EU.

Foreign direct investment.

Market economy status negotiations.

Britain's unexpected decision to leave the EU will cause a ripple effect in the global economy that will be felt years from now, affecting cross-border trade agreements and foreign direct investment strategies, leaving Britain with diminished influence over European affairs and trade relations. China is likely to benefit from the opportunities inadvertently created by this disruption.

London, the second largest offshore RMB hub after Hong Kong, was chosen earlier this year to issue the first RMB denominated sovereign bond outside of China. The city is one of fifteen offshore RMB clearing centers and plans are underway to launch a London-Shanghai stock connect exchange. The UK exit creates pressure to establish another RMB hub within the EU in the future, as London's position as a financial hub connecting to Europe is now under question.

China will get a boost in its trade negotiating power as a result of the UK's exit. The UK has emerged as China's second-largest trading partner in Europe, with trade volume increasing from $63.1 billion to $78.5 billion between 2012 to 2015. German Chancellor Angela Merkel commented "there must be and will be a palpable difference for those who want to be in the European family," indicating trade relations with Europe will be strained.

When this happens, China will be negotiating from a strong position as it seeks to bolster Sino-UK trade relations. Furthermore, exports to the UK account for only 0.5% of China's GDP, and Britain lost its leverage as a powerful advocate for China within the EU. This all leads to China being able to sign more favorable trade agreements with the UK for the foreseeable future.

While China may enjoy trade gains with the UK, trade with Europe as a whole may suffer. Europe is China's largest trade partner, and the shock from Brexit will almost certainly cause a continental slowdown. The immediate fallout from Brexit was a swift depreciation of the Euro. This depreciation created a relative price increase for foreign goods, which may decrease demand for Chinese products if PBoC or ECB do not react quickly with monetary policy actions.

China's trade with the EU in the medium run will be greatly impacted by the EU's impending decision to grant market economy status to China in December. Under the current WTO agreement, Europe can compare prices of Chinese goods to a third-party country when deciding to levy tariffs on Chinese imports. If granted market economy status, Europe would have to recognize prices in China as being determined by a free market, and would lose the ability to make the third-party comparison.

With the UK no longer acting as a powerful China ally in the EU, the decision may have less chance of falling in China's favor, as there are concerns over China's impact on the European steel industry. A positive decision would also drastically lower the price of Chinese goods and materials in Europe, which would help China lessen its current overcapacity issue, but would cripple some European firms unable to compete with lower priced Chinese goods and materials.

Chinese companies will now have to revise their foreign direct investment strategies now that Britain has left the EU. The UK was often used as a staging ground for Chinese firms to enter the European market, with an added benefit of itself being a strong domestic market for Chinese firms. Both of these advantages will likely be compromised, with some analysts referring to the Brexit decision as a "do-it-yourself recession." Chinese firms will have to look elsewhere, perhaps increasingly to Germany, for an influential partner and entry point to the greater European market.

The UK is still an appealing market for investment and there will certainly be savvy Chinese firms that seize the opportunity to scoop up foreign assets at a discount. Part of China's economic transition is the development of innovative domestic brands and products, evolving well beyond the copycat model. The Global Innovation Index ranked the UK as the second most innovative country in 2015.

The common focus on innovation, coupled with potentially depressed asset prices in the UK, may lead Chinese companies to ramp up their acquisitions of UK companies and assets. Chinese investors have also shown an affinity for real estate in developed English speaking countries with strong education systems. Juwai.com is a leading platform for Chinese investors to find foreign properties. Interest in UK properties on the site has doubled in the first week following Brexit.

De-globalization by the world's fourth largest economy will create inefficiencies by increasing barriers to entry and will weaken consumer and investor confidence, with knock-on effects that will spread far across the globe. That being said, periods of volatility and economic transition often present unique opportunities. Chinese companies are well positioned to benefit by continuing their accumulation of foreign assets at favorable prices, while China as a whole strengthens its economic position by negotiating with the EU and UK on a separate basis going forward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.