China’s conquistadors are marching across Latin America
China is rapidly increasing its influence over Latin America’s economies. This will bolster growth and development, creating opportunities for long-term investors, says James McKeigue.
When two elephants fight, it's the grass that suffers. So says an African proverb. But in Latin America the grass seems to be doing well out of the jostling between the US and China. In August El Salvador became the latest in a string of central American countries to switch diplomatic relations from Taiwan to China. In Panama, US protests managed to thwart the opening of a new Chinese embassy on the mouth of the canal.
But with 26 co-operation agreements between the two countries signed in the last year, this merely delays the inevitable spread of Chinese influence over Panama. China's growing clout is evident not just in central America, but in South America too. In south Argentina it has built a controversial space station to be operated by the military. It will serve as a strategic monitoring post. For lovers of geopolitics it's fascinating to see two superpowers vying for influence in a region a tussle reminiscent of the Great Game between Britain and Russia in the 19th century. But for investors the underlying economic story is more interesting. China is gaining political influence because during the last decade it has surpassed the US as the most important trading partner for the major Latin American economies.
It's also become a major investor, with Chinese firms making the most corporate acquisitions in the region. Finally, its state-to-state lending has also rocketed, and is now a bigger source of financing to Latin American governments than the World Bank and regional equivalents. China's emergence as a major player in Latin America is great news for the region's economies. It reduces dependence on the US, diversifies its sources of finance and investment and opens up new export markets. That's positive for investors in Latin America as it will boost economic growth and asset prices over the coming decades.
Why China is so interested in Latin America
In densely populated east Asia, China is hemmed in by nuclear Russia to its north, fellow rising power India to its west and US-backed Japan to its east. For the world's most populous country and soon-to-be largest economy, a key long-term goal is to ensure adequate supplies of energy, food and industrial metals. It has done an excellent job of gaining access to commodities in southeast Asia, but Latin America is uniquely abundant in all three.
In energy it has around 20% of the world's oil and gas reserves but less than 10% of its population, making it a natural exporter. In agriculture it already has a dominant share in key global export markets: 60% of world soybean exports, 44% of beef, 42% of poultry, and 33% of corn. Moreover, with 33% of the world's freshwater supplies and the most potential arable land on the planet, there is ample scope for these figures to grow.
The continent is also rich in base metals, with the world's largest reserves of copper, and around a quarter of zinc reserves. It also looks well placed in metals with more cutting-edge applications. For example, 54% of the world's reserves of lithium essential for the batteries that will power the boom in electric vehicles can be found in the "lithium triangle" of Bolivia, Chile and Argentina.
Going beyond the commodities cycle
China began beefing up its presence in Latin America in around 2005, as the commodity boom kicked off. But the economic relationship will outlast the vagaries of particular commodity cycles because the region is the only sustainable source of the essentials that China needs to maintain its economic growth.
Of course, this isn't the first time that a rising superpower has taken an interest in Latin America. But there is a difference this time. Unlike previous changes of the guard in the region when Britain replaced Spain as the most important international trade and investment partner at the beginning of the 19th century, or when it was then supplanted by the US after World War I the outgoing incumbent, the US, isn't going anywhere. As a result, the region will benefit from the sustained attention of two competing investors over the coming decades.
Deepening trade links
The most impressive aspect of China's rise in Latin America is how quickly it has happened. It has been based on three pillars: trade, investment and finance. At the turn of the century Chinese economic interaction with the region was negligible. Now it has usurped the US as the main trading partner of Brazil, Latin America's largest economy. The $76bn of goods traded between them make up a fifth of Brazil's total trade. In Chile and Peru, where the bilateral commerce with China is worth $34bn and $21bn respectively, it accounts for around a quarter of each country's total international trade.
Unsurprisingly the main Latin American exports are commodities, with Brazil sending soybeans and iron ore, and Chile and Peru mainly copper, while in return Latin American consumers receive a mixed basket of Chinese cars, electronics and industrial equipment. The pattern is repeated across South America. In Central America, which is less rich in commodities, trade is nascent but expanding rapidly. The only exception is Mexico, whose world-leading manufacturing and free-trade deal make it a genuine competitor to China in the US market.
The arrival of this new, massive trading partner has created both winners and losers in the Latin American economies, but on balance it has been good news. The commodity exporters tend to have a trade surplus with China, which generates hard currency earnings that have been reinvested in the local economies. Mexico has a trade deficit with China but many of these imports are inputs for manufactured goods that are later re-exported to the US.
An investment spree
The second thing China brings is investment. The Economic Commission for Latin America and the Caribbean (ECLAC), a United Nations regional commission, estimates that Chinese buyers accounted for 41% of the internationally funded mergers and acquisitions (M&A) in Latin America in 2017, worth around $18bn. To put that buying spree in perspective, US firms were behind just 6% of M&A activity.
What's really remarkable is that Chinese foreign direct investment (FDI) to Latin America increased in 2017, in stark contrast to a sharp drop in Chinese FDI to the rest of the world. According to ECLAC ,Chinese FDI worldwide fell by 36% as the government decided to "better align FDI flows with the country's strategic priorities". Remember, it is mostly state-owned companies making the Chinese acquisitions, so they reflect government policy.
The most famous of the strategic priorities is the "One Belt, One Road" programme, which involves building billions of dollars of infrastructure abroad to improve trade links to China. In other words, the type of investments China makes in Latin America fit with the country's long-term game, which is why FDI to the region remains strong. Indeed, ECLAC's analysis shows that Chinese FDI in Latin America is almost entirely focused on commodities and infrastructure, unlike in other places, such as Europe and the US, where it concentrates more on technology.
The third key element of China's advance is state-to-state financing, which it implements through the China Development Bank (CDB) and Exim (Export-Import) Bank. Before 2006 these two banks had barely lent a peso to Latin America. But since then they have made loans worth more than $150bn, estimates Boston University's China-Latin America Finance Database. That's far more than comparable Western institutions, such as the World Bank, managed in the same period. The distribution of these loans reflects Chinese priorities in the region. The key beneficiaries were oil-rich Venezuela with more than 40% of the total, Brazil at 20% and Argentina and Ecuador with roughly 10% each.
Boston University's Kevin Gallagher notes that the loans are meant to support China's national interest, "including Beijing's domestic reform agenda and complex energy security calculus. The policy banks therefore continue to offer oil-backed loans to Latin American nations, and to support projects that employ China's excess capacity, among other objectives". But they are popular with Latin American governments as they offer an alternative form of financing to "meddling" institutions such as the World Bank and fickle international bond markets.
China's help comes at a price...
Many Latin American governments are nave about China's growing political and economic influence. Several Latin American countries have legitimate complaints about their historic treatment at the hands of the US, but if you look at, say, Venezuela, it has simply swapped one rich foreign backer for another. In the same way that the US propped up various nasty Latin American dictatorships in the 20th century, China has lent Venezuela $5bn, which will prop up the cruel government of Nicols Maduro. Another problem is that the terms of Chinese loans are far less transparent than an international bond issue, which isn't ideal for a region cursed with corrupt elites. Meanwhile we have seen several grand Chinese infrastructure projects, such as the Transoceanic Nicaraguan Canal, announced but never realised.
On a corporate level, China has proved a fierce competitor for Latin American manufacturers, decimating domestic industries such as Argentine shoes. I have recently returned from Costa Rica, where pineapple growers are suffering from a supply glut following their unsuccessful attempt to break the Chinese market.
They boosted production on Chinese price promises that didn't materialise and found that when the deal went sour they were in no position to negotiate. As one producer told me, "We found out that in China we are nobody." China's demand for Latin America's commodities will make it harder for the region to diversify its economies. It's hard for small Latin American countries to beat a giant like China.
...but the overall impact is positive
Despite these qualms, I am positive overall on the rise of China in the region. One reason is that all of the challenges listed above were already inherent in Latin America's relationship with the US. Now at least there are two giants to negotiate with. My optimism is shared by Latin American leaders.
In the rich West the recent US arrest of the CFO of Chinese telecommunications firm Huawei (see page 12) shows Chinese investment is increasingly viewed with suspicion. But in Latin America it is still welcomed with open arms. It is telling that even when new leaders come to power, such as Mauricio Macri in Argentina or Lenn Moreno in Ecuador, they may renegotiate their predecessors' China deals but they don't rip them up. A second important point is the vast market for Latin American goods created by China's ascendancy, its deepening trade links with Latin America and the infrastructure projects it is building in the region. Some clear winners in the long term are the traditional commodity exports that powered Latin America's golden decade in the first part of this century. Now, on top of that, you will see agro-industrial products, such as Ecuadorian shrimp, Peruvian berries and Chilean wine, all starting to find their way into Chinese homes.
We can also expect a surge of Chinese tourism in Latin America, which counts as an export for the region. Finally, there is the financial angle. Latin America has traditionally been starved of capital, which has led to a lack of investment in infrastructure. China's desire to build the roads and ports needed to facilitate trade, plus its need to use up its spare capacity now its own building boom is slowing, will help Latin America finally fix its infrastructure deficit, giving a big boost to economic productivity. All this amounts to a compelling long-term outlook for investors in the region. We look at the best ways to play the theme in the box below.
The stocks and funds to buy now
When it comes to funds, I would recommend the BlackRock Latin America Investment Trust (LSE: BRLA). This trust is heavily skewed towards Brazil, which accounts for 73% of holdings. That suits us since the majority of China's Latin America trade and investment is focused on Brazil. The country is rich in the agricultural, mineral and energy assets that China wants to import, while its atrocious infrastructure means that there are plenty of projects for China to develop.
I have interviewed this trust's manager, Will Landers, who despite his British-sounding name is a Brazilian, several times and have alwaysbeen impressed by his understanding of the region. The trust's biggest holdings include Brazilian iron-ore miner Vale, oil firm Petrobras, and various local banks that should all benefit from China's growing presence in Latin America. The trust currently trades at a 15% discount to net asset value, compared with a five-year average discount of 12.9%, making it an attractive time to buy in. It also yields 4%, so you can earn income as you wait for the long-term drivers to increase the price.
If you're feeling more adventurous then there are several stocks well placed to benefit from the rise of the Chinese Dragon in Latin America. Chilean fertiliser-maker Sociedad Qumica y Minera de Chile (NYSE: SQM), mines potassium in the Atacama Desert. It turns about two-thirds of what it digs up into types of fertilisers while the rest is used for lithium batteries or industrial chemicals. So it is linked to two categories of assets that China is desperate to get its hands on: agricultural goods and metals. It's little surprise then that Chinese fertiliser firm Tianqi recently spent $4bn on a 24% stake in SQM. US analysts covering the stock rate it a strong buy, expecting a 15% share-price gain over the next 12 months.
One of the key sectors that should benefit from the increased economic interaction with China is infrastructure. At present Latin America spends less, as a percentage of GDP, on infrastructure than anywhere else in the world apart from sub-Saharan Africa.
ECLAC estimates that its infrastructure investment needs to rise from 2% of GDP to 6% if the region is to close its infrastructure deficit.It probably won't reach that target, but there will certainly be a boost from the new relationship with China. This could be from direct Chinese financing, or because new trade demand from China creates the economic rationale for a better roads and ports.
Local cement producers are a good way to play the boom as they tend to be extremely competitive in their home markets. Cementos Pacasmayo (NYSE: CPAC), which has three plants in Peru's less developed north, should benefit as that country upgrades its infrastructure.
Steel may seem a contrarian investment, given that a glut of Chinese steel has pushed down global prices. Yet regional steelmaker Ternium's (NYSE: TX) strategic presence across Latin America's biggest economies mean it should benefit from the upswing in infrastructure construction. The stock has gained 52% since I last tipped it in MoneyWeek in August 2012. Back then it was on a price-earnings (p/e) ratio of seven; now it's even cheaper on a p/e of 4.5.