China is biggest risk to emerging markets

January 28, 2014 8:21 am

China is biggest risk to emerging markets

By Henny Sender

Tight credit and slowing growth create ripple effect across EMs

Suddenly the prospects for emerging markets have dimmed further.

On Wall Street, wary traders speculate on which countries and securities will be under the greatest selling pressure, doubtless to get ahead of the anticipated wave of selling.

Debt markets have now seen 17 straight weeks of outflows and equities 13 weeks, the latter the longest streak in 11 years, according to data from BofA Merrill Lynch.

Last spring and summer, most of the selling came from institutional investors. Now, the longer the outflows continue, the greater the likelihood that spooked retail investors will seek to withdraw their money. That will force specialist fund managers investing in emerging markets to sell in turn.

As these managers often cannot sell their most illiquid and poorly performing holdings, they sell their best, thereby triggering even more redemptions. Meanwhile, those who determine how their firms allocate funds between developed markets and emerging markets say they think cheap valuations could become even more of a bargain tomorrow than they are today.

Most sophisticated investors shrugged off last week’s plunge in the Argentine peso. Argentina is among the small group of countries along with Pakistan that have the dubious distinction of having fallen from emerging to frontier market status. They are too small to matter.

A big part of what happens to emerging markets is tied to what happens to US Treasuries. “The reality remains that emerging markets will remain under pressure so long as 10-year Treasury bond yields are rising,” noted CLSA analyst Chris Wood, given the almost perfect correlation between the two. That is why this week’s Federal Reserve meeting will attract particularly intense scrutiny.

Risks from China

But the other big factor determining how emerging markets fare is China.

“China is the biggest risk,” says Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management and author of Breakout Nations.

When China was growing at 9 per cent, as it did for the past five years on average, its demand for everything from coal to capital goods contributed to growth in all its trading partners, from Australia and Indonesia for the former to Germany and Japan for the latter. Meanwhile, sectors such as shipping battened off China’s voracious appetite for imported natural resources and intermediate goods.

Sadly, Mr Sharma’s surveys suggest countries that grow so rapidly slow markedly in the following five years, even if the base is so much larger, as is the case in China.

If slowing growth in China was the catalyst for concerns in past months, that concern has now shifted to spillover effects from a possible disruption in China’s shadow banking system. “Rising interbank rates, as liquidity is kept tight, continues to push up borrowing costs and, along with the slower growth, risks amplifying financial stress,” note economists at JPMorgan in the bank’s latest Global Data Watch.

Many regulators looking at China believe Beijing will be forced to curb the activities of shadow banking institutions, which offer investors a much higher return than they can earn in safe deposits by using their money to lend to borrowers unable to raise loans elsewhere and willing to pay far more than official rates.

If they do that by letting some institutions go under or by allowing a product distributed by a major bank to default, the consequences are hard to predict.

Contagion to developed markets

Already, as Beijing attempts to rein in its excessive credit growth, liquidity in the banks in the official sector is suffering as they too get caught in the tightening. The line between what is official and regulated and what is shadow and grey is completely blurred.

The pressures are especially stark at year end. To be eligible for new loans, borrowers have to be up-to-date with repayments on existing loans. Many of them are forced to go to the shadow banks to borrow the money to service their debts in order to extract more official loans, with their artificially low rates. If regulators clamp down really hard, they could trigger widespread panic.

There are ripple effects offshore as well, which is why Chinese banks are asking some borrowers offshore not to draw down credit lines any time soon. Unfortunately, that withdrawal of Chinese funds comes just as domestic banks in these countries are tightening credit themselves. Central banks in both South America and Asia are raising rates.

In the past the emerging markets moved in lockstep. That is not likely to be the case going forward. The more difficult question, though, is if the emerging markets appear suddenly much more risky, do developed markets’ prospects look better by comparison or worse given the risk of possible contagion?

 

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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