Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

EM Volatility Has Just Started, China Is The Big Unknown For 2014.

|Includes:ASHR, CHINA, iShares MSCI Emerging Markets ETF (EEM), EMB, FXI, GXC, VWO

It has become a fad to worry about crisis nowadays, especially in Emerging markets. We have seen significant currency volatility and meaningful depreciation of many EM currencies. I would argue that this is actually good for those economies as it is helping them adjust economic imbalances domestically and rebalance the growth mix. The challenge in EM for 2014 will be the rebalancing of China (which does not have the same flexibility as other EM economies).

Stanley Fischer in his analysis of Asian crisis had concluded that the best way to avoid an EM crisis was to have flexible exchange rate regime (an effective escape valve when imbalances build up). In the midst of the current global angst over EM fx volatility, what is getting missed is the fact that FX depreciation is helping economies stabilize and improve their once deteriorating current accounts (India, Indonesia). Does that imply that we are not likely to see a crisis? Maybe, yes, at least the Fragile five seem to be taking the bitter pill and adjusting. Is there any other weak link - the big question in EM - China? Is there a benign path for the imbalances in the economy to readjust? Looking at the currency and external account one would be hard pressed to find a weak link. But, the seeds of external risk have been building up over time. Over the last decade China has been effectively running a managed currency, firstly pegging it to the dollar, subsequently letting it appreciate in a managed and predictable crawl over the last five years (as political pressures & noise from the US became extreme). This has sown the roots of a potential mega problem - a one way bet underwritten by the PBOC.

China may be entering 2014 with having to tackle a unique situation of twin crisis, one on the domestic front - fallout from past overinvestment resulting in falling capital productivity and rising risk to financial system and on the external front, a potential reversal of hot money inflows as the Fed enters Taper mode.

While a lot of people recognize the risk in China, the most common defence against a financial meltdown is the belief that it is a domestic issue and something that government will have to tackle over time, without any contagion to global financial markets, as there is no direct foreign currency exposure. A recent article in Forbes argued on the same line. The huge forex reserves that china holds (close to $3.82tr on last count) gives a lot of comfort that financial sector problems in China can be internally contained. What is conveniently missed is the fact that as per PBOC, China also has $3.25tr of overseas claims (FDI+Financial). In the next two paragraphs we look at these issues.

Firstly, contrary to belief, over the last few years, China has built up a big short term forex liability. Why it has escaped the attention of financial pundits is because it is not direct, but indirect cross border exposure built through offshore financial centers. Analyzing BIS data, the trend which is worrisome is the fact that while globally, cross border bank exposure declined in most economies globally, the rate of growth and magnitude of increase was dramatic in China. This flies in the face of popular notion that China does not have a foreign currency debt issue. The last available data (Q3 2013), put the size of foreign bank claims on China at $1tr, and the most worrisome part is the fact that >60% is short term, of less than one year duration ( Second concern is the pace of growth - in the 1st nine months of 2013, forex claims by banks on China have grown by 51% (after a muted 6-7% growth in 2012). Anybody who has been involved in HK financial market over the last couple of years will highlight the fact that with tightening credit conditions in domestic market in China, a lot of companies (especially in the property sector) turned to offshore funding, something highlighted in the following FT article from mid 2013.

As an investor, what worries me in addition to cross border financial liability, is the widely held belief among a lot of corporates in Taiwan, HK and some parts of Asean that the Chinese Rmb is a one way bet (it will only appreciate). This has led to many companies in Taiwan borrowing locally and lending the capital to their operations in China (as FDI) not just to invest but also to make financial gains. It is not uncommon to find a Taiwanese assembler making operating losses in China, but declaring overall profits due to financial gains. I saw this same hubris in Thailand, before the Asian Financial crisis (Thai companies believing that borrowing cheap capital overseas and using that in high interest rate environment in Thailand was risk free as the bank of Thailand will defend the exchange rate). Now this brings me to the main fallacy, the PBOC has $3.82tr of reserves, so the risk from FX contagion is low (everybody believes Rmb is a one way bet).

Given the size of reserves and with close to half of it in US treasury, it is not apparent how China can unwind its reserves without causing an upheaval in treasury market. So, if a China crisis needs the use of FX reserves to contain it, by default it is going to create a stir in US bond market. Secondly, a central bank has two sides of its balance sheet - while FX reserves form asset side of it, what a lot of investors do not realize is the fact that two thirds of FX reserves are covered by banking system Reserve Requirement Ration (NYSE:RRR) ( With widely reported fragility in the banking system, rising NPL risk from local government lending, wealth management products defaulting, the free availability of a fifth of system deposits is suspect, especially in an environment where policy makers are seeing a tight liquidity situation domestically.

This brings me back to the initial observation, the lesson from Asian financial crisis was that flexible exchange rate regimes provide a cushion to policy makers. The one EM which does not fit that bill is China - it cannot depreciate the currency without a political backlash, the corporate sector has accumulated significant short term forex liability which could be at risk from capital flight as financial markets adjust to the new world of Fed Taper. While FDI is generally sticky, not all FDI in china is project related and there is rising short term speculative capital going into China.

So, what happens if there is capital flight out of China - PBOC to ensure stability will have to dip its finger into its Reserves and domestically release RRR. But this brings a fresh dilemma, policy makers are focused on tackling the monster of shadow banking and getting it under control by tightening lending standards, refinancing contingent risk emanating from LGFV & WMP maturity without loss of system confidence. The last thing they would want is to change stance on liquidity and loan to deposit ratio (key to keeping RRR stable), shrink central bank balance sheet, in a fragile banking system, without deposit insurance. I can see the same potential dilemma which a lot of Asian economies faced going into the 1997 financial crisis, an impossible policy choice - a small policy error on one front could precipitate a domino of events.

Lot of investors have been calling for Armageddon in China for some time and getting egg on the face. None of those issues have gone away, but, every year a new one is added to the list of crisis indicators - excessive investment, property bubble, local government financing vehicles, wealth management products, falling capital productivity, unrecognized system NPLs. Maybe 2014 will add just another one, capital flight and FX volatility but investors in China also need to keep in the back of their mind - "too big to fail" syndrome, larger the size of a problem, higher the risk of a crisis. Nobody wants it, but a default in China will not be a surprise as this article highlights (

For investors buying ETFs to get China exposure (GXC, MCHI, PEK, FXI) the macro risk is worth keeping in mind as they are in effect getting exposure to the financial system in China as banks like CCB (OTCPK:CICHY) form the biggest component of the stock market.

The second risk that investors need to keep in mind is the potential for China to start another round of "Risk Off" globally. Consensus has bought into the thesis that the world may be entering a new synchronized growth phase let by US recovery. But, Emerging markets account for two thirds of growth and half the global economy in PPP terms. Slowing EM is not something which DM can ignore in this cycle as most large MNCs have significant exposure to EM and direct business interests in China. A China contagion will be bad for global earnings growth.

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