With investors already on edge as global markets came unglued last week, China picked a fine time to engineer a credit crunch.
Drowned out in the noise about Federal Reserve Chairman Ben Bernanke’s tapering talk last week was the fact that half a world away, China’s banking system was caught up in a cash squeeze. Short-term lending rates tripled as the financial system essentially froze. It was frighteningly reminiscent of the 2008 financial crisis in the U.S.
Hedge fund managers and economists have long warned of a potential bursting of China’s debt-fueled real estate bubble, a replay of our own subprime crisis. Could this be the beginning?
|China’s recent credit squeeze could set the stage for terrific buying opportunities in emerging markets.|
China is undergoing an epic transition. And while it’s too soon to say if its economy will experience a hard-, soft- or crash-landing, there are great investment opportunities in the region available at massive discounts.
China’s Credit Crunch
China’s liquidity crunch is contributing more than its share to rising volatility. In my view, China is the primary driver for the abrupt sell-off in emerging-market stocks and bonds, more so than the Fed’s announcement that it may reduce its stimulus as early as this year.
As shown in the chart above, interbank-lending rates — what banks charge one another for loans of a week or less — spiked dramatically last week, signaling a cash crunch in China’s financial system. Similar to our subprime credit crisis in 2008, China’s comes after years of excessive lending.
The difference, and it’s important, is that China’s central bank wants to limit credit.
For years, a “shadow” banking system has thrived in China, as smaller banks borrowed from the big state-owned banks at low interest rates only to turn around and lend at higher rates to private companies and real-estate speculators. Easy money flowed through the country, but it was devilishly difficult for authorities in Beijing to regulate.
China’s new leadership believes the shadow-banking system has grown too big, and the People’s Bank of China (PBOC) has decided to cut off the low-cost funding with the goal of ending shady lending practices.
As a result, the interest rate charged by Chinese banks to borrow overnight funds from one another jumped a week ago to a record 13.4 percent from 4 percent last month.
That’s why the selloff in emerging markets has less to do with the Fed’s tapering talk and much more to do with China’s credit squeeze. (Volatility in Japan, induced by a Fed-like stimulus program, also is playing a role.)
The trouble is, the liquidity squeeze couldn’t be happening at a worse time. China is struggling through an economic transition, resulting in slower growth.
As shown in the chart above, China’s PMI manufacturing gauge has been in a steady decline. It slipped to a nine-month low of 48.3 last month, a reading that signals a contraction. With China’s export growth close to zero and weakening investment, this intentional credit squeeze is risky business for the PBOC, which could easily backfire if China’s economy slows too rapidly.
Submerging Markets Create Profit Opportunity
Emerging markets have been hammered with a one-two punch. First, the Fed put an explicit expiration date on QE — meaning the beginning of the end for easy-money carry trades. That means borrowing in one cheap currency and investing in another is now getting diminishing returns. Then China decides to engineer a credit squeeze to rein in shadow banks while targeting credit creation toward the real economy.
The predictable result is massive capital outflows from emerging-market stocks, bonds, and currencies.
Remember, a great deal of excess liquidity found its way into emerging markets in recent years. Now with the end of ultra-easy monetary policy not as far off as previously believed, the carry-trades are unwinding, sparking intense volatility.
The graph above shows record cash outflows from emerging stock and bond markets. According to Bloomberg, emerging-market equity and bond fund outflows accelerated to $9 billion in the week ended June 12, the third-worst ever recorded and not far behind the panic selling during the global financial crisis in 2007 and 2008.
BRICs have been among the worst performers:
* China’s stock market slumped 11.1 percent in June.
* India has fallen 13.3 percent this year, and Russia has tumbled 18.8 percent.
* Latin America has been hit worst of all, with Brazil’s benchmark Bovespa Index plunging 30.6 percent in 2013.
Other Asian developing markets, including the Philippines, Thailand and Indonesia, have also been hit hard. However, I see this kind of manic selling as setting the stage for terrific buying opportunities in emerging markets.
As the U.S. economy picks up, and Japan recovers, emerging Asia stands to benefit from increased demand and exports. This is especially true for emerging economies with high-tech exports and other manufacturing.
The Key to Picking Emerging Winners
With financial stress on the rise worldwide, the key to picking likely emerging-market winners is to focus on countries able to finance their own growth.
Those that enjoy a current account surplus, as I mentioned last week in Money and Markets, are less likely to be hurt when the hot money exits. Meanwhile, avoid countries with chronic current account deficits that must constantly rely on foreign investors; India and Brazil are two underperforming examples.
The Philippine economy expanded 7.8 percent in the first quarter, faster than China, thanks to a young and rapidly growing consumer class. The nation runs a current account surplus, forms a key link in the global electronics supply chain, and acts as a hub for high-tech contract manufacturing.
South Korea and Taiwan are two other industrialized Asian nations that boast current account surpluses. Plus, their economies are geared toward higher value-added manufacturing and services. Two ETFs you may want to consider that track these markets are: iShares MSCI South Korea Capped Index Fund (EWY) and iShares MSCI Taiwan Index Fund (EWT).
The Philippines, South Korea, Thailand, Indonesia, and Malaysia, have combined foreign currency reserves of $833 billion, more than 10 times as large as during the last Asian financial crisis in 1997 and 1998. That’s a lot to ward off financial stress.
We’ve seen plenty of mid-summer swoons in emerging markets in recent years, and each one was a profitable buying opportunity. After a sharp sell-off in mid-2011, South Korean stocks rose 34.9 percent over the next six months, while Philippine shares surged 43.1 percent. And following last summer’s correction, South Korea rose 26 percent and the Philippines soared 62 percent. Will history repeat in 2013?