Since the beginning of December 2013, the MSCI emerging markets index has declined 13 percent.  The selloffs in many emerging  markets, especially Turkey, Argentina  and Brazil, were triggered by their sharp currency depreciation on US tapering as well as market fears of an external debt crisis (in Turkey), the negative impact of local rate hikes (in Brazil and India), high inflation (in Argentina, Brazil, India, Russia, South Africa), and potential economic contractions, as well as political instability (in Turkey and Thailand).

Interestingly, the Chinese H share  index (HSCEI) has also dropped by a significant 16 percent during the same period. This decline was close to the fall in the country equity indices of Turkey (-22 percent, in US dollar) and Argentina (-19.8 percent), and sharper than that of Brazil (-12.7 percent). It appears that the market believes that China’s economic situation has deteriorated by as much as those in Argentina and Turkey in recent weeks. Some investors are now asking us when China will ease macro policy to stimulate the Chinese economy, which is a question no one in the Chinese government is talking about, simply because there is not such a need.

We think this market perception of China is wrong. We strongly believe that China’s economic fundamentals are much healthier than most other emerging markets and China is one of the least vulnerable emerging market economies  to US tapering in 2014. Our specific arguments are as follow.

First, compared with other emerging  market currencies, China’s yuan has been the most stable in the past weeks, and it will likely remain stable in 2014. The yuan appreciated against the US dollar by 0.5 percent between December 1, 2013 and February 5, 2014, while the Argentine peso fell 22 percent, and the Turkish Lira fell 8.6 percent. Based on past experience of global crises (2008-09, 2011, and mid-2013),  the yuan should remain one of the most resilient to external shocks in 2014, given that its capital account is still largely controlled for portfolio flows, and macro fundamentals are very supportive of its  currency. We continue to expect the yuan to appreciate by about 2 percent against the US dollar in 2014, although a modest increase in its flexibility is possible (for example, an increase in annualized daily volatility from the current 2 percent to 3 percent).

Marco fundamentals

Second, macro fundamentals are much stronger in China than in many other emerging market countries. China’s GDP growth was 7.7 percent in the fourth quarter, higher than the 7.5 percent annual target, and its volatility was within 0.2-0.3 percentage points on a year-on-year basis in the past few quarters. Its CPI inflation was 2.5 percent in December and will likely remain around 2.5 percent for the coming few months, representing the most stable period in history. Its current account maintained a healthy surplus of about 2 percent in 2013 and will almost certainly stay in surplus in 2014. External debt is 8.8 percent of GDP. These data compare favorably with many other emerging market countries that saw significant growth deceleration, large current account deficits, and higher inflation.

Many people view the drop in China’s manufacturing Purchasing Managers’ Index January (by 0.5 percentage points to 50.5) as an indication of China’s economic weakness. Some even say the emerging markets selloff was partly triggered by the Chinese PMI number.  We believe this is a gross exaggeration of the significance of a monthly PMI figure, especially in January. Note that  historically, Chinese PMI could move by anywhere between -1.7 percentage points to 0.2 percentage points in January (from December) due to the Chinese New Year effect. In addition, at the beginning of this year, some cities implemented emergency measures in order to prevent a sharp rise in the air pollution index, by tentatively suspending the production of some coal-burning factories.

Thirdly, China’s political situation has become more stable since the change of leadership in 2013, partly due to the success of the anti-corruption program, while other emerging market countries,  such as Thailand, Turkey, South Africa,  India and Brazil, are now either experiencing serious political challenges  and/or facing very uncertain election outcomes. The recent Edelman Trust Barometer survey, which measures trust  in government among 27,000 people  online in 27 countries, reported that China ranked No. 1 in public trust in 2013 and its score improved by 4 points from 2012.

Aggressive reforms

Fourth, China is implementing the  most aggressive structural reforms in decades, while this determination is not seen in most other emerging markets due to political stalemate. The 60 reforms  announced in November last year were  unprecedented, and the recent establishment of the Central Leading Group for Comprehensively Deepening Reforms is another sign that the leadership is fully  committed to forcefully implementing  these reforms. As we discussed in  previous reports, China’s new reform  program, especially deregulation, would  enhance the country’s growth potential and reduced macro risks.

Fifth, China’s financial risks are being addressed by reforms. Many investors fear that China’s wealth management product (WMP) defaults and local government financing vehicle (LGFV) loans will lead to a blow up of the financial system. This is very unlikely, in our view. Given the recent resolution of the China Credit Trust event, it is now clear to us that the authorities are embarking on a path toward “managed defaults” to gradually improve risk pricing in the trust loan sector, while tightening rules on shadow banking activities (for example, by centralizing the WMP operation to banks’ headquarters, and by tightening supervision on trust companies).

As for LGFVs, their leveraging ratio (liability/asset ratio) actually declined in the past two and half years by 4.9 percentage points, according to the recent National Audit Report. The local government bond market will be developed to gradually replace LGFV loans as a more important source of financing for local  government expenditure. In sum, these changes are in the direction of reducing,  instead of increasing, financial risks.