The best 'unstable, uncoordinated' emerging market
Investor sentiment toward emerging markets has always been fickle. While emerging markets were the darling of investors after the global financial crisis, they now appear to be in retreat taking with them the currencies of South Africa, India, Brazil and Russia, which have respectively depreciated this year by 16 percent, 11.5 percent, 10.5 percent, and 4.5 percent.
Will emerging markets continue to be a good place to invest? Rather than draw general conclusions, let's look instead at the data to try to distill what is noise, what is temporary and what is structural. Specifically, consider nations that "walk the talk" of structural reform instead of stop gap measures that don't have lasting impact.
Out of the "BRIC" (Brazil, Russia, India and China) subgroup, China stands out as the one country willing to do the dirty work of structural reform at the risk of upsetting the powerful, entrenched constituency. Brazil largely squandered a golden opportunity for reforms when it had low inflation, high growth and an immensely popular president. India has done a great job talking about reforms but little evidence of change has ensued. In Russia, the rule of law has deteriorated, not strengthened, and it remains an oligarchy with little more than rich mineral resources.
(Read more: Is a hedge fund in your future?)
It is no wonder then that China has been the one to take a leading role in a multilateral, defensive plan to establish currency reserves. The "BRICS" (including South Africa) announced a $100 billion currency reserve this month at the Group of 20 Summit, aimed at providing liquidity should there be a sudden stop of capital and allowing them to shore up their currencies against sharp depreciation.
Such lines of defense have been deployed in the past. In the aftermath of the Asian financial crisis, ASEAN countries formed the Chiang Mai Initiative, which established a pool of reserves among many Southeast Asian nations that bore the brunt of the financial crisis. The availability of this capital in and of itself is meant to be a deterrent, especially to speculators wanting to make a fast buck by shorting vulnerable currencies.
"As China's president Wen Jiaobao famously said, China's economy is unsustainable, uncoordinated, unbalanced, and unstable."
Conspicuously absent from this currency reserve fund are "developed" countries like the U.S., Japan or members of the E.U. The fact that the BRICS have formed this line of defense without the usual suspects signals their discontent at the governance of the current multilateral system—the IMF. Since the global financial crisis, the IMF's resources have not kept pace with need. An IMF report cited the perception that the fund has been slow to identify risks and agree on strategies to address them as a sign of weak governance. Further, the U.S. has shown little willingness or ability to focus on certain issues related to the fund.
(Read more: The money mindset of Generation Z)
Enter China, which provided $40 billion of the $100 billion in capital to the BRICS countries. First, it is one of the few countries with deep enough pockets to do so, with total foreign exchange reserves of $3.5 trillion. The Chinese are also, ironically, least likely to need to draw on these funds, given the low volatility of its currency and also because of its relatively closed capital account. It is also one of the few emerging market currencies that appreciated, not depreciated relative to the U.S. dollar year-to-date.
As China's importance in the global economy continues to grow, it may also be setting an example over how to handle tough reforms: quietly and gradually. To be sure, China's path has certainly been far from perfect, leading to over investments in certain sectors, including the famous "ghost towns" with more high-rises than residents. As China's President Wen Jiaobao famously said in 2007, China's economic growth is "unstable, unbalanced, uncoordinated and unsustainable."
(Read more: US no longer the 'place to be' for investors)
However, there is recognition among top policymakers of the cost and benefits of reforms. For instance, in liberalizing its financial system, the People's Bank of China recently removed the floor on lending rates. This wreaked havoc with the money market for a few weeks but over the long run, this should help lower borrowing costs while increasing the efficiency of capital allocation. It is also slowly opening its capital account. By the end of the year, policymakers want to have an investment plan in place that will allow domestic individuals to invest directly in overseas markets and let foreign individuals invest in the mainland capital market. This would allow Chinese households to diversify their investments and provide opportunities for financial institutions.
To be sure, these steps toward liberalization will not be viewed favorably by all segments of the Chinese population. Those who are likely to be most opposed are those who gained most from the artificially wide net interest margin such as banks, large state-owned enterprises and state officials. Those most likely to view these reforms favorably include the traditionally less powerful—the savers. Whether the current leadership has the resolve to continue its slow and gradual reform path remains to be seen.
—By Teresa Kong, CFA, Matthews Asia Portfolio Manager.
The views and information discussed in this report are as of the date of publication, are subject to change and may not reflect the writers' current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information, and is independent of CNBC.com.