What's Behind the Emerging Markets and China Selloff

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Why have emerging markets been hit so hard by talk of an end to the Fed's bond buying program? You have to go back to the basic belief about the program: that much of the money that flooded the economy ended up in stocks, and that much of that money went to overseas investments.

There was a particularly strong liquidity-induced exuberance in emerging markets like India, Turkey, Mexico, Brazil, South Africa, even Indonesia.

But the opposite trend is now evident: moderating liquidity is putting a squeeze on emerging markets. The Fed's tidal wave of liquidity has distorted the risk curve. We are now seeing are pricing of that risk curve. The stronger dollar--and higher yields in the U.S.--has clobbered currencies and bonds.

And no wonder: U.S. investors are the biggest foreign investors in the world. When U.S. rates start backing up, you get a magnified effect. So everyone's long emerging markets, the bids disappear, and you get these crisis-type moves.

Throw in slow growth in China--a separate but equally important problem--and you have a stampede out.

What to do if you own emerging market stock,bond, or currency funds? A few observations:

1. Volatility is a fact of life for these funds. Emerging markets routinely move in 25 percent swings in any given year, so while the 14 percent decline in the iShares Emerging Market ETF (EEM) in the last 6 weeks is steep, it has happened before.
   
2. Because of the volatility, many investors might be surprised that any losses they have experience may be manageable. For example, the EEM, at $37 and change, is close to it's average price of roughly $39 since mid-2009. You might find you have had very little, if any, losses.
   
3. How will we know when we are near a bottom? Look for a drop in volatility, and some differentiation. I mean look for certain emerging market countries starting to outperform other emerging market countries. That's a sign that the panicky money is gone and the real investors are trying to pick winners.
   

Once things calm down, I am sure there will be calls that these markets are now a relative bargain. But we are not there yet.

China: a bigger story than the Fed? Reports that Chinese banking authorities are trying to tighten credit are a major reason emerging markets are down today. This may be a bigger story than the Fed.

Why are they trying to tighten credit? China has a major problem with its "shadow banking system," a group of several thousand lenders who operate outside the normal banking system and provide credit...at exorbitant rates.

You should understand that there are four large banks in China that do a very large part of the lending in China: Industrial and Commercial Bank of China (ICBC), China Construction Bank,Agricultural Bank of China, and Bank of China. Traders tell me that some 30 percent to 40 percent of all lending in China is done by those four banks. If you are one of the 2,000 or so state-operated enterprises,you're in luck: they will give you a loan.

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But if you are one of the 40,000 or so enterprises that are not a state-operated enterprise, you are on your own; many are just shut out of the normal process of borrowing from the main banks.

That's where the shadow banking system comes in. They will lend money--but at exorbitant rates. How exorbitant? One trader with knowledge of this told me that 20 percent is not uncommon.

Sounds crazy, but borrowing from these shadow banks has been very strong recently. Why? Because they have money to lend, thanks to China's attempts to keep pumping money into the economy.

But Chinese authorities are attempting to curb the power of these shadow banks by constricting liquidity.

They also have a big problem with the state-owned banks. They are trying to prick the real estate bubble.

Recall that in 2009, the Chinese government pumped over $580 billion in stimulus into the Chinese economy. While it did help stabilize the country after the shock of the global recession, it also enabled the state banks to loosen restrictions on lending, saddling the banks with mountains of bad debts that are still sitting on the books.

Much of that stimulus was put into real estate. This was the period of the "ghost cities," huge new cities with new highways and infrastructure and tall apartment buildings...with no one in them. In many, there's still no one in them.

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The government has responded by putting curbs on property purchases, by, for example, charging higher rates for people who buy secondary properties. But it still isn't completely pricking the property bubble.

So you have a double whammy you have to deal with: a lot of people with extremely expensive loans to "shadow banks" that could easily go sour if liquidity dries up, and a problem with gently deflating the real estate bubble without letting a mountain of loans go south.

And you think we have problems?