Reforms will enhance growth potential

Since the beginning of December, the MSCI Emerging Markets Index has declined 13 percent. The sell-offs in many emerging markets, especially Turkey, Argentina and Brazil, were triggered by their sharp currency depreciation as a result of the United States' tapering of its quantitative easing, as well as market fears of an external debt crisis, for example in Turkey; the negative impact of local rate hikes, for instance in Brazil and India; inflation in Argentina, Brazil, India, Russia, South Africa; and potential economic contractions, as well as political instability in Turkey and Thailand.

Interestingly, the Hang Seng China Enterprises Index 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 and Argentina and a little sharper than that of Brazil. It appears that the market believes that China's economic situation has deteriorated as much as those in Argentina and Turkey in recent weeks. Some investors are now asking when Chinese government will ease its macroeconomic policy to stimulate the economy.

However, this is a question no one in the Chinese government is talking about, simply because there is no need to.

This market perception of China is wrong. China's economic fundamentals are much healthier than most other emerging markets and China is one of the least vulnerable emerging economies to the US' tapering.

First, compared with other emerging market currencies, China's currency has been the most stable in the past weeks, and it will likely remain stable. Based on past experience, the renminbi should remain one of the currencies that is most resilient to external shocks this year, given that its capital account is still largely controlled for portfolio flows and the macro fundamentals are very supportive of the currency. The renminbi is likely to appreciate by about 2 percent against the US dollar this year, although a modest increase in its flexibility is possible.

Second, the macro fundamentals are much stronger in China than in many other emerging economies. China's GDP growth was 7.7 percent in the fourth quarter of last year, higher than the 7.5 percent annual target, and its volatility was within 0.2 to 0.3 percentage points on a year-on-year basis in the past few quarters. Its consumer price index 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 last year and will almost certainly stay in surplus this year. External debt is 8.8 percent of GDP. These data compare very favorably with many other emerging markets that experienced significant growth deceleration, large current account deficits, and higher inflation.

Third, China's political situation has become more stable since the change of leadership, partly due to the success of the anti-corruption program, while other emerging economies, such as Thailand, Turkey, South Africa, India and Brazil, are now either experiencing serious political challenges and/or facing uncertain election outcomes.

Fourth, China is implementing the most aggressive structural reforms in decades, while this determination is not seen in most other emerging economies due to political stalemate. The reforms outlined after the Third Plenum of the 18th Central Committee of the Communist Party of China in November last year were unprecedented, and the recent establishment of China's Leading Group for Comprehensively Deepening Reforms, is another sign that the leadership is fully committed to forcefully implementing these reforms. China's new reform program, especially deregulation, will enhance the country's growth potential and reduce macro risks.

Fifth, China's financial risks are being addressed by reforms. Many investors fear that China's wealth management product defaults and local government financing vehicle loans will lead to a blow up of the financial system. This is very unlikely. 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.

As for the local government financing vehicles, their liability to asset ratio has actually declined in the past two and half years by 4.9 percentage points, according to a recent National Audit Report. The local government bond market will be developed to gradually replace local government financing vehicle loans as a more important source of financing for local government capital expenditure.

Clearly all these changes are in the direction of reducing financial risks, rather than increasing risks.

The author Ma Jun is the Chief Economist for Greater China of Deutsche Bank.