Emerging Market Banking Crises Are Next

by James Gruber on March 1, 2014

Chinese whispers
The great economic rebalancing
More EM drama to come
Winners and losers

Financial headlines have rightly been dominated by the largest 7-day sell-off of the Chinese yuan on record. Everyone’s speculating whether it’s been a deliberate move by the People’s Bank of China (PBOC) or not. The consensus is that it’s been PBOC initiated to shake out carry trade speculators who’ve used low US interest rates to borrow low-yielding US dollars and buy the higher-yielding yuan and yuan-denominated assets. This before a move to increase the daily trading band for the yuan. A minority believe the yuan has unraveled of its own accord driven by a shortage of US dollars leading to the liquidation of yuan instruments. Either way, carry trades are being quickly unwound.

Asia Confidential thinks the vast majority of commentary has missed the underlying reasons for emerging market currency volatility, with the yuan being the latest example. What we’re really witnessing is a major rebalancing of global economic trade. Prior to 2008, the US had a massive consumption bubble, financed by its current account deficit which exported U.S. dollars and fueled global trade. Since the crisis, US consumption has slowed but QE has stepped in to provide the U.S. dollar liquidity needed for world trade. With the tapering of QE, that dollar liquidity is diminishing. And emerging market currencies such as the yuan are having to adjust to reflect real US demand. With or without PBOC intervention, that was bound to happen.

The concern for emerging markets is that this isn’t just a currency issue. The carry trades and subsequent inflows of capital have created substantial credit and real estate bubbles in many of these markets. The unwinding of these bubbles is likely to lead to banking crises in several countries, including China and China proxies such as Hong Kong, Australia and perhaps Singapore. 

The hit to global economic activity will hurt inflated stock markets. As well as commodities, particularly the likes of iron ore and copper which have been widely used as collateral to finance trade/purchases in China. The winners out of all this are expected to include the US dollar, given less dollar liquidity means reduced supply vis-a-vis demand. And US Treasuries too due to the deflationary consequences of the economic re-balancing.

Chinese whispers 
For years, the yuan has been a one-way bet. Even during the emerging market currency turmoil of last year, the yuan escaped unscathed and outperformed. Moreover, it’s done so with minimal volatility given a tightly-controlled trading band. That band involves the PBOC setting a daily fixing rate against the dollar around which the onshore yuan is permitted to rise or fall 1% a day.

Over the past week, things have changed rather dramatically. The PBOC guided the onshore currency weaker through higher fixes. The move caused consternation in some quarters. The one-way bet became two-way and many got burned.


The PBOC hasn’t adequately explained the move and it’s left everyone to speculate about the ultimate reasons. Most are in little doubt that it’s been orchestrated by the central bank. 

The most common reason ascribed is that it’s a tactical move by the PBOC to introduce more yuan volatility before widening the trading band, a long-held aim of theirs. This could be right though it’s a clumsy way to go about it.

Another explanation is that it could be a move to bring onshore and offshore rates together before the trading band increase. By way of background, the onshore rate is obviously that within China itself. The offshore rate is via Hong Kong, where the yuan is better known as the CNH and trades without restrictions imposed onshore by Chinese authorities.

Two weeks ago, the spread between the CNH rate and onshore rate reached its widest since 2010. Some suggest this prodded the central bank into action.

A third explanation has been put forward also. That the Chinese want a weaker currency to help its exporters and support the economy. This could well have validity and the authorities wouldn’t exactly advertise if this were the case. It’s dangerous though as it could lead to capital outflows and tighter credit, thereby accelerating the country’s economic slowdown.

There’s an altogether different explanation though involving the yuan devaluation having nothing to do with Chinese authorities. The theory is that the yuan carry trade is unraveling of its own accord. Reduced US dollar liquidity triggered by QE tapering has resulted in reduced flows for the carry trade and the liquidation of yuan-related instruments. And that’s caused a surge in offshore CNH liquidity. 

It’s difficult to pinpoint where the truth lies. But we are more certain that this isn’t the end of yuan volatility as it isn’t just a China issue. And it isn’t just a carry trade issue. And it certainly isn’t just a QE tapering issue. It’s deeper than that and the threads go back to the global trade imbalances of pre-2008 and the policies since which have covered them up … until now.

The great economic rebalancing 
To better understand this, let’s step back for a moment. As everyone knows, the US dollar is the world’s reserve currency. Given this, the US has to run large trade deficits (where imports exceed exports) in order to export US dollars and lubricate global trade. Other nations need US dollars to conduct trade and build foreign exchange reserves which bolster their own currency and provide the asset base for the expansion of credit within their own country. 

The US had a massive consumption bubble prior to 2008. This was financed by its trade and current account deficit (trade is a large part of the current account). US consumption collapsed during the crisis and the current account deficit started to narrow. 

Then Bernanke stepped in with QE, which in effect financed US consumption and global trade. It prevented the pre-2008 economic imbalances from correcting.

US deficits have continued to sharply decline due to the domestic energy boom (reducing the reliance on oil imports), cheap and more competitive labor given the more than decade declines in the US dollar and the end of the consumption boom. But QE1, 2 and 3 have filled the gap to finance global trade.

Now that the Fed is tapering QE, that’s reducing the supply of US dollars into the global marketplace. Global macro strategists, Gavekal, in a report called US Current Account and Vanishing Global Liquidity, describe the impact on emerging markets:

“…if the amounts generating by the US current account are insufficient to meet overseas nations’ needs, then these economies will…be forced to either borrow dollars (not a long term solution), flog domestic assets or run down foreign exchange reserves. Hence, when I see central bank reserves deposited at the Fed falling, I know we are getting close to a “black swan” event, as dumping these precious “savings” is, for any country, always a desperate last resort.”

And a reduction in foreign exchange reserves at the Fed is exactly what’s happening now.

FX reserves held with Fed

It’s important to note, as strategist Vince Foster points out, reductions of foreign exchange reserves held at the Fed have usually preceded financial crises. And it should also be noted that the largest foreign exchange reserves belong to China and its reserves dropped sharply both before the 2000 downturn and the 2008 financial crisis. The expectation here is that China’s foreign exchange reserves may well start falling soon. This would shock many investors.

More EM drama to come
The good times were very good for emerging markets prior to mid-last year. Capital inflows led to currency appreciation which provided the liquidity for domestic investment and consumption booms. 

Since the 2008 financial crisis, emerging market foreign exchange reserves have increased by US$2.7 trillion, their monetary bases are up US$3.2 trillion and money supply (M2) has risen by US$14.9 trillion.

Unsurprisingly, that’s fueled mammoth property booms. Hong Kong and Chinese residential real estate prices have doubled over the past five years, while Singapore’s are up 70%.

Carry trades have partly financed the asset booms. Bank of America Merrill Lynch estimates that emerging market external loan and bond issuance has increased by US$1.9 trillion since the third quarter of 2008.

And the banks are at the heart of this and other financing. Thus, Hong Kong banks have been the go-to for the China carry trade. And their net lending to China itself has increased from 18% of Hong Kong GDP in 2007 to 148% now.

HK bank lending to China

QE is the trigger for an unwinding of all this. The weakest links, those countries with chronic current account deficits such as Turkey, have been hit first. Asia Confidential believes the next in line will be the countries where the largest credit bubbles have occurred.

And that’s where China comes into play. Those who insist that China doesn’t have a debt problem don’t get it. History shows that it isn’t the amount of debt, but the pace it’s gathered which matters when it comes to potential financial crises.

With this, China is in a league of its own. Since 2008, Chinese total outstanding credit has more than doubled. Its banking assets having grown by US$14 trillion, or the equivalent of the entire US commercial banking sector.

Credit growth in the years leading to the bursting of previous credit bubbles – such as the US pre-2008, Japan pre-1990 and South Korea pre-1997 – has been 40-50%. China’s credit growth has dwarfed this and it’s easy to see the dangers that represents.

We believe the next phase of this crisis will be felt in the banking systems of several countries. China is the obvious one and that’s already begun (with defaults in trust funds).

Hong Kong banks are among the most vulnerable outside of China. That’s not only because of the exposure to lending to the mainland. But overall bank assets now total around 800% of GDP. It doesn’t take a genius to work out the disproportionate impact that even a small percentage of those assets going bad would have on the city’s GDP.

Australia and Singapore don’t have the same direct China lending exposure but the risks to their respective banking systems are high also. The Australian economy is highly dependent on Chinese commodity imports and the country’s big four banks have financed a monstrous property bubble off the back of the decade-long mining boom. Moreover, the Australian banks rely on short-term external financing as loan-to-deposit ratios are close to 120%.

The Singapore banking sector is also at risk given its domestic credit boom which has seen bank assets increase to total 650% of the country’s GDP. Yes, Singaporean banks have large capital buffers but significant risk remains.

Winners and losers
There are a number of commentators, particularly out of the US, who suggest that the emerging market crisis won’t have any impact on developed market economies. They’re deluded.

Emerging markets account for more than 50% of global GDP. Moreover, emerging markets ex-China represent a third of global imports. Including China, they account for 43% of imports. An slowdown in emerging markets will hurt their imports and therefore exporters in the developed world.

In addition, the profits of many US and European companies depend on overseas markets, particularly in the developing world. For instance, more than 50% of S&P 500 profits are generated outside of the US. 

So the emerging market crisis will substantially impact global economic growth. And stock markets, particularly elevated ones such as the US, are most vulnerable.

Commodities are likely to be hit too. China is the largest consumer of most commodities and a downturn there will reduce their previously insatiable consumption. Even precious metals may be impacted given the deflationary consequences of a China slowdown. Though bullish on gold, we suspect it may break key US$1,180/ounce levels and have a further lurch down before climbing again.

As for the likely winners as the emerging market crisis deepens, Asia Confidential would put the US dollar at the top. The reason is that a reduction in the exporting of US dollars will result in less supply amid growing demand. This could well result in a sharp spike in the dollar.

The fate of US treasury bonds is an interesting one. Declining foreign exchange reserves of emerging markets should mean reduced demand for treasuries. In theory, this should put pressure of bond prices. However, given accelerating deflationary forces, we’d suggest Europe and the US central bank will step in to plug the demand gap. 

AC Speed Read

- The Chinese yuan has dominated headlines given its largest weekly loss on record. 

- What we’re really witnessing in China and other emerging markets is a major rebalancing of global trade.

- Carry trades and subsequent inflows of capital have created substantial credit and real estate bubbles in many of these markets. 

- The unwinding of these bubbles is likely to lead to banking crises in China and in China proxies such as Hong Kong, Australia and perhaps Singapore.

- That should lead to corrections in elevated stock markets, particularly in the US. Commodities are also expected to suffer.

- The biggest winners are expected to be the US dollar and US treasury bonds.

Have a nice weekend,


{ 11 comments… read them below or add one }

James Gruber March 10, 2014 at 6:45 pm


Thank you for your comments, which address several issues.

Given the currency moves today, the question has to now be asked whether the Chinese strategy involves a much weaker yuan. Many have suggested this isn’t the case, but I’m not so sure. The appreciating yuan has put Chinese exporters at a distinct disadvantage vis-a-vis the likes of Japan.

I am not sure your other suggestions are practical, from a Chinese viewpoint. Given around 75% of Chinese own property, and the biggest property owners are Communist Party officials, a collapse in real estate prices would hurt many including the top leadership. They’ll try to avoid that at all costs.

Similarly, making the yuan fully convertible at this point doesn’t seem on the agenda either. As an aside, many people think the yuan will become the world’s reserve currency in the not-too-distant future. I don’t see this at all. The reason is that to become a reserve currency involves willingly running significant trade deficits to allow the exporting of yuan. That would require a significant restructuring of China’s economy which is many, many years away.

Today’s market moves have been significant. I have a particular eye on the copper price which is flirting with key $3/lb levels. A lot of copper (amount indeterminant) is used as collateral for trading and asset purchases in China. The copper price falls are signaling the slowdown is starting to have a domino effect through the economy. In other words, the credit bust is accelerating.


Peter S. March 10, 2014 at 3:21 pm


I came back and re-read this post after this mornings news of increasing RMB weakness, copper price declines and further “shadow bank” defaults here in China.

In addition to your hypothesis of falling USD liquidity and PBOC maneuvers, would you care to comment on possible geopolitical/currency “war” maneuvers?

Is it plausible to assume that Beijing knows it has a debt bomb on it’s hands and a restructuring is inevitable? Perhaps they are intentionally shaking out currency speculators, Chinese shadow lenders/developers/companies and maybe even the SOE bank malinvestments, on purpose!

Let’s say Beijing realizes this is the time to make the RMB fully convertible, backed by the newly announced and surprisingly large holdings of physical gold? Let’s say they open up the doors to all the excess global liquidity that may want to dump other fiat for RMB denominated distressed assets? Could this re-liquify the banks while rationalizing/selling off the uneconomic excess capacity? Do you think Beijing might see they could consolidate central power even though many provincial heavyweights would go bankrupt? Would foreign lenders want in on this if the assets were now fairly valued to a much larger segment of the population?

The average Chinese folks I work with complain about housing prices. What if this default/repricing suddenly made all these excess apartments affordable? I bet Beijing would love to have that image if they can pull it off without TOO much disruption. And at the same time add a HUGE amount of leverage to the BRICS/emerging markets currency/trading problems.

Love your insights to this vital part of the world and the underlying banking/currency/trade issues. Let us know what you think.



James Gruber March 5, 2014 at 5:57 am

Jason, I largely agree re. peak oil (and written about it previously) but don’t see hyperinflation around the corner given weak global demand and muted wages. I think a deflationary event is more likely in the near term. That said, such an event would bring more QE and the potential for serious inflation down the track.

On rate rises, again I largely agree with you on that and Hussman’s work.



ManAboutDallas March 4, 2014 at 5:09 am

There’s a new “safe haven” currency as of January 1st, 2014; actually, it’s the old, long-standing, historically-demonstrated “safe haven” currency. It’s name : GOLD. The US$ is toast, Mr. Gruber, and those still foolish enough to flee to it as a “safe haven” simply because it is, for a bit longer, still the world’s so-called reserve currency need to run, not walk, down to Betty’s Barrel Boutique and pick themselves out a nice, spiffy, off-the-rack double-breasted pin-stripe barrel and a pair of wing-tip pony kegs for shoes to wear home from the Courthouse.

Jason Emery March 4, 2014 at 12:13 am

Hi James,

I didn’t see much mention of crude oil prices. A lot (most?) of the world’s economic problems are a result of hitting peak cheap oil about 10 years ago. Seems like the likelihood of a hyper inflationary outcome increases with each passing day, as expensive oil becomes a larger and larger share of the global oil mix.

Since they started tapering, oil has been rising, although not as much on a seasonally adjusted basis. I think if W. Texas crude ($wtic) takes out $110/bbl, which is only $5.50 higher than the current price, it will spike much higher.

Regarding your comment about Yellen not wanting to raise interest rates, wouldn’t it be more accurate to say that she absolutely, positively CANNOT raise short term rates? If I correctly understand the ‘liquidity preference’ work of John Hussman, the fed would have completely end QE, AND shrink their balance sheet by well over $1.5 trillion, just to raise rates a paltry 25 basis points.

James Gruber March 3, 2014 at 7:06 pm

Jason, you could be right (I am long gold and therefore biased). Deflationary episodes usually aren’t friendly to gold. Witness 2008 where gold held up a bit better than equities, but still suffered. Any future deflationary episodes though are likely to be met by yet more central bank QE and that should be friendly to gold, particularly as inflation may take hold, at a later stage.

Jason H March 3, 2014 at 6:28 pm

I think it was a well thought out analysis of how a probable crisis emerges from China instability. I am eager to see where precious metals go if it falls out as you think it will. I agree that the physical demand from China will drive the price down in gold, however think an equities decline will push up gold’s safe haven value for the paper markets. Also how will India’s import restrictions play out? I do think price volatility could push gold lower than its 1180 floor, but would be surprise if that lasts longer than six months. Large paper gold investors have left the market in 2013, leaving real support to physical demand, as equities decline, I think they will be rushing back at some point.

James Gruber March 2, 2014 at 1:15 pm

Todd, I agree with Rickards’ thinking but believe that scenario potentially happens later rather than sooner.

todd H March 2, 2014 at 12:14 pm

Regarding your statement: “However, given accelerating deflationary forces, we’d suggest Europe and the US central bank will step in to plug the demand gap.”

According to a similar hypothetical situation in Jim Rickards’ book Currency Wars P.250, at some point when the US central bank steps in to support bonds…”For once, the selling power of the panic outweighs the buying power of the Fed.”

James Gruber March 2, 2014 at 6:36 am


Thanks for your thoughts. In hindsight, I could have better explained the last point on US treasuries. I think as the emerging market turmoil accelerates, the US dollar will again be seen as a natural safe haven. And given the massive short US dollar carry trade, that could lead to a sharp dollar spike.

At the same time, forex reserves of key countries such as China may start to decline. Initially Europe may step into the breach. By the way, the most recent data had China and Japan decreasing their holdings of US treasuries and Europe increasing theirs.

But if foreign holdings of treasuries do decline, it’s likely that the US may have to step in with more QE at some point. I just don’t see them wanting higher interest rates. While the US economy is in better shape than many others, it’s still very sensitive to higher rates. Look what happened when treasury yields hit 3% – the housing industry was clearly impacted. So, the US economy is still very fragile. And I don’t believe Yellen will want higher rates in the near future.

More QE, of course, would be expected to put pressure on the dollar. Though that would depend on the state of other countries as the emerging market crisis gathers steam.

In sum, I see it as a bit of two-stage process: a sharp dollar spike followed by some softness. And for 10-yr US bonds to head lower towards 2.25% before gradually rising again. There are a number of assumptions in the latter thesis and therefore I have greater conviction in the US dollar call.

Tim F March 2, 2014 at 3:34 am

Hi James, really enjoyed reading your latest thoughts. I do think that a large part of the recent Yuan activity is driven by the PBOC trying to squeeze carry trade speculators – the recent export numbers surprised even the chinese regulators and showed them just how much money is seeping in through false invoicing, etc – they are concerned that without accurate numbers (across the economic spectrum) they will find it very hard to manage the delicate rebalancing they are attempting. So squeezing the speculators helps to get more accurate export numbers and also adds a new risk element for when the widen the currency band. that said, the broader thrust of your note (especially US dollar liquidity and demand post QE) is very on point. But your final comment intrigues me – how can the US and European central banks step in to plug the demand gap other than via QE – unless they are prepared to drive up interest rates? And being super-simplistic – you are right about deflationary pressures – all the more so if the US dollar is rising – but that is exacerbated by higher interest rates! Sooner or later, it will force the West to borrow a lot less. Or did you have some other central bank approach in mind?

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