China ETFs: Crisis and Opportunity

by: Don Dion

Economic data from China was anything but positive in the past month. Steep drops in manufacturing indexes and interest rates, factory closings, massive stimulus packages, and rapidly slowing growth rates all point to a severe recession in the world’s workshop.

Economic Slowdown

China’s leaders have plenty to fear, given their emphasis on harmony and stability. Riots by unemployed factory workers in Dongguan, Guangdong; taxi strikes in Guangzhou; and potentially millions of migrant workers flooding back to their rural homes are just a few signs of the current economic malaise. Guangdong province, the global center of light manufacturing (textiles, toys, shoes, etc.), reported that GDP growth was 4.4 percent below year-ago levels in the first 10 months of 2008, and last month the provincial government unveiled a 40-billion-yuan plan to support manufacturers.

As with the rest of the globe, the once-hot real estate sector has cooled as well, and construction projects are being halted around the country. More than one Chinese economist predicted a 50 percent decline in real estate prices, and Ling Xiuli of PICC Asset Management is one of the most pessimistic, saying prices could fall for 10 years. She compared the home price to income ratio of Beijing’s fourth ring homes to the average family income in the city, and the ratio recently exceeded 22, way above the World Bank target of 3 to 6, she cites.

Government Action

China’s central, provincial, and local governments have not been slow to react. Massive infrastructure plans, some already in the works, may be accelerated or find their budgets increased. A bridge connecting Hong Kong, Macau, and the city of Zhuhai in Guangdong province will begin construction in 2009, about a year ahead of schedule. In the north, Hebei province began its “Three Year Big Changes” plan to upgrade the province, which locals liken to the Sichuan earthquake for the number of buildings it has brought down—with many more marked for demolition—to make way for modern urban infrastructure. The 700-billion-yuan project (roughly US$100 billion) is not part of the central government’s recent stimulus package, however.

In total, 10 trillion yuan in spending was announced by provincial governments in November, equivalent to nearly 40 percent of China’s GDP, although the spending will stretch over several years. Undoubtedly the plans will boost the economy, but GDP is an imprecise measurement of economic health. Misallocated resources can send GDP higher today but may lay the groundwork for another recession if the market needs to clear bad investments. China’s infrastructure boom in the late 1990s also picked off a lot of low-hanging fruit, and as time goes by, the marginal benefit of further infrastructure development will be diminished.

More promising are further economic reforms already in place or on the way. China’s stock market will allow short-selling and margin in the near future. To raise the hundreds of billions of yuan needed for the economic stimulus package, Beijing may allow the provinces to issue bonds—a move that will increase political decentralization. Income taxes will be cut by raising the threshold for taxation. Most important was the rural land reform passed in October, giving farmers greater property rights. Those familiar with the work of Hernando de Soto of the Institute for Liberty and Democracy will recognize the potential for higher land values, which will raise rural incomes, lower the wealth gap, and expand the financial system.


One cannot discuss China without addressing its “lack of consumption,” but I believe that this attention is misplaced. In a free market, the ratio of savings to consumption will reach a natural balance, and it cannot be said to be too high or too low. Nonetheless, distortion of the economy through government intervention (such as the artificially low interest rates in the United States, which led to unnaturally high consumption and conversely low savings) will eventually cause recessions. An undervalued yuan has suppressed domestic consumption and led to unprofitable investments in the export sector (and placed China in a weaker position than it otherwise would be), but this is a currency issue, not a consumption issue. The prescription for the problem of under consumption is not government intervention but termination of interventionist policies that maintain the distortion.

China ETFs

Although technical analysts are becoming short-term bullish on the country and Chinese ETFs outperformed in November, stock market history indicates that bear markets can persist for some time. Many latecomers to China were enamored with the recent bull run, which sent the Shanghai composite from 1,092.82 at the end of October 2005 to 5,954.77 in October 2007. Bulls explain the drop to 1,728.79 by the end of October 2008 as a reaction to the weakening economy, but this ignores the behavior of the index at the start of the decade. The index traded more than 50 percent below its 2001 peak until mid-2005, when the index bottomed and set up its historic gains—at a time when China’s economy enjoyed rapid growth—because many of the companies on the exchange are inefficiently run state-owned enterprises (SOEs). Much of the gain in recent years came on the back of strong natural resource prices and financial bubble activity, sectors dominated by SOEs, and also sectors over-weighted in many China ETFs.

Below are six China ETFs, with assets under management and expense ratios, and the top 15 holdings in FXI, with the corresponding allocation in other funds. I chose FXI because it is by far the largest China ETF, but also to highlight the overlap in holdings across the funds.

click to enlarge

Click to enlarge

Aside from the huge assets of FXI, the funds are very similar in their holdings, except for HAO, which invests in small caps. PGJ offers heavy exposure to the U.S.-listed tech sector, but its top 10 still have a high correlation, due to large positions in the energy and telecom sector. Nonetheless, even small-cap HAO has a high correlation with other funds since inception.

I expect the correlation between HAO and the large-cap funds to decline in the future, however. In the long run, China’s insistence on maintaining state control of certain industries should lead to equity underperformance as profits are sacrificed for market share or political and social stability (we’ve already seen the oil companies lose profits due to gasoline price controls). Meanwhile, the small caps will be free to maximize profits and deliver shareholder value.

A Bright Future

All the economic data and research in the world, however, cannot capture the Chinese people’s desire to succeed. They are the most optimistic people in the world and view the current economic problems as speed bumps on the road to prosperity, not an end to a way of life. China’s attitude is in stark contrast to Western societies that are desperate to avoid risk and preserve their current position. (In fact, the only people in China trying to preserve their position are the members of the Communist Party.) Inevitably, the optimism of the people will return to the stock market, and though it’s hard to predict when the country will recover, it will probably be one of the first to do so.