A stream of bad news from China means my pessimism on the country in the short-term will not be assuaged today.
China’s banking regulator announced Thursday that if the price of homes in Shanghai drops by ten percent, the bad loan ratio for banks there would triple. This adds further weight to my warnings about playing China by using an ETF such as Claymore/AlphaShares China Real Estate ETF (NYSEARCA:TAO) or iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI).
10% may seem like an unrealistically steep drop for real estate prices, but investors familiar with the run up in prices that have led to speculation of a Chinese asset bubble know better than to be skeptical. This is because they have watched as prices of residential properties in Shanghai rose by 8% in December alone, and they know that prices can go down just as quickly.
The banking regulator’s comments on the financial repercussions of a property value tumble make me wary of the financially heavy FXI, in addition to the real estate focused TAO. An increase in bad loans would mean banks would have to raise capital in order to meet reserve ratio requirements, which increased last month.
The market would react negatively to such a move and FXI allocates 46.4% of its holdings to financial companies. Reports that the government is considering injecting capital into Bank of Communications, one of China’s largest banks, already make me all the more concerned about the stability of the country’s financial system even before asset prices have come down.
In addition to the reserve ratio hike, the government has also asked banks to refrain from issuing property loans that may be used for speculative purposes. This all adds up to my steering well clear of Chinese financial- and real-estate exposed ETFs, and I encourage investors holding these funds to get out at current levels.
Although Claymore/AlphaShares Small Cap (NYSEARCA:HAO) would still be substantially affected in the event of an asset bubble burst, it would go down less than FXI or TAO due to its much smaller 12.9% allocation to financials.
I do not think this is the best time to chase gains in China, however, even with an instrument such as HAO. But, for those still bullish on the country, the fund is the best place to be, and it will also be the best fund when China fears blow over.
Disclosure: No positions