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Over the past decade, China has become an incredible economic force, surging from an investment afterthought to one of the key nations for trade in the world today. The country is currently the world’s second biggest economy from a GDP perspective and exports more products, in dollar terms, than any other nation on earth. Yet, with incredible growth comes difficult choices as well; inflation in the country has begun to settle at uncomfortable levels with recent readings putting the year-over-year change above 6%. This high rate of price increases, coupled with China’s relatively lax response to the situation, is starting to creep into a number of other sectors and may be resulting in unintended consequences for the economy that could be far more severe than many analysts could have initially predicted.

The nexus of this problem stems from Chinese government leaders and their intense fear of clamping down too heavily on the rate of increases for fear of sending the economy into a sharp slowdown. While all governments are obviously worried about this problem, it is an especially troublesome one in China due to the autocratic nature of the regime and ever-present reminders of demands for more freedoms in the political sphere, growth must remain high in order to quell any talk of unrest.

After all, when things are going well, it makes it much more difficult for the average citizen to complain, a chief reason that China has let inflation slowly creep up over the past few years rather than risk a slowdown. In many ways, this is the ‘Singapore model’; give your citizens the opportunity for wealth and security and they will allow a single party to remain in power for a long time. Given how well it has worked in Southeast Asia, China is loathe to try and tinker with this technique, making high growth the top priority for the government, at least for the time being.

Thanks to this policy, as well as a variety of investment restrictions, many Chinese feel that they have no choice but to put their money to work in the country’s property market. This has pushed credit as a percentage of GDP up to the 200% level, a near doubling in just three years time. Thanks to this rampant use of credit, homes are now selling at outrageous levels when compared with personal incomes, 22:1 in some coastal regions. Investors should note that this ratio is far worse than anything the American property market experienced before its bubble burst suggesting that rough times could still be ahead for China and the likely overbought real estate market.

These concerns have already begun to rock the main way for Westerners to play the market, the China Real Estate ETF (NYSEARCA:TAO) from Guggenheim. The fund tracks the AlphaShares China Real Estate Index, which is designed to measure and monitor the performance of the investable universe of publicly traded companies and REITs deriving a majority of their revenue from real estate development, management and/or ownership of property in China or the Special Administrative Regions of China, such as Hong Kong and Macau. The product has lost close to 13.5% in the past two weeks alone, nearly 29% in the past half year, and about the same when looking at the trailing one year returns. These heavy losses exceed any other product for any of the time frames mentioned above, suggesting that fears over China’s property market are bubbling over the surface [see all the ETFs that have exposure to China with our.

A Closer Look At TAO

The only solace that investors have when looking at TAO from a medium-term perspective is that the fund is much more heavily exposed to Hong Kong than it is to the Mainland, suggesting that it may actually skirt by the worst of any bubble bursting. In fact, close to 70% of the fund’s assets are invested in Hong Kong while the remainder goes to Mainland companies. Investors should also note that thanks to these widespread fears, the fund is arguably trading at a discount as the product has a PE of just 7.7 and has a price to book ratio below 1.0.

With that being said, many Hong Kong-based firms likely have huge operations on, what was until recently, the quickly growing Mainland, so just because a company is based in Hong Kong doesn’t mean it will be immune from a slowdown. Also, given the rapid appreciation of housing in China, the lack of affordability when compared with incomes, and the incredibly overbuilt status of many areas of the nation, one has to think that there will be more turmoil ahead for the sector even when taking into account the already steep losses that many of the components have experienced.

However, for those with a strong stomach for risk who are looking to add more to their China holdings, this relatively cheap fund could be an interesting long-term pick thanks to relatively favorable valuations. Either way, it looks to be an interesting few months for China’s property market and could be a wild ride for investors in TAO no matter how the Chinese government decides to intervene in the space.

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Disclosure: No positions at time of writing.

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Source: Can The China Real Estate ETF Survive Bubble Fears?