Is the China ETF Stuck or About to Break Out?

The iShares FTSE/Xinhua China 25 Index ETF (FXI) has been in a downtrend for months. In the last month or so it has bounced off a support level in the $140 area several times. The ETF has finally begun to turn up. On Tuesday it came right up against its downward sloping trend line. On Wednesday it fell back within the channel (see chart below).

Are we seeing merely technical trading or are there fundamental developments in the Chinese economy that will drive the ETF one way or the other?

In reviewing some of the recent news out of China there are a couple of developments that are worth discussing.

Inflation

China's consumer price index was reported up 7.1% in January, the highest since September 1996 and well above December's 6.5%. This was partially due to the severe winter storms that disrupted economic activity, caused crop damage and generally brought parts of the country to a standstill. Some analysts that this high level will not last and that China will see a moderation in prices.

On the other hand, Chinese authorities have placed price caps on certain categories of food (food prices climbed 18.2%) and it is well known that the government subsidizes oil imports in order to keep prices at the pump artificially low. Without these government induced distortions, would the CPI have been even higher?

With prices rising, it increases the likelihood that China will allow its currency to appreciate more rapidly. This is something the U.S. has been asking China to do but the Chinese government has been moving slowly in order to avoid making Chinese goods less competitive abroad.

Interest Rate Outlook

With inflation this high and bank accounts yielding only about 4%, there are expectations that the central banks will be raising rates. In the current state of affairs, depositors are getting a negative rate of return compared to inflation. With the standard weapon for fighting inflation being an increase in interest rates, we will almost certainly see a tightening in China this year.

To help cool the economy, the Chinese government supposedly set limits on lending. It appears that Chinese banks have ignored the limits. Lending continues at strong levels and plenty of liquidity is available for real estate and industrial borrowers.

Economic Activity

Last week it was reported that China's trade surplus in January exceeded analyst expectations. There have been many anecdotal stories of how Chinese exporters are already suffering as a result of the U.S. slowdown. These numbers, however, paint a different picture. In December, we saw the surplus come down a bit but now it seems to be right back at the strong levels China has become used to seeing. And this is despite the high prices of oil which inflate the import numbers.

We have pointed out in the past that China is developing a strong domestic market and is seeing growing trade among Asian neighbors and other emerging nations. It appears that, so far at least, China is protected by some degree of decoupling.

Conclusion

The Chinese economy continues to roar along. If things don't get any worse in the U.S.; ie, we don't fall into a deep recession, it looks like China can escape without a major slowdown.

As always with China, the government is the wild card. If they allow the yuan to appreciate, if they raise rates aggressively, it could throw Chinese stocks into turmoil. After the extremely strong gains of last year, a case can still be made that Chinese stocks are overvalued and vulnerable.

As for FXI, it has been trapped in this chart pattern since last October. We'll need to keep a close watch as this can't continue forever.