China Stocks: Risks Ahead

In my current line of work, I travel a lot to key international markets (China, India, Brazil, Europe) and interact with a wide range of business people. I am also an active trader of my portfolio.

It is shocking to me as to how companies in mainland China have a complete lack of transparency as it pertains to their financials. It is very difficult to figure out the extent of government involvement and amount of government financing in these enterprises. It is also very tough to figure out true profitability due to substantial subsidies that many of the enterprises get from the Chinese government.

As such, I am amazed at the talking heads in CNBC and many of the wall street analysts who continue to recommend investing in iShares FTSE/Xinhua China 25 ETF (FXI). In my humble opinion, with inflation spiking (inflation soared to a near 12-year high of 8.7 percent in February), mainland Central Bank is bound to increase interest rates substantially this year (China last year increased its key rates six times and in January raised the reserve requirement on bank deposits to its highest level since the 1980s). This will be a major deterrent to stock prices going higher.

Another key fact to note is that monies have been flowing to the stock market in huge quantities because real estate prices have gone up 5x and 10x in many markets. Ordinary citizens who cannot afford to chase the real estate market are instead putting money into the stock market. This real estate bubble is bound to collapse at some point. With interest rates going up, and home prices slowly coming down, this is a recipe for disaster for the stock market. The government due to the Olympics, etc, will of course not allow a complete stock market meltdown to occur, but there is a good chance of an additional 5% - 10% correction this year.

Therefore, I feel that even though FXI has come down from a high of $219 to a low of $128, there is still significant downside. One effective way of playing this downtrend is buying the Ultrashort of FXI (FXP). I have made good money trading FXP (including last week). Plan to get back into this game after the FOMC meeting today.

Disclosure: none

Comments

[Gaz:]

Chinese companies sole reason to be publicly listed is to get something for nothing. Most listed companies I have looked at in China over my 4 years of being here are not actually making profit in real life, only on their stocks. They hide the truth and invariably have government officials investing prior to listing which shields them from any laws that might exist. Many of them raise funds and act basically as shell companies feeding the money through to some other new venture or personal fund with no ties to the stock whatsoever, all with government officials on the payroll if they aren't the coordinators themselves.

I've been here 4 years, speak the language, deal daily with listed companies and their staff, and I would NEVER invest in any Chinese stocks and it is clear to me that anyone who invests in ANY Mainland Chinese stocks usually has the false belief that trading is governed by laws. If you've invested in Chinese stocks, well, personally if that money was important to me I'd cut my losses or bubble gains right away before I lost all of it.

2008 Mar 18 11:50 PM

[Yossel:]

Interesting post, followed by a comment from GAZ, whose website is indispensible for any investor wanting an unvarnished and up-to-date view of the larger Chinese economy. A real eyeopener, GAZ !

2008 Mar 19 12:38 PM

[huangthomas:]

Those are government owned enterprises. The government is owned by communist party. What do you expect communists to behave when they own the companies. You cannot resist airing naive American thinking in public?

2008 Mar 19 04:42 PM

[Mr. Zhao:]

Non-food inflation is still mild. Chinese gov't should do more to promote food imports instead of hiking interest rates and reserve ratios. You are actually shorting Hong Kong H shares with FXP. IMO H shares are in the process of bottoming and shorting them at this valuation not rational. Even A share will not collapse but rather may go down to around 3000 and reach parity valuation with H shares. China's fundamentals are still bright.

2008 Mar 19 06:42 PM