Inside the Struggling China A-Shares ETFs

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Thanks to the advent of ETFs, there are plenty of options available for investors to buy up shares in the Chinese market. Easily the most popular is the iShares FTSE China Large Cap ETF (FXI – ETF report) which has over $5 billion in assets under management.

Inside the Struggling China A-Shares ETFs

Even though this is the most accepted way to gain exposure to Chinese stocks, a new type of Chinese ETF investment has burst onto the scene lately; the China A-Shares ETF.

These types of shares trade in Shanghai and Shenzhen that are currently closed off to many Western investors. Only Qualified Foreign Institutional Investors and Renminbi Qualified Foreign Institutional Investors have access to these shares.

However, global investors can access these markets via the Market Vectors China ETF (PEK – ETF report)PowerShares China A-Share Portfolio (CHNA – ETF report)and the newly launched db X-trackers Harvest CSI 300 China A-Shares Fund (ASHR – ETF report(read: China A-Shares ETFs Explained).

Tumbling China A-Shares ETFs

The lackluster economic scenario in China has not only crushed the popular ETFs, but China A-Shares ETFs have also not been spared. While both PEK and CHNA have tumbled more than 10% in the last one month, ASHR has fallen in the high single digits.

A deeper look at the index tracked by these funds reveal the reason for the fall. Both ASHR and PEK track the CSI 300 Index. The index’s heavy exposure to Financials and Industrials sectors (almost 50% allocation) can be blamed for the poor performance of the above ETFs.

Both these sectors have delivered lackluster performance in 2013. In fact, the ChinaFinancials ETF (CHIX) has tumbled 11% in the last one year (read: China ETFs Tumble to Start 2014).

Reasons for the Fall

The world’s second largest economy has lately divulged a series of economic readings, revealing a slowing economy. The high growth rates achieved in yester years on the back of massive debt could now be a thing of the past.

The Purchasing Managers’ Index (PMI) for China in both factory activity and the services sector declined in December, indicating a slowdown in the country’s growth. New business expansion was the slowest in six months.

Moreover, the Chinese economy is expected to report 7.6% growth in 2013, representing the weakest growth rate since 1999. However, some leading analysts predict a figure even below 7%.

Apart from the unimpressive growth numbers, official data suggests that China’s local government debt has soared 70% over the past three years to 10.6 trillion yuan.

China’s unbalanced fiscal policy and shadow banking are cited as the main reasons for this massive debt problem. The Chinese government’s heavy investment in public infrastructure projects, which usually generate low long-term returns, aggravated the debt problem.

The Recent Trigger

China’s financial sector again took a beating at the beginning of 2014 as the new State Council guidelines proposed stricter regulations for shadow bank lending.

The shadow banking system operates outside the regulated financial market, and permits banks and finance companies to lend money to businesses and the government sector at high interest rates.

The immense popularity of shadow banking in China during recent years is blamed on the highly regulated banking system of the country. Tight regulations have made shadow banking a popular way to lend and borrow money (see all the Asia Pacific ETFs here).

However, the lenders of the shadow banking system, which themselves borrow from regulated banks, have made a whole bunch of questionable loans that could default. Defaults on loans can trigger broader financial crises.

Moreover, fear of another cash crunch towards the end of this month, ahead of the Chinese New Year holiday, has raised fresh concerns.

The recent fear of a broader financial crisis and a cash crunch led PEK and ASHR to fall around 5% each in the last one week, while CHNA has dropped around 3%.

Is There Any Hope?

While stricter lending norms and new regulations to limit growth on unregulated loans will hamper short-term credit growth, implying a lower GDP growth rate, it is expected to be beneficial for the Chinese economy in the long run.

Moreover, the implementation of several social and economic reforms over the next five years will reinvigorate the economy (read: China ETFs Jump on Government Reform Afterglow).

Bottom Line

Though the China A- Share ETFs are currently in bad shape, it can be a good option for long-term investors if the government can successfully implement reforms aimed at a sustainable growth rate and reduction in its massive debt burden.

However, these ETFs do look to remain volatile, and certainly will see bigger swings than its multi-national focused peers like FXI, so make sure to use caution when trading in this relatively new slice of the market.

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DB-HRVST CSI300 (ASHR): ETF Research Reports

PWRSH-CHA A-S P (CHNA): ETF Research Reports

ISHARS-CHINA LC (FXI): ETF Research Reports

MKT VEC-CHINA (PEK): ETF Research Reports

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