ETFs to Watch in the Chinese New Year

The Chinese market has seen a rocky start to January thanks to concerns about slowing manufacturing activity and a shaky financial sector. These financial concerns really were starting to panic markets, as investors were worried about a possible default for a ‘riskless’ investment product.

The Product

The product in question -- 2010 China Credit-Credit Equals Gold #1 Collective Trust Product -- which promised a 10% return annually, far better than the 3% earned on bank deposits, was seen as likely to default on its payments worth $492 million.

The trust product, issued by China Credit Trust, was sold through different branches of ICBC to around 700 of the bank's high net worth clients (HNI) (read: China ETFs Tumble to Start 2014).

The money raised by the trust was loaned to Shanxi Zhenfu Energy Group, an unlisted coal mining company. However, Zhenfu never obtained key licenses for its operations as its owner was detained in 2012. Subsequently, the coal mining company declared bankruptcy, causing China Credit Trust to declare that it might default on its payments for this product.

Default Avoided

The default fear that was looming large over the Chinese economy over the last few days has been temporarily averted. China’s (and the world's) largest bank by assets, Industrial and Commercial Bank of China (:ICBC), recently declared that an unidentified third party has stepped in to avoid the default (read: China ETFs Struggle on Weak Data, Bailout Speculation).

A mysterious third party acquired the shares of the coal mining company from Zhenfu to avoid default on the WMP. Investors will, however, receive only the principal amount and will have to forego the final interest payment.

Market experts were thinking that the Chinese central bank might after all allow this WMP to default. The default would have jolted investors of their complacency, making them more aware of the pitfalls of investing in alternative financial products for more returns.

Blame it on the Shadow

It is China's shadow banking sector that takes most of the blame for the debacle. The shadow banking market works outside the regulated financial market. This system permits banks and finance companies to lend money to businesses and others at high interest rates.

The lenders of the shadow banking system, which themselves borrow from regulated banks, have made a whole bunch of questionable loans that could default.

Is China Doing Anything About This?

In order to curb financial risk, China is seeking tighter controls on the shadow banking system and has issued new regulations to limit growth on unregulated loans (see China ETF Investing 101).

Though China is taking steps, the pace of default on trust loans points to a rather gloomy picture. Market data suggest that there are more than 100 billion yuan ($16.5 billion) in mining-related trust loans, which are expected to mature this year. While this amount is just for the mining sector, there are trust loans outstanding for other sectors as well.

Moreover, increasing defaults in the shadow banking sector might scare investors away from risky investments. This might lead to a credit crunch in the Chinese economy as money is pulled off the table. Authorities even while clamping down on the system will not want to put a grinding stop to its liberalizing efforts.

ETF Impact

Beyond the concerns over the health of the Chinese Financial sector, the slowdown in manufacturing and service activities is also one of the factors plaguing China. Many Chinese ETFs have plunged in the double digits since the start of January.

Popular large cap ETFs -- iShares China Large-Cap ETF (FXI), iShares MSCI China ETF (MCHI), FTSE China (HK Listed) Index Fund (FCHI) , China All-Cap ETF (YAO) , and SPDR S&P China ETF (GXC) -- are the worst hit this year, falling more than 9% each since the start of the year.

During the past one week Golden Dragon Halter USX China Portfolio (PGJ), iShares MSCI Hong Kong Small-Cap ETF (EWHS) and iShares MSCI Hong Kong ETF (EWH) were the top three losers, plunging around 7.6%, 6.5%, and 5.9%, respectively.

Though the major large cap ETFs were the worst hit last week, the A-Shares market held up better. The trio of db X-trackers Harvest CSI 300 China A-Shares Fund (ASHR), PowerShares China A-Share Portfolio (CHNA) and Market Vectors China ETF (PEK) reported flat to slightly positive gains (read: Inside the Struggling China A-Shares ETFs)

Bottom Line

Though China looks to have averted a high profile default ahead of their New Year, a wave of defaults by trusts would weaken the confidence of the people in the shadow banking system. The overall credit condition within the economy might be affected and a likely spike in interest rates might not be avoided, suggesting that the Year of the Horse might also be rough for China ETFs.

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