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Weakening Banks Could Pressure Financial-Heavy China ETFs

China’s banking sector is weakening as profit growth slows, nonperforming loans rise and years of stimulus-driven ending begin to end. Consequently, investors looking into China-related exchange traded funds should monitor their financial sector exposures.

For instance, the iShares China Large-Cap ETF (FXI) is the largest China country-specific ETF and allocates a hefty 48.4% tilt toward the financials sector, and the slightly more diversified SPDR S&P China ETF (GXC) includes a 30.1% weight toward financials. In comparison, the Powershares Golden Dragon Halter USX China Portfolio (PGJ) only allocates 2.0% toward financial stocks but overweights tech companies at 52.6% of its portfolio. Year-to-date, FXI has increased 3.9%, GXC gained 1.5% and PGJ rose 1.2%.

The Global X China Financials ETF (CHIX) , which targets China’s financial stocks, has dipped 0.6% year-to-date.

On Wednesday, the Industrial & Commercial Bank of China, the country’s largest lender by assets, revealed that net profits increased at a slightly better-than-expected 7.7% in the third quarter year-over-year but was still down from the 10.1% growth for all of last year, reports Aaron Back for the Wall Street Journal.

The bank is experiencing declining growth as the balance of nonperforming loans jumped 23% from the end of last year. Meanwhile, the provision coverage ratio, a measure of loan-loss charges taken against nonperforming loans, declined to 217% from 257% – a higher ratio indicates a better ability to fulfill obligation to lenders.

Bank of Communications, or Bocom, revealed net profits was 6.3% higher in the third quarter, or below expectations and slightly down from 6.8% growth last year. Nonperforming loans increased 19% from 2013 while provision coverage ratio fell 12 percentage points to 201%.

Looking at the ETF holdings, FXI’s portfolio includes a 7.1% position in Industrial & Commercial Bank of China and 1.7% in Bank of Communications. GXC includes Industrial & Commercial Bank of China 5.1% and Bocom 1.3%. CHIX has a 10.1% position in Industrial & Commercial Bank of China. [How to Use China ETFs]

Given the current slowdown in China’s economy, Barclays analyst May Yan argues that the sector-wide profit growth will continue to slow to just 3% next year. Additionally, banks could see margins squeezed if Beijing pushes on with interest-rate liberalization, which would force banks to compete for deposits.

“Looking forward, as the government shifts the drivers of growth from capital investment to consumption, these state-controlled firms might find their oligopolies (and profits) a little less secure,” according to Morningstar analyst Patricia Oey. “In the banking sector, the government recently loosened its control over lending rates to stimulate competition among banks and provide more credit to the private sector. Within the next few years, the liberalization of deposit rates (an important step for China’s planned transition to a consumer-led growth model) will follow.” [Behind the Ignored Rally in China ETFs]

However, China’s financial sector is not in immediate danger as the state-owned companies are still backed by the government. Moreover, Chinese banks are still among the most profitable companies in the world.

The Industrial & Commercial Bank of China is the most profitable company in the world, USA Today reports. Four Chinese banks are also among the top ten most profitable global companies.

For more information on China, visit our China category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.