China ETFs Feel the Pressure

06/27/2013 7:45 am EST

Focus: GLOBAL

The weakened economy and building credit problems are disappointing investors in China's large-cap ETF, write John Spence and Tom Lydon of ETF Trends.

The iShares FTSE China 25 Index Fund (FXI) has been under pressure recently amid worries that a spike in short-term lending rates could trigger wider liquidity problems in the world's second-largest economy.

Recent trading in FXI was brisk, as investors continued to focus on a report from The Daily Telegraph on China's so-called "shadow banking" system, as well as a warning from Fitch Ratings. Fitch said China's credit bubble is unprecedented in modern world history: "China's shadow banking system is out of control and under mounting stress as borrowers struggle to roll over short-term debts."

Chinese interbank lending rates have surged following reports that China Everbright Bank failed to repay a loan from Industrial Bank.

Shibor, the Shanghai interbank offered rate, is "telegraphing the rising stress in the opaque financial system of the world's second-largest economy," reports Matt Phillips for Quartz. "What does the spike in rates mean? Large banks are increasingly leery of tapping into their pools of cash to lend to each other."

ETF traders are positioning for more weakness in Chinese stocks, since the price of put options on FXI has gotten expensive lately.

Investors are also worried about lackluster economic data from China. A record 7 million students from universities and colleges across China are set to graduate, but jobs are getting more scarce as the economy falters, The New York Times reports.

—John Spence

It's Getting Pricey to Bet Against China ETFs
Slack data out of the world's second-largest economy and investors running for the exits are among the issues that have weighed on the largest China ETF over the past few months.

FXI is not taking all this bad news well. It recently lost 2.75% on volume that was nearly 86% higher than its daily average. The fund is down 9.5% in the past month and 19% year-to-date—a loss roughly 600 basis points worse than what the iShares MSCI Emerging Markets Index Fund (EEM) has endured.

There are signs traders expect things to get worse before they improve for FXI. The price of three-month puts on FXI recently jumped to the highest levels since September, while the 4.3-point premium of puts over calls was the widest since April 17, reports Bloomberg.

That news is significant, because while there is no shortage of ETFs offering exposure to China, none of the China-specific funds have the robust level of options activity that FXI does. That includes funds with a penchant for outperforming FXI over long-term time frames, such as the iShares MSCI China Index Fund (MCHI).

The open interest in FXI's August $33, $33.50, and $34 puts is almost 50,000 contracts, compared to just 2,900 contracts for the same strikes on the call side, according to Options Monster data. In September, those same put strikes currently have open interest of about 9,600 contracts combined, but open interest for those same calls is less than 300 contracts.

FXI is often criticized for its largest weight to financials (55.3%), but it is some of the ETF's non-bank holdings that have been real problems as of late. In the past month, China Mobile (CHL) is down 10.3%. Offshore oil exploration firm CNOOC (CEO) is lower by 8.6%, while PetroChina (PTR), China's largest oil company, has plunged 16%.

China bulls—however few in number—cannot deny that the cost of betting against FXI is rising. Those same bulls may also point to one strand of silver lining for Chinese stocks: Valuations.

To wit, FXI's current P/E ratio is 13.22, compared to 19.4 for the iShares MSCI Brazil Index Fund (EWZ) and 18.1 for EEM, according to iShares data. —Tom Lydon

Read more from ETF Trends here...

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