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Investment Exposure in China, Here Are The Risks (NYSEArca:FXI, NYSEArca:EWH)

November 9th, 2012

Richard Cox: With many market participants focusing on the negative circumstances in both the European and US economies, investment opportunities in China are looking more and more attractive to many investors seeking an alternative.  Because of this, investors should look to assess the potential risks involved when investing in Asia’s emerging markets, as there are some key issues that will likely affect equity market prices throughout the rest of 2012.

Vulnerability in the Banking Sector

First, and perhaps the most important, is the vulnerability of the Chinese banking sector.  In recent weeks, the local authorities inBeijinghave required banks to roll over loans made to smaller government agencies, confirming beliefs that the official investment policy in the region lacks sustainability.  High levels of credit exposure in commercial banks to a potential property bubble add to the worrisome scenario and given that 1.7 trillion USD worth of bank loans given to these government entities are scheduled to mature within three years, downside risks to credit availability remain clear.


The Chinese banking system is widely considered to be under-developed but despite this, four of the largest banks in the world operate within the country (Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China), with combined assets valued at roughly $9 trillion and shareholder equity worth nearly $600 billion.  Total loan values to government entities are seen at nearly $1.7 trillion, however, so any delays repayment of these loans will provide substantial strains on shareholder equity.  These loans are, in fact, guaranteed by the Chinese government but restructured payment programs will likely have a dragging effect on the nation’s economy and lower annual net incomes for each of these large banks.

Emerging Housing Bubble

The next major factor is seen with the latest trends in Chinese property prices.  Housing equity is generally thought of as the most significant savings asset for individual families and some of the latest increases in housing prices have been described by many as alarming in terms of how they are increasingly out of budget reach for a substantial portion of the Chinese population.  This is especially true in the coastal areas, where the largest percentage of the population resides.

Reversals, though, have been seen since the end of last year and what we could be seeing now is a major inflection point for the way markets will react in the longer term.  Capital requirements have been made more restrictive by the People’s Bank of China (PBoC), which should make it easier for home owners to handle a substantial fall in the value of their properties but it should be remembered that many Chinese home owners have nearly all of their savings tied to their home mortgages, and this created additional consumer vulnerabilities.

The main problem here is that investment opportunities for the Chinese are limited given that financial markets are closed and this forces an exaggerated dependence on family home values.  A likely result is that this creates bubbles in the investment assets that are available and any major reversal could easily cause panic in the retail market.  This could have an immensely destructive effect on consumer confidence and bring down domestic retail sales figures as well.

Political and Social Turmoil

The global slowdown could also have effects that enter into non-economic realms and lead to social and political tensions in the region.  GDP growth inChinais seeing a consistent slowdown in momentum, albeit still at a relatively strong 8 to 9 percent, according to estimates from the IMF.  Many analysts have suggested, however, that this could easily drop to 7 percent if unemployment continues to rise and the possible social unrest that could result from this could become a difficult problem for local governments that do not have much experience handling this type of issue.

Conclusion

The combination of these potentially negative factors means that investors need to closely monitor risk exposure in the Chinese economy.  The most recent 5-year plan proposed by the Chinese government shows a commitment to decreasing social tensions that are building with the widening gap seen between the country’s wealthy and poor.  Some suggest that this gap is now wider than what is seen in theUS, and this is a worrisome factor for the ruling Communist party.  The ability of the central government to create stability and harmony in the economy within the country will now be tested and receive a great deal of media scrutiny in the process.

Chinese economic planners are focusing on their Grand Regional Infrastructure program, which will attempt to provide a more even distribution of wealth amongst all social classes and in each of the major population centers.  If these plans are unsuccessful, there will most likely be significant drags to economic growth as domestic consumption still plays a small role with respect to annual GDP figures.  If this negative scenario does actually unfold, the combination of a vulnerable financial system and declining home prices could lead to losses for investors overexposed to price volatility in Chinese equity markets in the medium to long term.

Richard Cox is the author of Core Concepts in Technical  Chart Analysis and has published a daily fundamental and technical analysis of  the major asset markets (stocks, commodities, forex) for a variety of news  outlets. He has a Bachelor’s Degree in History and a Master’s Degree in Finance  and currently lectures in International Trade for university students in  Nanjing, China.

The successful investor today seeks an edge and is prescient enough to fully  leverage it. Waterbury Research delivers that edge on a daily basis,  combing exhaustive research and deft analysis that is the product of years spent  filtering through multiple investing approaches and learning the nuances of  the markets. Our team is comprised of seasoned market pros that focus solely  within their respective areas of expertise: Small Caps, Exchange-Traded Funds,  Income & Dividend, and Energy & Commodities.


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