Be Wary of Some China ETFs
If Americans want to measure the impact of state-controlled businesses, they need to look no further than China. From Google(GOOG) watching to price controls the policies of the Chinese government impact both citizens and state-run enterprises (SOES).
Emerging market ETFs focused on China have experienced explosive growth in recent years as the maturing economy is fueled by government stimulus and a growing population.
Government interference, however, has been a double-edged sword. ETFs are a good way to gain exposure to Chinese equities, but investors should avoid funds like iShares FTSE/Xinhua(FXI) that are loaded down with SOEs.
Better bets are small-cap China firms and ETFs like Market Vectors Coal Miners(KOL), which benefit as Chinese consumers compete with rising global demand.
Coal prices for utilities may rise 10% this year in China, but industry analysts predict the government will only allow a 5% or 6% increase in utility rates. The difference will come out of the earnings of firms such as Huaneng Power, a holding in iShares FTSE/Xinhua China 25(FXI).
Many SOEs are in socially important industries such as utilities, energy and telecom. It’s a universal trait that people do not like to pay higher prices for heat, water, gas and telecommunications, and also that politicians like to get involved. A timely example comes from Martha Coakley, who is running a for U.S. Senate seat in Massachusetts and is highlighting her fight against a utility rate increase in speeches and ads.
In China, the government sets the rate utility companies can charge, but it doesn’t set the world price for coal, and coal prices look to rise about 10% this year, based on contracts recently signed by utilities. That’s only for fixed price contracts though; some agreements only have a fixed volume.
The recent cold snap sent coal prices back over $100 per ton, as the crackdown on illegal mines has reduced supply and inventory. Low reserves have led the country to import beyond the usual supplies from Australia and Indonesia. The South China Morning Post reports that demand will be about 1.5 billion tons in 2010, with 0.6 billion coming from Chinese mines.
FXI has only two utilities. Besides Huaneng, there is Datang International Power Generation with 0.8% of assets. That latter firm owns coal mines, which will partially shield it from the coal price.
The larger takeaway, however, is that investors should reduce their exposure to SOEs and turn to ETFs such as the Claymore/AlphaShares China Small Cap ETF(HAO), as this is just the latest example of unfavorable government interference. The same problem plagued refineries when world crude oil prices diverged from government controlled gasoline prices, and telecom restructuring reduced profits at the telecom firms.
Another takeaway is the bullish news for the coal industry, as Chinese demand will compete with rising demand around the globe. The Financial Times reports that a line of 60 cargo ships is waiting for coal in Australia, as infrastructure bottlenecks plague the country. KOL, which is comprised of 40 global coal companies, is the best way to play rising coal prices and rising coal demand.
When it comes to state-controlled enterprises, the government giveth and taketh. Investors looking to tap into China’s growth while skirting government controlled behemoths should consider HAO. And since sheer demand trumps price controls, KOL could also be a good bet in the upcoming months.
