Emperors With No Clothes: A Banking Crisis Will Expose China ETFs

SHIBOR is now the acronym of the week.

The Chinese equivalent of the London Interbank Offered Rate (LIBOR) spiked overnight, roiling global financial markets in the process. At one point, overnight SHIBOR surged almost 580 basis points from yesterday's levels to 13.4 percent and one-week SHIBOR climbed nearly 300 basis points to 11 percent.

That forced the People's Bank of China to inject $8.2 billion into the country's banking system to stem off a possible banking crisis. The one-year interest-rate swap, the fixed cost needed to receive the floating seven-day repo rate, rose 17 basis points to 4.66 percent after earlier trading as high as 5.06 percent, an all-time high, according to Bloomberg.

Concerns regarding interbank exposure and leverage to opaque wealth management products that have contributed to a boom of sorts in China's so-called shadow banking system are among the issues that have pressured Chinese banks, both in the A- and H-Shares markets.

Chinese banks flirting with the brink of disaster conjures up images of a phrase many U.S. investors have grown to loathe. That being "too big to fail." Indeed, Chinese banks, some of them anyway, may just be "TBTF." At the very least, Beijing should do what it can to avert a banking crisis because four of the 10 largest banks in the world are based in China.

Still, a Chinese banking controversy, and that is putting the situation mildly, is already having and will continue to have an impact on billions of dollars in U.S. ETF assets because some China ETFs are just too heavily weighted to bank stocks.

The Usual Suspects
The $2.2 billion iShares MSCI Hong Kong Index Fund EWH is down 2.7 percent Thursday, exerting further pressure on already slumping valuations of H-Share banks. EWH's downside is not surprising as the ETF is not at all diverse at the sector level. The ETF allocates almost 60 percent of its weight to financial services names and that explains why the ETF is trading near six-month lows today.

The $5.6 billion iShares FTSE China 25 Index Fund FXI, the largest China-specific ETF by assets and the most heavily traded, is down 2.4 percent. More importantly, the ETF is trading below $33 and a close below there would be the first since September 2012.

While FXI has long been a favorite China ETF among both professional and retail investors due to perceived robust liquidity and perhaps the fact that it has one of the more attractive options markets among single-country emerging markets ETFs, the fund also has a tradition of lagging other China ETFs over longer time horizons.

Like EWH, FXI is not the place to hideout when it comes to dodging SHIBOR. China Construction Bank is the ETF's largest holding and the other three banks that make up the Big Four of Chinese banking are found in the fund's top-10 holdings. The quarter represents roughly 28 percent of FXI's weight and the financial services sector in total accounts for 54.6 percent of FXI's weight. That is more than three-and-a-half times the next largest sector weight, which is 15.2 percent to telecom, according to iShares data.

Alternatives, Sort Of
The $1.2 billion iShares MSCI China Index Fund MCHI is showing that a lighter allocation to Chinese banks does make a positive difference, both intraday and over longer time frames. Translation: MCHI's 38.8 percent weight to bank stocks makes it less bad than FXI, indicating it is really inexplicable why FXI is almost five times larger.

MCHI is down less than FXI and EWH today and over the past two years, MCHI has outpaced FXI by 630 basis points. The $900 million SPDR S&P China ETF GXC is proving to be a bit of disappointment. That ETF is down roughly the same as FXI today, although its financial services weight is "just" 33.7 percent, which is underweight relative to its underlying index.

GXC and MCHI have another issue to deal with beyond SHIBOR: Exposure to energy stocks. State-controlled energy stocks have been repudiated this year and the Chinese names are no exception. GXC and MCHI have energy allocations of 12.3 and 14.8 percent, respectively. GXC's two-year loss is roughly half that of FXI's.

The Guggenheim China All Cap ETF YAO, home to an almost 35 percent weight to financials, is down 2.2 percent today on volume that is more than triple the daily average. In a sign of just how deep investors' distaste for China ETFs currently runs, the $223.3 million Guggenheim China ETF HAO, which has a mere 15.8 weight to financials is down 2.3 percent on more than double the average daily volume.

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