China’s Liberalized Equity Market A Boon

By Peter Pham - May 8, 2012 | Tickers: HBC, FXI, DSUM, BNO | 0 Comments

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China’s equivalent to the SEC announced changes which began on May 2^nd that can be seen as positive baby steps towards opening up those markets to a broader range of potential investors.  China, like Vietnam and India, is what is known as an “ID” market, meaning that foreigners have to trade publicly which puts them at a disadvantage to domestic traders.

The reforms for China’s markets, though, are very bullish for a number of other reasons.  Among the changes are:

• A drastically reduced transaction fee schedule.
• Increases in Foreign Ownership in joint ventures with Chinese banks and brokers to 49%
• Broadened de-listing rule for stocks that have failed to perform

Bull in a China Stock

These moves have been seen as positive for increasing liquidity and interest in Chinese equities which have seriously underperformed their peers.  The iShares FTSE China 25 Index Fund (NYSEMKT: FXI) should be the beneficiary of these changes.  The fund is made up to mirror the FTSE 25 China Index largely represented by Chinese ‘Red Chips.’  FXI, however, has not responded along with the Shanghai market, up just 2.9% and looking very range bound between $36 and $38 per share.  After bottoming on March 29^th at 2252 the index has rallied 9% closing at 2452.01 on May 4^th.  After bottoming on March 29^th at 2252 the Shanghai Composite Index has rallied 9% closing at 2452.01 on May 4^th. 

This movement has tracked with the rise in the Baltic Dry (BDI) Index after it bottomed in mid-February.  The BDI has risen faster than the Shanghai Index but that trend halted abruptly when these changes took effect and the Shanghai market took off this week, rising 2.3% in just three trading days.  With the BDI having turned around in the face of increased shipping supply coming into the market this year (22% by best estimates), that would suggest a global slowdown is not happening now. 

The Oil Slick

The easing of the oil prices in the past two months has unburdened shipping as well.  Two of the local grades of oil, Asia-Pacific Tapis (heavy crude proxy) and Minas (light crude proxy) have dropped 9.6% and 12.2% from their peaks.  For countries like China and Vietnam which have strict price controls on petroleum products like gas and diesel these price drops on fears of an implosion in the U.S. and Europe are actually liberating for their economies which have suffered under rapidly rising oil prices.

Whether this is a trend in oil prices or the short-term effect of new margin rules put into place recently by Dodd-Frank and the CME as well as President Obama’s increased pressure on so-called speculators remains to be seen. 

As both Tapis and Minas crude trade at a premium or discount to brent crude, anything that happens that affects how Brent trades on ICE ultimately affects how it trades in Asia.   Tapis prices track Brent pretty closely as the spread has hovered around $10.30.  Minas crude’s average spread has been slightly higher at $10.70 per barrel but the range is much wider, indicating a much more elastic demand, 

Dim Sum in Those Hills

It is looking to me that the market has fully priced in the effects of any hard landing in China’s economy and the flurry of moves in both the Yuan and now the equity markets recently are indicative of greater confidence that China’s financial markets can handle greater inflows of foreign capital. 

The so-called Dim Sum Bond market is another area where liberalization has resulted in growth; from just $3 billion in July 2010 when the de-regulation of them went into effect to an estimated $38 billion today.  There are currently a handful of ETFs available to play in this market. PowerShares Chinese Dim Sum Bond ETF (NYSEMKT: DSUM), holds most of its assets, 70%, in corporate paper from around the world, with half of its AUM not rated by either S&P or Moody’s.  85% of the fund is held in 1-5 bonds with 1-5 years to maturity.  Government bonds make up 20% while Agency and Supranational debt comprises the balance along with some cash.  Volume during the period from April 27^th to May 4^th contained 4 of the highest volume days in the fund’s short history. 

The first example of a floating rate yuan-denominated loan based on a local interbank rate was announced on May 5^th. Uni-President China Holdings has opened up a $95 million, 3 year line of credit, who will pay a 1.50% premium over the average overseas Renminbi interbank rate, as quoted by Bank of China and HSBC (NYSE: HBC), which was 2.15% as of May 5^th. 

All of these instances exist at the statistical error level of daily market capital flows, but they are examples of the changes that are happening in this area of the world outside of the daily headlines of what number is being discussed to death on CNBC.  As the U.S. and European markets continue to deteriorate in quality, as evidenced by MFGlobal’s spectacular bankruptcy and lack of response from the authorities, this will drive capital into new corners of the world.  These may be small numbers compared to Apple’s corporate bond market but they are enormous relative to the markets around Southeast Asia, which was the fear that drove the high barriers to foreign investment in the first place.

Now the circle is in the first stages of completing itself and offer investors some very unique opportunities in the coming months and years ahead.

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