China ETFs On Sale, But Worth the Risk?
Rachel Koning Beals

China's economic outlook, like the rest of the globe, is a puzzle

Exchange-traded funds that track China had been high-flyers over the past few years. This year has been a different story, featuring a double-digit percentage drop that has now run into a mild late-year bounce.

This year's markdown may not be reason enough for investors to jump into China -- just yet. That's because the country's economic outlook, like the rest of the globe, is a puzzle.

Prospects are mixed for this global giant as officials there try to control inflation risks, especially in the financial and property sectors. Officials are also charged with keeping the banking system well-oiled. China tightened monetary conditions and raised bank reserve requirements earlier in the year, but officials are clearly wary of stifling growth. Government data issued in early November showed Chinese banks issued $2.78 billion in new loans in October. For some analysts, this was a signal that the government is opening the lending spigot to help support the economy. On Wednesday, China eased the reserve requirements for banks, a move meant to loosen lending.

China's strong export position is well-known.

Now, an expanding middle class fuels domestic projects like roads, utilities, and housing construction. But this global player is not immune to the globe's ills. Europe's debt and economic troubles, which look to cut that region's demand for Chinese-made goods, pose risks. What's more, the United States, a major Chinese customer, is sputtering along with modest economic growth and faces deficit challenges of its own.

Careful navigation.

Chinese Vice Premier Wang Qishan said in a November speech reported by the state-run Xinhua News Agency that the world is likely to experience a prolonged economic slowdown. His remarks echoed a similar statement the same week by Chinese Premier Wen Jiabao, who also said officials hope to secure a "reasonable correction" in housing prices.

"So far, the early indications suggest a soft landing is in progress. However, planners may remain cautious until inflation retreats further, possibly not until early 2012. Thus, a new leg up in China's economic expansion may have to wait," said Paul Christopher, chief international investment strategist with Wells Fargo Advisors, in a commentary.

While full-on monetary policy easing won't come until 2012, China will face a significant economic slowdown as the export sector feels the impact of a fragile global economy, and residential investment, which makes up 12 percent of GDP, falls drastically as the People's Bank of China seeks to control a real estate bubble, analysts at Barclays advise.

Investors are often challenged to predict central bank moves, but this is especially true of China. "Extraordinary policies designed to stimulate growth during the past years have generated some unintended consequences, such as an asset bubble, overcapacity and imbalances," Barclays analysts said in a research report.

"The People's Bank of China appears set on forcing property prices to fall by about 20% in 2012. They have also pushed to lower shadow banking credit and non-bank lending. This has led to a slowdown in China's economy, with GDP slowing steadily to 9.1% in the third quarter and inflation, as measured by CPI, falling to 5.5% in October [from 6.1% in September]," the Barclays analysts said.

Global troubles are China's, too.

Their data show that a recession in the United States, where output falls by 1 percent, and in the Eurozone, where GDP contracts by 3.5 percent, would shave off 4 percentage points from Chinese GDP growth. A 10 percent to 30 percent fall in real estate prices would subtract 0.5 percent to 1.5 percent from GDP growth.

In 2012, Barclays estimates that CPI will fall to 4 percent and GDP to 8.4 percent, with the economy cooling significantly in the second half of the year. But importantly, China has more arrows in its interest-rate quiver unlike much of the developed world, where historically skinny interest rates did not produce the speedy fix policymakers had hoped for.

Much of the world is watching China's improved but vulnerable financial system. "China's banks and financial sector are healthy, but there are vulnerabilities that should be addressed by the authorities," says Jonathan Fiechter, deputy director of the IMF's Monetary and Capital Markets Department, part of his team's first Financial Sector Assessment Program (FSAP) review of China, which was carried out jointly with the World Bank. China is among the 25 nations that agreed to such testing at least once every five years.

"While the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and the formation of bubbles, especially in real estate. The cost of such distortions will only rise over time, so the sooner these distortions are addressed, the better," Fiechter said.

The stock market is reflecting the uncertainty.

Actively traded stocks, including Dangdang and Youku, reported third-quarter losses recently, and Baidu's stock has tread water for much of this year.

For sure, a liquid, relatively easily accessed exchange-traded fund is a good way to get exposure to China and other pockets of the globe that may lead the next international growth spurt, particularly as the developed world whittles down its debt load at the expense of risk-taking expansion.

Some economists predict that China will become the world's largest economy in 15 years. But for now, investing in China through ETFs requires some careful consideration with attention on inflation levels and the resolution of Europe's debt crisis. The bottom line: Investors will be well-served to familiarize themselves with the more heavily-traded China ETF options so that they're ready to move when steady growth signals emerge for this emerging-market engine.

Here's a look at the U.S. News Best Fit China-Region Funds:

1. SPDR S&P China ETF (GXC)

2. iShares MSCI Taiwan Index Fund (EWT)

3. iShares MSCI Hong Kong Index Fund (EWH)