Will China Devalue Its Currency?

What's the outlook for the Chinese yuan, and how should you invest in China?

Mar 15, 2014 at 2:02PM

It's been a rough week for China. This week, China's currency, the yuan, fell after the central bank cut the currency's fixing by the most since July 2012. In fact, the yuan dropped 0.27% to 6.1445 per dollar. What is behind the drop?

Weak trade data
Some analysts see that the weakening of the yuan is related to recently posted poor foreign trade data. Numbers coming from customs showed that overseas shipments fell 18.1% in the country last month compared to prior year, the biggest drop in five years. On the other hand, imports into the world's second-largest economy rose 10.1%. As a result, China faces its biggest trade deficit in two years: $23 billion.

Considering that the Chinese government has strong control over the exchange rate, some analysts suggest that the authorities in the country might be willing to devalue a bit more to help the country's exports.

The scenario is still complex and uncertain, but depending on where you see the Chinese economy heading there are some Chinese ETFs that could help you profit.

China ETFs 101
To get a quick idea of how the country's equity market is doing you may start by checking out the broadest China ETF available, SPDR S&P China (NYSEMKT:GXC).

This fund tracks the S&P China BMI Index, which is a float-adjusted market-cap-weighted index that measures the investable universe of publicly traded companies with operations in China. The fund holds about 250 securities, and its diversification has resulted in better risk-adjusted returns. However, year to date, this fund is about 9% down. 

Then you also have iShares FTSE/Xinhua China 25 Index (NYSEMKT:FXI), which invests in the 25 largest Chinese companies listed in Hong Kong. This fund is dominated by state-controlled enterprises, and has a substantial position in the financial sector (55%) and energy firms. These companies have benefited from political and financial support from the government, which holds a majority stake in most of them. Hence, they enjoyed favorable regulations and strong oligopolistic positions in their respective industries, which helped profitability. This fund, though, is down 12% this year.

If you want funds with a more mid-cap tilt, and lower weightings in the state-controlled financials and energy names, there's Matthews China Investor (NASDAQMUTFUND:MCHFX). This fund in fact has a relatively high degree of exposure (about 29%) to consumer names. This is because its managers pursue companies with moderate valuations that could become strong growers. What you'll notice is that this fund holds a relatively modest average market cap and owns several lesser-known firms. But what's behind this investment approach?

Basically, they buy companies that are expected to benefit from the rising personal-income levels in China, while they reduce their exposure to the financial sector. This is a key difference from the other funds, and although it is not a success story yet, things could change. Year to date, the fund is down 6.5%.

Final thoughts
Before jumping to conclusions, you need to know that the recently posted foreign trade figures may have been distorted by the Chinese Lunar New Year holiday and over-invoicing a year earlier. Although it is troubling, it might not be something to worry too much about unless other negative data comes later supporting a strong devaluation thesis.

In addition, the yuan's volatility has nothing to do with those of other developing-nation currencies. The country is expanding into a two-way floating of the exchange rate, where daily fluctuation is up to 1% north and south of the reference rate set up by the Chinese Central Bank. Hence, do not expect strong swings.

The real question is where is the government's policy going to aim? If you decide to invest in the iShares FTSE/Xinhua China 25 Index, keep in mind that you are betting on the Chinese government's capital-intensive economic growth model, which has been applied for a good number of years already and may not be as strong going forward.

Matthews fund, instead, bets on China's next growth story -- the rise of the middle class. Since the beginning of 2012, Chinese consumer-related stocks have gained far less than financial stocks on average, and many smaller-cap and lesser-known selections have also struggled. However, this could change, as many analysts foresee the government changing policies toward a consumer-oriented economy. Keep in mind this fund is actively managed and sports a hefty annual fee of 1.12%.

SPDR S&P China's broader portfolio could help reduce exposure and volatility. Plus, it carries a lower expense ratio of 0.59%, which makes it one of the lower-priced options for China equity exposure. Therefore, it could help you have exposure to Chinese assets at a low relative cost. Nonetheless, about a third of this fund is in banking and financial stocks, which are often the first ones to adjust in unstable markets and are a definite risk.

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Louie Grint has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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