Be Cautious on China

 | Dec 18, 2012 | 1:00 PM EST  | Comments
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The new Chinese government is beginning to announce changes to the rules allowing foreigners to invest in China. The most important of these are the changes made to the Qualified Foreign Institutional Investors (QFII) and Renminbi Qualified Foreign Institutional Investors (RQFII) programs.

On Dec. 13, Chinese government officials announced that they would be expanding both programs in an attempt to attract more capital to China.

There is nothing new in this though and no logical reason for the announcement to cause investors to believe that an inflow of foreign capital to Chinese equities is imminent and that it will cause the markets to reverse the three-year, nearly 40% slide in the value of the Shanghai Composite Index following the Lehman Brothers' crisis bounce in 2009.

Following the announcement, which was made at the same time a positive Manufacturing Purchasing Managers Index was announced, the Shanghai Composite Index soared over 4% and set the stage for discussions of a bottom in China's economy and markets as well as discussions of the beginning of a new long-term resurgence in both.

This sentiment has also been helped by Technical Analyst Tom DeMark's call for a 48% increase in the Shanghai Composite Index within the next nine months; which he offered about 10 days before the Dec. 14 surge.

I would be cautious about all of this though. The changes to the QFII program and introduction of the RQFII program have been under way for about a year and a half.  The amount of QFII and RQFII capital allowed has tripled, the eligibility has been made less restrictive, and the allowance for taking profits out of the country has been increased.

Of the 192 investors awarded QFII licenses in China since the program began in 2002, 57 were added this year alone. The initial changes to the QFII and introduction of the RQFII began a year ago in December 2011. The Shanghai Composite Index increased about 4% into March of this year before steadily declining to its lowest level since Lehman debacle.

It has since rebounded from 1960 on Dec. 3 to about 2160 today, or about 10%. This is probably due to investors exhibiting relief as a result of the new government not postponing the anticipated changes and instead maintaining cohesion with the previous administration's actions.

There has been, and still is, a lot of concern about the economic and financial market policies that will be pursued by the new government. It is important to note as well that, in the past, the Chinese has attempted to attract long-term investment capital while trying to prevent speculative capital. The most recent changes to the QFII program will cause speculative inflows to increase. The introduction of the RQFII program was an attempt to halt the flight of Chinese investor capital from the country.

The performance of these programs will provide insight into future changes by the Chinese regulators. If they are successful, the rules will be loosened further with the currency eventually being opened as required by the World Trade Organization.

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