How Yuan Policy Affects China ETFs

The Chinese yuan is, undoubtedly, one of the most widely followed and controversial currencies in the world. Previously a lightening rod for U.S. politicians that believe China intentionally weakens the yuan to the benefit of its exporters and the detriment of U.S. companies, the yuan is now seen by some market observers as undervalued.

Massive capital outflows from China along with dwindling though still robust foreign currency reserves are seen plaguing the world's second-largest economy. Those factors, among other have weighing on China exchange traded funds, including the SPDR S&P China ETF (NYSE:GXC). GXC, home to nearly $696 million in assets under management, is down 11.6 percent year-to-date, but to the ETF's credit, it is up more than eight percent in the past week.

As A-shares have tumbled in recent months, investors have endured situations such as days where half the stocks trading on the mainland where halted by Chinese regulators and ineffective market interventions, a tool Beijing has since told market participants that they should not become too dependent on.

The Peoples Bank of China (PBOC) now faces a classic situation of a market against a central bank, where each new move is met with diminished marginal utility by the markets. With the yuan weakening, it remains to be seen how successful the PBOC can be in controlling capital outflow and how many reserves it will use to defend its currency before engaging in a one-off devaluation, according to a new note from State Street Global Advisors (SSgA).

Like other China ETFs, GXC is heavily allocated to bank stocks, but the ETF's 30.4 percent weight to that sector is lower than that of comparable China ETFs. Additionally, GXC's nearly 27 percent weight to technology stocks is overweight relative to rival China ETFs.

As is the case with plenty of single-country emerging markets ETFs, GXC reflects the low valuations currently available in the developing world with a price-to-earnings ratio under 10 and a price-to-book ratio of just over one.

When it comes to the yuan and China ETFs, capital outflows cannot be overlooked.

Capital flight accounts for about 50% to 60% of Chinas recent $700 billion reserve drawdown. While the data isnt fully transparent, it is estimated another third comes from Chinese companies paying down US dollar debt. While that is favorable because it reduces the hit due to currency mismatch, January marked the 22nd consecutive month of net capital outflows, according to SSgA.