By Donald Dion
ETF Report

        The second quarter was a good one for commodity and China ETFs. Almost everything risk related advanced in the past three months, with PowerShares Financial Preferred (PGF) sporting a 57 percent return, the fifth best among funds in our newsletter. Other strong performers include the India ETFs and ETNs, which popped more than 20 percent in one day following the country's election results in May. Aside from the reduced risk aversion, these funds advanced on isolated factors. Commodity and China ETFs, however, were pushed by common threads, most important among them the growth in Chinese loans.
        As early as February, Chinese economists were "ballparking" that as much as one-third of the country's loans could be headed into stocks and real estate. The percentage may still be in the neighborhood, with roughly 20 percent heading into stocks, according to a Bloomberg story, which cites Wei Jianing, a deputy director at the macro-economics department of the Development and Research Center under China's State Council.
        Based on the current exchange rate of 6.83 renminbi to the U.S. dollar, Chinese banks loaned $358 billion in the first half of 2008 and $719 billion in all of 2008. Through the first half of 2009, banks have lent $1.1 trillion; Reuters reports that the Bank of China's research department predicts that loan growth could surpass $1.4 trillion by the end of 2009. Those loans paid off for stock investors China's Shanghai Composite Index gained 63 percent in the first half of the year, 30 percent in the first quarter and 25 percent in the second quarter. The market capitalization of Chinese shares has risen from about $1.8 trillion at the end of 2008 to $3 trillion this July.
        EPFR Global reported that $3.8 billion of foreign money flowed into China in the second quarter, but that's dwarfed by the $82 billion that potentially came via misallocated bank loans. If the stock market's rally was fueled in large part by these loans ($135 billion in the first quarter), then further gains will be dependent on further loan growth. In order to hit the $1.4 trillion loan total for 2009, banks can lend only another $400 billion this year, roughly equivalent to the amount of loans in the second quarter and less than double the amount lent in June alone. However, as yet there is no sign of a slowdown in lending growth, aside from a minor regulatory change.
        Unlike in the U.S., where there are little to no signs of inflation anywhere in the economy, China has almost completely reflated its stock market and real estate bubble. The Shanghai Composite is at a 52-week high and roughly 80 percent off its lows. One fund manager said that Chinese small caps were in a bubble in mid-June, some of them sporting P/Es over 100, but prices continued to rise into July. As of July 1, the People's Daily said that P/E was 25 for Shanghai stocks and 35 for Shenzhen stocks.
        At the end of June, a parcel of land in Beijing was auctioned for the single highest price ever, and China Daily reports that the same parcel had been pulled 15 months ago "due to a lack of bidders." That article cites a property broker, Homelink, which claimed that residential property in Beijing's Central Business District appreciated 6.5 percent in the last week of June. A Homelink broker went on to say, "We used to talk about monthly price growth, but recently, it's more about daily change." To further quote the article, jam-packed as it is with great anecdotes: "Unlike the previous growth, mainly driven by first-time homebuyers, the recent transaction growth is largely buoyed by rising investment sentiment,' said Chen Weiye, a researcher at Shanghai Centaline Property Consultants."
        Similar to the U.S., China undertook several measures to boost home buying, but unlike the U.S., China was more conservative during the boom times. For instance, Chinese home buyers often needed 30 percent down payments, something virtually unheard of in subprime America, with its zero or even negative down payments. Recently, the government has again stepped in to slow the real estate market. Hangzhou, a wealthy city in Zhejiang province, recently tightened the rules for purchasing a second home. JLM pacific Epoch reports: "Second-home buyers must now pay down payments equal to 40% of the total property price, while interest will be charged at 110% of a base rate, according to Binjiang Real Estate Chairman Qi Jinxing. Previously, down payments were 20% of the total property price and interest was charged at 70% of the base rate, the report said."
        And I haven't even mentioned the rally in crude oil, copper and other hard assets. Besides money being plowed into stocks and real estate, money also flowed into commodity markets as Chinese imports surged. From February 27 through June 11, iPath Copper ETN (JJC) popped 58 percent, 22 percent of that in the second quarter. PowerShares DB Oil ETF (DBO) advanced 66 percent between February 18 and June 11. Another industrial metal ETN, iPath Nickel (JJN), gained 56 percent in the second quarter alone.
        We've already caught a glimpse of what happens when China stops adding to its commodity reserves. According to John Gartnaut of The Sydney Morning Herald, China's resource spread ended on June 30. The article mainly focuses on the impact on Australia's economy, which managed to grow in the first quarter thanks to China's appetite, but also cites a Chinese economist who says that China needs to ease purchases to slow the growth of heavy industry and relieve the pressure on commodity prices.
        Many natural resource ETFs sold off in June, save JJN, which peaked on July 2. JJC fell 11 percent between June 11 and July 7 and DBO lost 12 percent. PowerShares DB Base Metals (DBB) fell 9 percent over the same period. PowerShares DB Agriculture (DBA) tumbled 18.3 percent since June 1.
        While it's clear that prices can reverse quickly once the loaning stops, it's not clear that the loaning will stop, and this has Chinese economists worried. Every week, if not every day, there are new stories fretting about bad loans, misallocated resources, potential inflation and other negative repercussions. Influential financial magazine Caijing had the following to say in a recent editorial: "If the nation's GDP growth rate hits double digits, and the current flood of excess liquidity is not curbed within 12 months, CPI may rise by more than 5 percent per month next year. China's current liquidity levels are unprecedented, laying a foundation for steep inflation. A lesson from the past is that consumer and asset price inflation always follow increased liquidity levels."
        Of course, it's also possible that, in the absence of a global economic recovery, the inflation ends via deflation. Another stock market and real estate plunge, in addition to a financial crisis (something China avoided in 2008), could be in the offing if the global economy suffers a double-dip. Even for investors avoiding the Chinese market, the impact would be widespread and could unleash another round of global deflation.
        In June, iShares FTSE/Xinhua China 25 (FXI) received the bulk of investors' dollars, $248 million total. Next was the ProShares Ultra Short FTSE/Xinhua China 25 (FXP) with $65 million; followed by SPDR China (GXC) with $31 million; Claymore/AlphaShares China Small Cap (HAO), $23 million; PowerShares Golden Dragon USX China Index (PGJ), $19 million; and Claymore/AlphaShares China Real Estate (TAO), $15 million. iShares FTSE China HK Listed (FCHI) saw no inflows.
Performance-wise, TAO and HAO delivered more than 50 percent returns and PGJ rallied more than 40 percent, while the three broadest ETFs had gains north of 30 percent. FXP fell significantly, down more than 50 percent. As long as China's bankers and bureaucrats allow loan growth to continue, this bull will continue to run. The recent dip in commodity prices will put a lid on inflation and ease inflation fears temporarily. A correction may be coming, but chances are good that loan growth will not be curtailed until sometime late in the third quarter, at the earliest. And note that commodity buying has slowed and real estate controls have just begun. Speculators will move out of the restricted markets and into relatively unrestricted ones, helping to fuel a bubble even if loan growth slows. This should be an exciting second half.
        Editor's Note: Donald Dion is editor of ETF Report, 25 Main St., P.O. Box 387, Williamstown, MA 01267, 1 year, 12 issues, $99. www.fidelityadviser.com.