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China slowdown concern spurs record option hedges on ETF

[NEW YORK] Investors are rushing to buy protection against declines in Chinese stocks amid concern an economic slowdown will undermine their world-beating rally.

Demand to hedge against future losses on the largest US exchange-traded fund tracking China's mainland market climbed to the highest since the ETF was created in November 2013, according to data compiled by Bloomberg. The buying pushed the ratio of bearish to bullish contracts to a five-month high on March 11 as investors pulled $34 million from the fund in a second week of outflows.

The bets underscore growing investor skepticism that the Shanghai Composite Index can sustain its advance after rising 39 per cent since October against a backdrop of monetary easing and weaker-than-estimated economic data. The central bank has cut interest rates twice in four months to revive an economy expanding at its slowest pace in 24 years, helping fuel gains in the so-called A-share market.

"There'll be some pull-back," Chang Liu, a London-based China economist at Capital Economics Ltd, said by phone on March 12. His firm predicts a decline of about 11 per cent from last week's close on the Shanghai gauge by the end of 2015.

"GDP growth will be slower, the property market remains weak and overcapacity is still an issue."

Purchases of so-called puts, or options to sell the US$1 billion Deutsche Bank's X-trackers Harvest CSI 300 China A- Shares ETF, has jumped fourfold to an all-time high of 44,760 contracts last week from a January low. The open interest on options to buy the ETF, or calls, increased 45 per cent during the period to 52,924, also a record.

The Deutsche Bank fund rose 4.7 per cent to US$36.66 last week, extending its advance since the end of October to 38 per cent. The Shanghai Composite rose 2.3 per cent to 3,449.31 at the close on Monday, extending a 4.1 per cent gain last week, while the CSI 300 Index of A-share stocks on mainland exchanges added 2.4 per cent after climbing 4 per cent last week.

Industrial output, investment and retail sales growth all missed analysts' estimates in January and February, while Bloomberg's gross domestic product tracker, which draws on that data as well as measures such as electricity production, shows economic growth slowed to 6.28 per cent in the period, the weakest pace since the start of 2009.

Policy makers this month set the lowest economic growth target in more than 15 years at 7 per cent, down from last year's goal of about 7.5 per cent. The Chinese economy expanded 7.4 per cent in 2014, the slowest pace since 1990. China will intervene with targeted measures to support growth if the economy slows to a rate that hurts jobs and people's income, Premier Li Keqiang said at a briefing in Beijing.

Short sellers are also betting that China's mainland markets may decline. Borrowed stock was 6 per cent of outstanding shares in the Deutsche Bank ETF on March 12, up from just 0.1 per cent at the end of last year, according to data compiled by Markit Ltd. and Bloomberg.

China's slower and more sustainable growth path will attract long-term investors, according to Brian Jacobsen, the Menomonee Falls, Wisconsin-based chief portfolio strategist for Wells Fargo Advantage Funds. He forecasts the A-share market will continue to rise this year.

"Unless you think that China somehow is going to implode, there are tremendous opportunities throughout the country for investing," he said by phone on March 13. "It's becoming a little bit easier for foreign investors to access the Chinese markets."

China started an exchange link between Shanghai and Hong Kong in November, which gives foreign money managers greater access to mainland-traded equities.

Losses in Chinese financial shares are also flashing a warning signal to investors in the world's second-largest stock market.

The CSI 300 Financials Index has dropped 8.1 per cent this year through March 12, the most among 10 industry groups, even as the CSI 300 Index gained 1.7 per cent. When financial companies lagged behind the broader market by this much in November 2007 and August 2009, the CSI 300 Index lost an average 42 per cent over the following 12 months.

Banks' bad-loan ratio rose the most in at least a decade last quarter as a property-market slump and slower economic growth hurt borrowers' ability to repay. Nonperforming loans accounted for 1.29 per cent of commercial banks' total advances as of Dec 31, up from 1.16 per cent three months earlier, the China Banking Regulatory Commission said in January.

While China's easing measures should be positive for stocks, the worsening data suggest it may take longer for the economy to respond, said Michael Wang, a strategist at Amiya Capital LLP in London.

"It doesn't seem like a great fundamental backdrop for equities and they've gone up a lot," Mr Wang said by phone March 12.

BLOOMBERG