Exchange traded funds that invest in China are essentially flat this year as the central bank keeps boosting interest rates in a bid to quell high inflation. Officials are trying to engineer a “soft landing” for the economy after years of stimulus-fueled growth.

The largest ETF tracking the country, iShares FTSE China 25 (NYSEArca: FXI), remains well below its 2007 peak.

“Over the last decade, Chinese equities (as measured by the FTSE China Index) have had annualized returns of 21%. These very strong returns were driven partly by low valuations and better than expected economic growth during that period,” said Morningstar analyst Patricia Oey in a profile of the ETF.

“Looking forward, we do not think Chinese equities will perform as strongly, as the Chinese government focuses on guiding the economy towards lower, more sustainable growth rates. However, we think China equities have a place within a diversified portfolio, given China’s standing as the second largest economy in the world, whose growth will likely outpace that of the developed world in the near and medium term,” she wrote. “Over the long run, investors may also benefit from the anticipated appreciation of the Chinese yuan.”

China’s central bank recently increased benchmark loan and deposit rates by a quarter point, its fifth interest-rate increase in eight months, reports Aaron Back for The Wall Street Journal. The move comes a week before the announcement of June inflation data, which analysts expect to be more than 6% year-over-year. [Portugal, China Rattle Global Credit Markets.]

“Inflation will be effectively suppressed when the government policies take effect,” Chinese Premier Wen Jiabao assured.

“We think this is likely to be the last hike of the year,” commented Goldman Sachs analyst Yu Song, in the report. “We believe the government is reluctant to use the [interest-rate] tool too often for concerns on potential hot money inflow s… and the negative impact on real economic activities.”

Credit Suisse predicts a 20% chance that China may experience a “hard landing,” or a period of sustained growth of less than 7%, over the next 12 to 18 months.

Analysts interpret the rate increase as a strong sign of growing concern over inflation, given the Chinese government’s reluctance in using broad policy moves. The rising rates also increase the cost of the central bank’s “sterilization operation,” which the bank issues to purchase funds from exports and foreign capital inflows. Furthermore, interest rate hikes pus increased pressure on municipalities to repay debt — China’s National Audit Office calculates that local governments owe more than a fourth of the country’s GDP.

Earlier this week, Moody’s warned that Chinese banks have more exposure to local debt than originally estimated. [China, Portugal Rattle Markets]

ETFs that invest in China include:

  • iShares FTSE China 25
  • SPDR S&P China ETF (NYSEArca: GXC)
  • PowerShares Golden Dragon Halter USX China Portfolio (NYSEArca: PGJ)
  • Guggenheim China All-Cap ETF (NYSEArca: YAO)

For more information on China, visit our China category.

iShares FTSE China 25 Index Fund

Max Chen contributed to this article.

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