Last week, the IMF admitted the Chinese renminbi to the Special Drawing Right with a surprisingly large weighting of 10.92%.

That makes it the third-largest weighting, more than the weightings of sterling and the yen.

This should increase the proportion of world trade invoiced in renminbi and, over the long term, remove restrictions on Chinese citizens owning foreign assets, strengthening the Chinese economy itself.

Income investors seeking to buy a “piece of China” should be relieved that a number of Chinese companies pay decent dividends.

In fact, China is a relatively favorable environment for Americans seeking dividend income, in part because its relatively low withholding tax can be offset against U.S. taxes.

Additionally, Chinese investments are better than most foreign holdings in a tax-free account like an IRA, since the income loss from the withholding tax is moderate – 10% rather than the 20% of many countries.

Slow and Steady Wins the Race

While income investors should look seriously at China, they shouldn’t go overboard.

The country is suitable for only a modest part of the overall portfolio, and the IMF’s allocation of 10.92% is too high for an individual investor. A more sensible allocation would be 5%.

There are a lot of bad assets in the Chinese banking system and in Chinese real estate, resulting from the “stimulus” overbuilding of 2009-10, which are sure to cause a financial crisis at some point.

Still, the long-term prospects for China are so good, and the valuations so reasonable, that a modest allocation to Chinese income stocks seems sensible.

Thus “scaled-in buying” of Chinese assets – acquiring a little now and a little more each year – and taking advantage of any market downdrafts would seem an optimal strategy.

As an additional benefit, I’d expect the renminbi to appreciate generally against the dollar over the next several years – increasing the value of Chinese dividends from companies engaged primarily in domestic business.

Powering Up

For many individual investors, the best way into Chinese income stocks is through a fund.

The Matthews China Dividend Investor Fund (MCDFX), part of the Asia specialist Matthews group, is a $176 million open-end mutual fund with a somewhat high expense ratio of 1.19% but no front-end load.

The fund yields 3.2% and has returned an average 9.3% annually since its inception in 2009, compared with 2.5% on the MSCI China Index.

Of individual stocks, China Mobile Ltd. (CHL) just beat MCDFX with a yield of 3.4%, based on two semi-annual dividends in April and October.

China Mobile is the world’s largest mobile telecom service in terms of subscribers, with an astounding 823.9 million at the end of October 2015. During the first nine months of 2015, the company added 157 million 4G subscribers, bringing total 4G subscribers to 248 million.

During this period it recorded a 6.5% increase in revenue and 3.5% increase in net profit. It currently trades at 13.9 times historic earnings and 12.6 times 4-Traders’ estimate of 2016 earnings.

Huaneng Power International Inc. (HNP) is a Beijing-based electric power company that sells power to regional authorities in China and Singapore. It generates power from coal, wind, gas, oil, and hydro resources with controlled generating capacity of 81,132 megawatts.

Huaneng’s revenue for the first nine months of 2015 decreased 8%, but its net profit increased 16%. The company trades at 9.3 times 4-Traders’ estimate of 2016 earnings and has a dividend yield of 6.2%, based on quarterly dividends of $0.565. The next is due to go ex-dividend in February.

Both of these companies are very solid “blue chips” in the Chinese context, with market capitalizations in the tens of billions of dollars.

For a higher but riskier income, look to Xinyuan Real Estate Co. Ltd. (XIN), which develops residential real estate for middle-income consumers in China. Its market capitalization is just $250 million, but it pays $0.19 annually in four equal dividends and yields 5.9%.

Revenue was up 88% in the third quarter of 2015, while net income was up 602% from the previous year and up 12% from the previous quarter. The company sells at a historic P/E ratio of only 3.6 times the trailing four quarters of income and at 27% of stated book value.

This one is risky – Chinese real estate isn’t for everybody, to say the least – and it’s small. But the income and the upside potential are very attractive.

Bottom line: China may sound like the ultimate growth play. But income investors can take advantage of some attractive yields while giving themselves a modest exposure to what could well be the world’s largest economy within no more than a decade.

Good investing,

Martin Hutchinson