Sunday, January 10, 2010 5 comments ++[ CLICK TO COMMENT ]++

Could be a critical year for China

UPDATE: The Dec 15 CNBC video doesn't show up properly for some reason :( Click here to go to the relevant CNBC page and check out the video on the left, in the article.

I thought China was going to be a big issue in 2009. I was wrong. Nothing happened.

But I am maintaing my stance. Is it still vulnerable to an implosion? Mike Shedlock links to two China bears, Doug Noland and Jim Chanos, who think China may be reaching dangerous territory. Mike Shedlock has also written in the past about his bearish views of China.

I'm not a fan of Doug Noland (too perma-bearish for my likes) but I do pay attention to Jim Chanos. As you may know, Jim Chanos is perhaps the most successful short-seller in the last 30 years. There are others, like Jim Paulson, who profitted off short-selling mortgage bonds but they are not short-selling specialists; they go back to a long-only portfolio afterwards. Chanos, in contrast, is a specialist and very good at detective work. But his techniques are sometimes questionable, and he is, for those not aware, one of the short-sellers that was attacking Prem Watsa's Fairfax Financial.

One thing about Chanos is that he, like most short-sellers, uses propaganda so you have to be really careful (another person who is an even better media influencer is William Ackman of Pershing Square.) I notice that Jim Chanos floats stories to the media and uses that to influence perceptions. For instance, he was apparently the first person to pass along the questionable techniques of Enron to the journalist at Fortune magazine. Without the media publicizing the Enron story, I don't think Enron would have imploded quite the way it did. Enron probably would have collapsed a bit and had to pay huge fines but there is a possibility it wouldn't have declared bankruptcy. I'm not saying what Chanos does is wrong; he isn't doing anything wrong. All I'm saying is that short-sellers love to use the media.

Anyway, the bearish China call appears very different from Chanos' past, successful, bets. Chanos is very good with short-selling individual securities but I'm not clear on his track record on macro bets. If I remember correctly, he was bearish on the Dubai real estate boom but I'm not sure if he made any money. Jim Chanos has been bearish on China for more than an year now and been completely wrong. It remains to be seen if he ends up being right.

Mike Shedlock links to a New York Times story, picked up by Yahoo! News, touching on Jim Chanos. Nothing new in the article but it's a good recap of the battle between bears (like Chanos) and bulls (like Jim Rogers):

As most of the world bets on China to help lift the global economy out of recession, Mr. Chanos is warning that China's hyperstimulated economy is headed for a crash, rather than the sustained boom that most economists predict. Its surging real estate sector, buoyed by a flood of speculative capital, looks like "Dubai times 1,000 -- or worse," he frets. He even suspects that Beijing is cooking its books, faking, among other things, its eye-popping growth rates of more than 8 percent.

"Bubbles are best identified by credit excesses, not valuation excesses," he said in a recent appearance on CNBC. "And there's no bigger credit excess than in China."

A lot of this seems like hyperbole. I don't think there is anything that is 1000x worse than Dubai. Really! I mean, Dubai has a ski slope in the middle of the desert! Dubai has a Tiger Woods golf course that needs something like 100,000 gallons of fresh water a day—again, in the middle of the desert with shortage of fresh water.

So, maybe in terms of dollars. China is much bigger so the number will look big. But the problems are not as bad as Dubai IMO.

Still, betting against China will not be easy. Because foreigners are restricted from investing in stocks listed inside China, Mr. Chanos has said he is searching for other ways to make his bets, including focusing on construction- and infrastructure-related companies that sell cement, coal, steel and iron ore.

Chanos probably got burned badly last year, given the spectacular rally in nearly all assets, but, of relevance here, commodity businesses like coal, steel, etc. But Chanos is a long-term investor so the question is what happens over the next 5 years.

The simplest short-selling strategy is to sell short the ETFs or invest in an inverse ETF. For instance, one may short sell the FXI ETF. I suspect that is not how you make money. Given how short-selling only has a maximum upside of 100%, it is probably best to bet big that something will completely implode (an index won't completely implode.) The best thing may be to short sell individual securities. Because of capital controls, as well as various distortions—for example, most of the major Hong-Kong-listed Chinese companies are majority owned by the government—it is hard to find something that will be profitable.

Short-selling commodities that depend heavily on China, like iron ore, are probably worth considering. I don't know how easy it is for small investors but this would be a clean strategy. Jim Chanos, in the video linked near the bottom of the post, suggests some techniques.
"I find it interesting that people who couldn't spell China 10 years ago are now experts on China," said Jim Rogers, who co-founded the Quantum Fund with George Soros and now lives in Singapore. "China is not in a bubble."

Colleagues acknowledge that Mr. Chanos began studying China's economy in earnest only last summer and sent out e-mail messages seeking expert opinion.

But he is tagging along with the bears, who see mounting evidence that China's stimulus package and aggressive bank lending are creating artificial demand, raising the risk of a wave of nonperforming loans.

"In China, he seems to see the excesses, to the third and fourth power, that he's been tilting against all these decades," said Jim Grant, a longtime friend and the editor of Grant's Interest Rate Observer, who is also bearish on China. "He homes in on the excesses of the markets and profits from them. That's been his stock and trade."

Mr. Chanos declined to be interviewed, citing his continuing research on China. But he has already been spreading the view that the China miracle is blinding investors to the risk that the country is producing far too much.

"The Chinese," he warned in an interview in November with, "are in danger of producing huge quantities of goods and products that they will be unable to sell."

In December, he appeared on CNBC to discuss how he had already begun taking short positions, hoping to profit from a China collapse.

Here is the CNBC video from December (click here if the video does not show up):

It's interesting that Chanos implies that gold is not in a bubble. He doesn't really discuss it but does say that "no one is building anything out of gold."

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5 Response to Could be a critical year for China

January 11, 2010 at 7:58 AM

It is hard to stand in the way of exponential growth.

Over the last 100 years or so, the US has experienced:

3 or 4 banking/credit crises,
2 world wars,
3 or 4 other major wars,
the great depression,
the great recession,
a baker's dozen of garden-variety recessions,
a couple of major oil price spikes,
more bubbles than I can count on all my fingers,
& interest rates ranging from basically 0% to over 20%.

And despite all this the US economy (and stock market) has undergone remarkably steady exponential growth.

I have a similar belief when it comes to China.  I believe that temporary market excesses and dislocations will have little ability to halt China's inevitable rise over the next half century.

January 11, 2010 at 12:45 PM

We are all bulls on China over a 50 year horizon.  The question is whether investing in China today is like investing in the US in 1928 or 1929 or before the panic of 1907.

I believe Jim Rogers said that moving to China today is like moving to the UK in year 1800 or to the US in year 1900.  I partly agree here, that being a creditor nation mattersl, but then the UK and the US at their heydays were the countries in the world that had the best institutions, strongest rule of law, most economic freedom and best opportunities for entrpreneurs.  China has gone from very poor economic freedom to average or slightly above average, and that has big impact due to China's massive population, but it doesnt mean it's going to dominate the world like the UK and the US have done. 

I'd say the places to be right now are creditor nations with strong rule of law and low tax. Singapore and Hong Kong are candidates, and possibly Switzerland and maybe Panama.

Sivaram Velauthapillai
January 11, 2010 at 4:50 PM

I don't follow India very much. It is largely a closed economy so what happens within the country has a bigger impact than any global issue per se. The fact it has capital controls on investments (can't really invest directly in their companies) sort of makes it difficult to read the situation there. For instance, it appears that Indian stock prices are overvalued but it's hard to say for sure.

Like all countries, India has its own issues. I think some big cities have real estate bubbles on par with China. I am curious to see how the government fiscal spending situation is handled. India's government finances are weak--at least China is sitting on large foreign exchange surpluses and is running a current account surplus--and it remains to be seen what comes of it.

Over the next 50 years, I think China's problems will largely be economic in nature with some serious political issues. In contrast, I think India's long-term problems will be mostly social. Things like discrimination against women, problems with class structure, relgious tensions, etc are the problems that need to be solved in India. I like to think of India as 1800's USA while China is early 1900's USA.

Sivaram Velauthapillai
January 11, 2010 at 5:05 PM

MrParkerBohn and Martin84,

Thanks for the comments. I share similar views as you two. China certainly has very good long term prospects. The stars are certainly aligning in its favour. Like ParkerBohn alludes to, there will be some issues that need to be overcome. I think the biggest problem will be their political apparatus.

Totalitarian states have never succeeded economically in the last few centuries. Sure, the Romans, Egyptians, and others did ok but that was around 2000 years ago. Perhaps, as a liberal, I am biased in favour of freedom but I honestly don't think a country can prosper for very long with  top-down politics with a few "uber" leaders calling the shots.

One of the reasons authoratarian structures rarely work for very long is because of something Jared Diamond once mentioned (and I linked to his thoughts once.) All it takes, under a top-down structure, is for one guy to make the wrong call, and the whole society would be penalized. The classic example Diamond gave was China and its naval fleet. China used to have one of the top naval fleets in human history--it was far superior to Columbus' ships or anything else Europeans had--but the 'powers that be' decided to shut down their naval operations. This essentially destroyed China's seafaring interest and changed history forever. In Europe, as Diamond suggests, this never happened because there were many little countries, all de-centralized, and competing with each other. If Italy didn't want to support Columbus, or if some Portugese leader didn't, maybe Spain would.

China also has looming demographic problems but my view is that they will eliminate that after removing the so-called 'one child policy' and loosening immigration of women. Yeah, kind of controversial but they'll probably end up doing that.

Anyway, all of us, present, past, and future, (will) live in unique times. Ours will be to watch what happens in China. And maybe some of you will become wealthy investing off it :)

Sivaram Velauthapillai
January 11, 2010 at 5:21 PM

Martin84: "I'd say the places to be right now are creditor nations with strong rule of law and low tax. Singapore and Hong Kong are candidates, and possibly Switzerland and maybe Panama."

I'm not so sure that the rule of law is very strong in some of those countries. It may be strong in the sense that the citizen will be punished by the state and can't get away from crimes, but I am not so sure how fair any of it is. Few like to invoke fairness into the notion of any rule of law but it is an important element--especially the ability to challenge the state for perceived wrondoings. For instance, my impression is that citizens have little power against the Singaporean government. So, what happens if there is dispute over your property with the state? So far, no one talks about this because, like Dubai, nothing bad has happened. But I just wonder.

It's interesting that you bring this up because this could turn out to be a huge issue in China if something bad happens. I hope nothing bad materializes but I just wonder about property rights in China. Other countries in Latin America and Eastern Europe also look questionable to me.

Anyway, in the grand scheme of things, I don't think being a creditor nation matters much. The ultimate thing is how well your economy develops and how efficient/profitable your businesses/workers/etc are. Australia had been running a current account defict for decades (it may have turned positive due to the commodity boom in the last few years but it wasn't liike that before) and yet many would consider it quite safe and attractive.

Another way I think of this is as follows. As long as you can earn earn more than you borrow, you will be fine. If your country borrows at the rate of 5% and is able to generate profits at the rate of 10%, you may even be better than the creditor. Over a long period of time, you will probably become more wealthier than the any lender.

I haven't looked at the latest numbers but Americans have generated more in profits than they paid out in interest payments for a long time. The question is whether they can keep it up.

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