Would You Short China?

Monday, January 18, 2010 5:43

One of the more interesting discussions I had last week was surrounding how one (a firm or an individual) could position themselves against China in the markets. That, if one believed, China’s economy was in a bubble – and that the bubble was going to pop – how would one position themselves favorably.

It was an interesting discussion as the person I was speaking with historically would have loaded their portfolio with short positions on those he thought would be the first to fall. In China this option is largely negated by the fact that you can’t short Chinese stocks in China, and that there aren’t really enough firms listed overseas (or at least not the right ones should the fit hit the shan).

Typically a topic I would avoid on All Roads, I figured it was worth a post as the “recession” seems to be over, people are turning back into good consumers, but then there was an article that forced me out of my cave. So, in my first random act of amateur journalism, let’s get right into it and take a look at the Pulitzer prize winning author Thomas Friedman’s latest article  Is China the Next Enron. Friedman, , who is a leading expert on war, globalization, global warming, and NOW US/ China economic structures, writes a piece that questions the logic of James Chanos who recently said that China is “Dubai times 1,000 — or worse”, and he offers up two gems of advice for Mr. Chanos:

First, a simple rule of investing that has always served me well: Never short a country with $2 trillion in foreign currency reserves
Second, it is easy to look at China today and see its enormous problems and things that it is not getting right. [...] I am reluctant to sell China short, not because I think it has no problems or corruption or bubbles, but because I think it has all those problems in spades — and some will blow up along the way (the most dangerous being pollution). But it also has a political class focused on addressing its real problems, as well as a mountain of savings with which to do so (unlike us).

Now, correct me if I am wrong, but neither of those have ANYTHING to do with the real estate market, and while I would agree that having 2 trillion in reserves and a focused government help, perhaps Friedman is just a bit overly optimistic about China? or perhaps it is just that he is so pessimistic about the US that anything looks better?

The second half of his article gets even better as he lays out WHY China is long term in the stronger position. Having lunch with some students from HK, he comes to understands (not sure if this is a watershed moment for him) that China’s sea turtles are retyrning home (note: a sea turtle in Chinese is someone who goes abroad to study, perhaps work for some time, and then returns home), and that the represents a long term advantage for China:

One of the biggest problems for China’s manufacturing and financial sectors has been finding capable middle managers. The reverse-brain drain is eliminating that problem as well.

On this point, I would agree, but I would also say that this belief that all sea turtles are coming home is not only false, it is misleading. Many are only returning because there is an opportunity right now, but few that I have spoken to plan on staying in China forever. This is, for many (not all), a short term proposition, a feast of you will, where everyone is trying to get their piece of the action and then go home with as much fat sotrage as possible.
These are not people returning to the “motherland” to build the nation, and that is the flaw in Friedman’s belief.

Friedman wraps up his article with the following assessment on a China Short:

“So I asked several Taiwanese businessmen whether they would “short” China. They vigorously shook their heads no as if I’d asked if they’d go one on one with LeBron James.”

.. damn, he is a good writer, but is he write? (UPDATE: Read this post by Barrett Brown who really tears into Friedman)

In short, no.  I think that Friedman’s analysis is flawed, his sourced (based in TW and HK) are the wrong ones for the story, and there are signs that I would say present a concern for many.  Including Chinese leaders, banking officials, and those in commodities.

At the heart of it for me, the main issue I see everyday, the low hanging fruit, comes in the form of real estate.  Walk down Huai Hai road, Nathan in HK, or visit the latest SOHO project in Beijing, and you will see that retailers are turning over.  A LOT.  Some will say that it is a heathy sign of an economy that there is turnover, and typicallly I would agree, but at this time what I am seeing instead is a phase where established retailers are closing shops and landlords are offering up firesale deals to fill spots.  Spots that vacate after 4-6 months becuase the concept did not work.  A condition that is not limited to a single store, but to entire blocks.

Looking a bit higher, and moving  bit further from the inner ring roads, and it becomes clear that the next real problem is in the vacany rates in all the recent commerical and residential buildings that have been built.  18 months ago, these projects were DEAD. Cranes were idle. Trucks were not moving. Workers were clearly on a siesta.  Then, 9 months ago everything changed over night (hello stimulus!) and my entire district become a construction pit with 24/7 dump trucks going down the road, cranes whirling steal beams around, and migrant laborers flowing back into the city.

It was a period of manufactured economics, and it has created a condition where many supporting industries began to find themselves in a situation where there was more capacity in the market than demand.  Everyone rushed in for stimulus money, and with that largely drying up we are looking at some very interesting times as China’s banks (who issued the largest proportion of the debt) will now be left to collect on that money.

This was just one sector of the domestic expansion that was inflated to offset the export market deflation.  there are others.

Which leads me back to how I would place a short on China.

For me, China has been a market that offered a diverse number of opportunities for years, and while there may be a move from low to high end, the fact is that the leading indicators of this economy are still (and going to be for a long time) in the raw materials  sectors.  Ore. Coal. Metals. Oil.

It was in the immediate aftermath of the financial crisis that these prices plummeted, and it is in recent weeks following the snow storms that we saw an equal inflation in energy inputs.

So, that is where I would start (were I one to believe that the economy was about to double dip).

Next, I would look at the stocks overseas of firms who service these sectors – Autralian resource firms, American construction equipment, bulk logistics, etc – as candidates, keeping in mind that there are some who are more exposed than others

Finally, and this option is the option that should only be exercised were there be a serious meltdown…  look at all those companies who saw China as their holy grail market.  Easy to identify, if there are firms who are counting on China to return 30-40% of their future growth targets, then their stocks are going to get hammered.

Now, all this being said, would I short China at this point, and are there areas of growth that I see going forward?  I am an optomist by nature, and while I would not short China on a broad base just yet, there are some stocks that I am pretty sure are rip for a reduction in growth expectations and are certainly candidates for a reduction of their share prices.

So, that wraps up my first post for the year.  Hope you enjoyed it.

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