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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12 Responses to “Would You Short China?”

  1. Ann Danylkiw says:

    January 18th, 2010 at 6:19 am

    I spent last year in an MSc program in Finance and Development Economics and the thing you have to remember that stock market values and shorting have very little to do with reality on the ground– like the infrastructural observations you’ve had. So would one short China? Well, that depends on if investors can drive up the value of Chinese stocks. It has nothing to do with company assets etc.

  2. Rich says:

    January 18th, 2010 at 6:37 am

    Hi Ann.


    Totally agree -which is why I was left to basically (and have pretty much always) looked at resource stocks. that, if their market expectations (and shre prices) were built on a China story, you could short that.


  3. Adam Minter says:

    January 18th, 2010 at 8:02 am

    A great post, Rich. Thanks for it. In re to Friedman: I sense a growing backlash against his pronouncements on China by those who have some experience here. They are becoming increasingly preposterous. On that topic, an amusing take-down by Matt Taibi, someone not here, but who certainly understand Friedman’s tics: “This is Friedman’s life: He flies around the world, eats pricey lunches with other rich people and draws conclusions about the future of humanity by looking out his hotel window and counting the Applebee’s signs.”

    Full article here: http://www.nypress.com/article-19271-flat-n-all-that.html

  4. Rich says:

    January 18th, 2010 at 8:19 am

    Thanks Adam.

    Yeah – uh, I have NEVER been a fan of Friedman – at least as it related to globalization or climate change. He seemed to be really strong on Mid-East, probably a function of his time spent there, but the World is Flat and Flat, Hot, and Crowded were … flat.

    But, back to topic at hand, what are you seeing these days at EXPO? Come by the JUCCCE event next week, I got students presenting a workshop on taking down the pavilions… going to be interesting.

  5. Craig Mattoli says:

    January 18th, 2010 at 8:41 am

    The bubble is more comprehensive than that: it is the way that people conduct business, here. That retail turnover that I see in Guangzhou is related to the high rentals, on the one hand, and a get rich quick mentality that causes many of them to over charge, while having the additional belief that if they build it they will come, on the other: advertising? For What?
    In the rental market, arbitrage principles say that, frame-wise, there is a choice between rental (equivalently short) and ownership. I pay Y3K/mo for a place that the owner has on the market for over a million, mortgage payments in the neighborhood of Y7K/mo. Sorry, but I won’t go long on that.
    The bubble in the stock market (one already burst) was simply an extension of real estate speculation, but for the poor man: it costs less to “play” stocks than to buy a house: house of cards.
    The export marjet is dead: the arbitrage has been stretched. There are those still in the business who had loyal clients and friends, but the streets of my neighboorhood are a ghost town as far as all the people who were in that business two years ago. Many people I knew turned it in about a year and a half ago.
    What’s left is government spending, like the hugh amounts of debt that Guangzhou has built up doing facelifts all over town, for the Asia Games. Again, it’s a house of cards. It puts people to work, like the work gangs cutting a new highway through the mountains with individual jackhammers, but it is only borrowing time.
    Sure China has amassed large foreign currency reserves because the Yuan is an undervalued controlled currency, and therefore the central bank has to buy, buy, buy, but what happens to the value of that currency when the Yuan goes to where it should be based on purchasing power parity.
    In investing there is a time to react and a time to keep still. You could do what you suggest, and I could say more, but, somtimes just not being long is a good idea. Besides, can’t you also just short China index funds out of the country?
    Craig Mattoli
    Red Hill Capital Corp.

  6. David says:

    January 18th, 2010 at 5:24 pm

    I greatly enjoyed the Matt Taibi link above. I have often felt that Friedman is the ‘master of the obvious.’ In the end, he is like a stock broker or comedian — sometimes he hits (oil price relating to strength of dictorships — despite what Taibi says), sometimes he misses (Iraq invasion is good for America). He writes a column 2x a week. Plenty of fodder for naysayers. I don’t really care how big his house is or how many malls his wife’s family owns. Is he a blowhard? Is there a columnist who isn’t?

    Friedman is among the few in the US MSM to connect the dots on many global issues. Say what you like about his “World is Flat” book. It conveyed the topic of globalization in a way that most Americans had never contemplated. For that, he should be praised. I remember my first visit to a BPO call center in Mumbai in 2005. It was eye opening. I talked about it in the US for weeks, and spent months pushing the the topic of BPO with corporate staff at my US company. Friedman’s book brought the same ‘ah haa!’ moment to millions in the US.

    In one of my favorite Friedman columns (link below), he comes pretty close to admitting to being wrong about Iraq and stumps for US withdrawal (this was in 2007). And he does it in the context of China. This is what makes Friedman interesting to many Americans who don’t go to economic conferences in Dalian or eat lunch with US Army officers in Baghdad. Connecting dots. Putting things into context. Sometimes his metaphors are stretched thinner than the jeans on Valerie Bertonelli’s ass. But, they can still send a strong message… or just get my motor running.

    “Iraq Through China’s Lens” http://select.nytimes.com/2007/09/12/opinion/12friedman.html?_r=1

    OK. I know. I’m losing the audience….


  7. David says:

    January 18th, 2010 at 5:32 pm

    As for shorting China: It seems that at this point in the Great Recession a broad meltdown in China worthy of “shorting China” (i.e., the entire economy) would have equally negative affects on waorld markets. To a certain degree, isn’t shorting China in 2010 simply shorting the global recovery?

  8. Leslie Forman says:

    January 18th, 2010 at 6:45 pm

    Thanks for this, Rich. I read this article in hard copy on my way back from Hong Kong last week and it really didn’t sit well with me either. Your argument about real estate turnover makes a lot of sense. I see lots of empty storefronts in malls and liquidation sales. And, prices for apartments have gone up and up and up and that can’t be sustainable.

  9. Chris says:

    January 18th, 2010 at 8:23 pm

    Actually this is about the only Friedman article I have ever liked or thought reasonable. It is indeed difficult to ‘short’ an entire country with such large reserves, internal capacity and demand.

    Rich’s overall point that there are possible market opportunities and money to be made by ‘shorting’ specifics stocks and sectors is spot on and not contradictory to Friedman’s overall point. There will be corrections, bubbles bursting etc and the most obvious are overpriced real estate and equities. I saw an article yesterday that over 70% of Australian iron ore is exported to China. A great opportunity there to short sell Aussie miners when the real estate bubble bursts.

    However a sector of the economy is not a country. During the last market corrections in equities and real estate in 2007/2008, my own sector (services) grew by over 30% in China. At the time I found it difficult to believe and it was quite contrary to my rather pessimistic business forecasts at the time…

    The more general point is that a wide range of sectors will continue to grow at healthy rates while the inevitable market corrections reduce the value of inflated asset prices. There will be some spillover into the ‘real’ economy, but a range of other sectors will continue to grow. The country and the economy are not just the parasitic real estate and finance sectors.

    The ‘house of cards’ that Craig refers to is unfair and unreasonable. The facelifts in Beijing (for the Olympics), in Shanghai for the Expo and Guangzhou for the Asian games have greatly improved the living environment in these cities. Significant useful infrastructure has been put in place (subways, roads, parks & public facilities). Indeed, across the country without the impetus of these mega events, China’s cities and towns are undergoing major transformation.

    This is not a Ponzi game or a confidence trick.

    At the Central level, public finances are in reasonable order, with budget deficits and debt at quite reasonable levels. Moving to the SOE, Provincial, Municipal and Country levels, there are indeed serious questions about local finances and I have no doubt that there will be a terrible hangover from the current debt binge.

    However, at the same time, the ability of authorities to squeeze further taxes from enterprises and individuals is remarkable. China has built a remarkably efficient and robust taxation system that is as sophisticated as those in the West and continues to expand the tax take (fiscal revenue up by over 11% during 2009). Given the propensity of enterprises and individuals to evade tax here, there is scope for much more growth in the tax base to fund all of the above.

    If I was going to ‘short’ China, I might pick a sector or two that is due for a correction. However I would not short the country and am certainly happy to keep RMB assets.

  10. sophia says:

    February 5th, 2010 at 9:53 pm

    ” I read this article in hard copy on my way back from Hong Kong last week and it really didn’t sit well with me either. Your argument about real estate turnover makes a lot of sense. I see lots of empty storefronts in malls and liquidation sales. And, prices for apartments have gone up and up and up and that can’t be sustainable.”
    I agree with this. Thanks for your article. If you have time, please view my blog:About China!

  11. Taipeir says:

    April 23rd, 2010 at 12:55 am

    ‘At the Central level, public finances are in reasonable order, with budget deficits and debt at quite reasonable levels. Moving to the SOE, Provincial, Municipal and Country levels, there are indeed serious questions about local finances and I have no doubt that there will be a terrible hangover from the current debt binge.’

    But the provincial and city debts will be heaped on the central government..and all at the same time. This is going to be a huge problem for them.

    The main issue is can Chinese afford to pay their loans on paltry salaries for assets that are depreciating rapidly. Once the asset value starts to drop there will no market for real estate there. Large numbers of companies (public/private) are also invested in real estate in China. Investors from HK/Taiwan/overseas will also lose their shirts.

    Many foreigners like you who reside/work in China tend to take exception to the talk of China’s ‘demise’. That is only natural since you can see the great strides that been made there. That doesn’t mean there isn’t a huge bubble in the real estate and stock market or massive corruption in government at all levels! China is also not as easy to do business in as many wishful thinkers believe..you get taxed for everything and they heavily regulate businesses.

    Many people are trying to make quick money there now as they can smell the party and days of 10% GDP growth. Excuse me, 10% GDP growth at the tail end of the world’s worst recession in decades..does that not teach you something. Real exporters like Japan, Taiwan and Korea got hammered.

    Remember China is supposed to an export economy too…obviously it is not so much based on export but stimulus and construction now.

  12. Taipeir says:

    April 23rd, 2010 at 1:00 am

    I must say that real estate in China IS a ponzi trick..because it is backed up by cheap credit and leverage…in exactly the same manner as the US and other countries.
    There is an argument commonly used against this, that China NEEDS massive amounts of new residential and commercial properties. As anybody who travels around China will testify, large amounts of them are empty. Finally there is no strong urbanisation trend anymore to the big cities, peak population of working age has already been reached and many Chinese are remaining in their own provinces, cheaper and better life. The big cities offer poor quality of life to immigrants from other parts of China, too expensive and no rights.This can be seen by labour shortages on the East coast.

    In the end it’s all about cheap money…but even cheap money needs to be paid back or else the ‘ponzi’ scheme breaks down. Then the cheap money gets expensive fast.