5 Reasons to Bet Against China

01/04/2011 1:15 pm EST

Focus: MARKETS

Michael Shulman

Editor, Short-Side Trader

The country’s rapid economic gains have been fueled by promiscuous lending and overproduction, tailwinds that can’t last, argues Michael Shulman, editor of Short-Side Trader.

According to the Chinese zodiac, 2011 is the “Year of the Rabbit,” which is considered to be a lucky sign. But I think China’s luck is about to run out, and I’m not the only one who sees the writing on the wall.

China’s central bank announced a surprise interest rate hike on Christmas Day, but this was really just window-dressing. Chinese banks have unspeakably conflicted relationships with their big borrowers, and small increases in interest rates will not slow down underlying speculative fever. Chinese land developers and industrialists are now engaged in financial musical chairs—they will keep borrowing to grow until they absolutely, positively cannot borrow any more, assuming someone else will get left standing without a chair. Well, the US financial crisis began when Bear Stearns found itself without a chair.

So despite what you hear from the China bulls out there—and there are plenty of them—2011 will not be the “Year of China” for investors…unless they plan on shorting China stocks and ETFs, that is. Here are five reasons traders should bet against China in 2011.

The Great Chinese Credit Bubble
The most pernicious impact China is having on world markets stems from a massive credit bubble similar to the one that blew up Japan in the early 1990s and the US markets in 2007-2008. Hedge fund manager Mark Hart, who made a killing anticipating the US subprime mortgage meltdown and the European debt crisis, is now focusing on China, saying in an article in The Telegraph that China is in the “late stages of an enormous credit bubble,” and the “economic fall-out” will be as “extraordinary as China’s economic out-performance over the last decade.”

Here are some of the problems Hart highlights:
Property construction: Excess floor space exceeds 3.3 billion square meters, yet 200 square meters per year is being constructed.
Property prices: The average price-to-rent ratio of eight key cities is 39.4 times, which compares to 22.8 times in the US just before the housing crisis.
Banking: Chinese banks are concealing the extent of their exposure to the credit bubble in shell entities that borrow from the banks and invest in fixed assets.

In short, this bubble is ready to burst. Remember, Chinese state banks are arms of the government, and their debts are assumed to be backed by the government. (Do the names Fannie and Freddie come to mind?) And, according to Hart’s analysis, the government-debt-to-GDP ratio is 107%, which is five times higher than “official” numbers.

Trade: Short Chinese banks and real estate management companies listed on Western markets.

[For more on Chinese banking pitfalls see Jim Jubak’s posts here and here. And here is where Jubak explains why these won’t slow China down, in the short run. Though Chinese stocks stank up the joint last year, valuations are now lower than they’ve been in quite some time—Editor.]   

The Great Chinese Labor Force
According to Chinese data, as well as more reliable sources such as the World Bank, in the next five years, the Chinese labor force available for industry will add the same number of industrial workers as currently employed in the United States and Europe. This mass increase is the single greatest deflationary force on the planet.

Combined with non-existent labor laws, non-existent environmental regulations, and dodgy loans from state banks and other entities, this labor force has destroyed tens of millions of jobs around the world while reducing the cost of many products. The end game: more job relocation to China. And any industry segment targeted by China is subject to massive price deflation, a terrible and unpredictable situation for traders.

Trade: Follow the growing political debate on Chinese exports and look to short Chinese exporters.

The Great Chinese Commodity Gobbler
China’s commodity imports are driving the price of everything from iron and coal to rare earth minerals. The country’s excess capacity is staggering. For example, Mark Hart’s analysis states that China’s steel output is more than that of the next seven largest producers combined, and its excess steel capacity is more than the EU and Japan’s combined total annual production. Additionally, only 65% of the cement produced (after exports) has been consumed.

This has created false prosperity and inflated asset values in exporting countries. The bulls believe the country will eventually use this capacity and consume these commodities as it builds out roads, bridges and other public works. However, this kind of public-funded consumption can only go on for so long since it is fueled by government credit, which is already overextended.

Trade: Prepare to short industrial commodities and bulk shippers.

The Great Chinese Currency Reserve
The Chinese love to remind the world about their currency reserves and drop hints about shifting away from the US dollar if the United States does not do this or that. China is now in a trap of its own making by restricting the flow of capital and pegging its currency, the yuan, to the dollar.

With $2.4 trillion or so in dollar-denominated bonds, any revaluation diminishes the value of these bonds. This is what Japan did as it accumulated reserves through tough capital controls and then watched its newfound wealth melt away when the world forced it to let the yen appreciate.

As the value of Chinese foreign reserves diminishes, so does the capital base supporting the credit bubble, meaning China is not likely to revalue their currency, and so the trade war begins.

Trade: Short Chinese exporters.

The Great Chinese Nation-State
China has the world’s largest population, and this has manifested itself in behavior similar to emerging nation-states in the middle of the 19th century. More and more, the country is characterized by its bellicose gesturing and militant statements when anyone steps on its toes.

Recent events on the sea, on the Korean peninsula, in cyberspace and in Chinese prisons have laid bare China’s grasp for world power, exposing the nation to harsh criticism, and with this politicians in the United States and Europe have begun to abandon a veneer of tolerance for Chinese trade policies. The trade war, if it comes, will be a trigger for major market problems.

Trade: Short the whole country. Two of the most prescient short sellers in the world, Mark Hart and Jim Chanos, are doing so, and that’s not bad company to keep. The safest way to do this is with put options on the iShares FTSE/Xinhua China 25 Index ETF (NYSE: FXI).

Subscribe to Short-Side Trader here…

Related Articles on MARKETS