Monday, October 24, 2011

China: Understanding The Nature Of The Bubble

Jim Chanos, an investor made famous by his wise shorting of Enron years ago, is now shorting China. He is also giving seminars to investors, and taking the opportunity to talk up his book. Among other things, Chanos claims that China is about to see a western-style credit implosion. He claims that "China’s bust will be a thousand times worse than Dubai." Chanos' view is based upon an erroneous assumption that Chinese growth is based upon a credit boom, like growth in Dubai and western nations.

Chanos does not seem to understand Chinese monetary conditions. Unlike Americans and Europeans, folks there don't trust governments or banks. Many EM countries have a long history of currency debasement, and China is no different. International speculators may think the renminbi has a grand future, but China's own people don't. They don't trust cash to retain long term value, and they buy real estate with the idea that it will protect the value of their earnings.

In many emerging markets, the safe haven function was once performed by the U.S. dollar. That was never the case in China because the dollar does not freely circulate there. But, since the advent of heavy US dollar debasement, in the first decade of the 21st century, the idea that the dollar is a safe haven has lost its allure in much of the world, anyway. Throughout the emerging world, starting in the year 2000, people began an intensive search for other perceived havens. The favorite has been real estate, especially in emerging markets, but also in developed credit driven markets.

People in China, and elsewhere in the emerging world, invest in real estate in the hope of preserving the value of their hard-earned savings against the depredations of their government. That's why they often leave the apartments and office buildings they buy empty and incomplete. New buildings are parking spots for ever-debasing cash, not something that the initial buyers ever actually intend to occupy. Like their human cousins in American, Europe, Dubai and elsewhere, the average Chinese person is prone toward group-think and the herd mentality. People tend to always do the same things at the same time. That's what causes economic bubbles. The bubbles eventually burst.

The question is not whether or not the Chinese real estate market is in a bubble. It is obviously in a bubble. The question is what effect the bursting of that particular bubble will have on the rest of the Chinese economy. Chanos thinks that China is the "mother of all bubbles". Maybe, but only to foolish western investors who margined themselves to the hilt in order to "leverage" positions in China. To the Chinese themselves, the adverse effect of a real estate price collapse will be substantial but short-lived, and nothing like the bursting of the credit-driven bubble in Dubai or in western real estate markets.

The critical difference is that the China is not credit driven. Credit plays a part, but a small one. China's real estate is cash driven. Upper middle class and wealthy Chinese, like other emerging market investors, face an overwhelming sea of cash, because their government prints seemingly endless wads of cash, creating seemingly endless amounts of inflation. This is done to depreciate the currency against major western currencies so as to spur exports and inhibit imports. So upper middle class and wealthy Chinese take this cash and buy real estate, including empty residential flats and office buildings. Others buy stocks.

Emerging market investors, including the Chinese, choose to invest in real estate particularly because it had an upward trajectory to begin with. Prices were rising for real reasons, like increasing movement from rural to urban areas and demand for places to live. So with few places to put their ever-increasing wads of money, Chinese citizens bought real estate, in the hope it would preserve their wealth partly because they don't know what else to do. In the short run, the fact that Mr. Chanos does not fully recognize this will make little difference to whether or not he makes money on his short positions.

The dramatic differences between the credit driven real estate boom in the West, and the cash-driven boom in China will not stop the bubble from bursting. But, understanding the nature of the bubble changes the rapidity with which investors who short the China market must act quickly. Understanding the situation in China will help determine when to exit the short position.

The M2/M1 money supply ratio in China is something on the order of 2 to 1, which is approximately the same as the money supply ratio that existed in America in 1959. Those were the days before Americans used credit cards, and while the fear of bank failures, arising out of the Great Depression, was still clear in their minds. This compares with a current ratio of about 4 to 1, after the 2008 crash, and about 7 to 1 before the crash. Europe is similar to the USA. Western economies, and those who try to emulate them, like Dubai, are heavy on M2 and M3 and light on M0 and M1. China is heavy M0 and M1, and light M2 and M3, just like America once was. It is a cash economy.

The basic issue is not that real estate (or China stocks) are "bad" investments. The issue is that the abundance of cash has caused intensive buying, and both real estate and stock prices have been bid up faster than even the hefty money-printing rate. But Chanos goes too far in claiming that the entire Chinese economy is going to collapse simply because this bubble collapses. The Chinese government is cash rich, to the tune of trillions of dollars and Euros worth of foreign currencies. It can spend its way out of any foreseeable downturn.

In an attempt to support his argument, Chanos says that intense corruption pervades China. But should Chanos concentrate his attention on Chinese corruption? China has printed money to spur its exports, and speed the import of new technology. The Federal Reserve and Bank of England, in contrast, has printed money and targeted it into stock and bond markets, with the openly stated intention of artificially inflating asset prices. Beyond that, the Federal Reserve has been helping Bank of America (BAC) shift potentially destructive derivative obligations from Merrill Lynch into its FDIC insured retail deposit division. This increases the probability that the biggest multi-trillion dollar bank in America could fail, resulting in huge losses for taxpayers and any depositors whose assets exceed the FDIC insurance limit. What is happening in the western world is at least as corrupt as anything happening in China.

So, is Mr. Chanos correct about China? No doubt, there is a real estate bubble. No doubt, it will eventually burst. But, in spite of those who claim that China is in the midst of a credit bubble, the hard data proves that claim to be false. If China was inside a credit bubble, the M2 money supply would be many times the size of M1, and that is not the case. For this reason, although the real estate/stock market implosion in China will be very painful, it will not have the same ramifications with respect to the rest of the economy as credit implosions have had on credit driven economies, like Dubai, the USA and Europe.

Chanos and anyone else shorting China can make money in the short run if they are nimble. But they need to get in and out in a very timely fashion. In the long run, if Chanos holds on to his short position just a little too long, he will lose his shirt. That's because China will not stop growing simply because of the bursting of a cash-driven real estate or stock market bubble. There will be only a short window of opportunity during which Chinese equities will decline a lot. After that, Chinese growth will outpace that of of the western nations, and its markets will explode upward again.

You can go long or short on Chinese equities by using a number of investment vehicles. Speculating on emerging market economies, however, is extremely speculative and can result in the loss of a major part of your money, if you don't know what you are doing. Chanos may yet lose his shirt. But, those with the inclination to follow him, or long-China investor Jim Rogers, can buy individual companies, or ETFs. The ETFs are an easy way to go short or long on China without needing to juggle a huge number of buys and sells.

Fees vary a lot, depending on the fund management company, so you should carefully compare the fees charged by each one. Leveraged ETFs, in particular, are extremely costly, and are a poor choice for long-term investing. Companies that sponsor them buy and sell positions in the fantasy-futures markets. Prices at futures markets are only peripherally related to real world supply and demand. Futures prices reflect the capricious whims of banks and hedge funds.

To a large extent, leveraged ETFs, like static commodity funds, are relied upon by the nimble bank-connected traders, to supply cash losses out of which they can get gains. Leveraged ETFs, unlike nimble traders, blindly roll over long or short positions at maturity, month after month, regardless of market conditions. In doing so, they pay huge premiums to banks that control the futures markets, and are exquisitely vulnerable to whatever the controlling banks and hedge funds want to do with the price near maturity. Funds that blindly invest in futures positions are cash-cows for manipulators in futures markets. For these reasons, among others, leveraged ETFs do not accurately reflect the ups and downs of the cash markets in the long run, and should only be utilized for ultra-short term trading goals.

Here is a list of China oriented ETFs that can be used to take a position on China's future or lack thereof.

iShares FTSE/Xinhua China 25 Index Fund (FXI)
iShares MSCI Hong Kong Index Fund (EWH)
Direxion China Bear 3X - Triple-Leveraged ETF (CZI)
Direxion China Bull 3X - Triple-Leveraged ETF (CZM)
EGS INDXX China Infrastructure ETF (CHXX)
Global X China Consumer ETF (CHIQ)
Global X China Energy ETF (CHIE)
Global X China Financials ETF (CHIX)
Global X China Industrials ETF (CHII)
Global X China Materials ETF (CHIM)
Global X China Technology ETF (CHIB)

The idea of going long or short on China is interesting to talk about. This particular investor, however, prefers more prosaic investments, and won't be betting on or against China. We'll leave that to Jim Rogers and Jim Chanos. But one thing is clear. Even after the real estate bubble bursts, the Chinese government will continue to print renminbi. Having discovered that real estate and stocks are flawed havens, Chinese citizens will turn to something else.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.


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