Contributor: John Pulliam
Title: Portfolio Manager
Firm: Vela Capital
Location: New York, NY
Notable Stock Expertise: ZNGA, YUM, RMS
Undergrad: Wheaton College
Post Grad: Columbia Business School
Recommendation: Short iShares FTSE/Xinhua China 25 Index (NYSE: FXI)
Timeframe: 6 Months to 1 Year
Recent Price: $37.00
Price Target: $15.00
Brief Investment Thesis
The short China thesis is several years old. However, there has been a significant amount of new economic data released in China that supports the original China short thesis from Jim Chanos. As a result, I am posting a new short China thesis that depends not just on predictions of a collapse (as the Chanos thesis did) but rather a description of one that is already taking place. My primary goal is to get feedback from a) China bulls b) investors who are not bearish enough to short but are considering it c) China bears who are short. I am heavily short China and want to add size and conviction to my various positions as I believe Europe's return to crisis mode implies a Chinese stock market collapse will occur in the next several months (Europe is China's largest export partner, see below on timing).
The facts about China's economy were released last week and allow for a significant amount of necessary deductive reasoning:
China's economy expanded by $520 billion (8.7%). China's fixed asset investment grew by $516 billion (24% - http://www.chinadaily.com.cn/bizchina/2011-12/09/content_14241000.htm). Therefore, China's economy ex-fixed asset investment did not grow. Given that China's growth depends on fixed asset investment, it is necessary to conclude that if fixed asset investment is not true economic growth than China's economy is in a recession.
Many people believe China can put off the day of reckoning for several years due to foreign currency reserves and a large sovereign wealth fund. That is not the case. First, when China pays people to build buildings that are not purchased, there is an addition to the money supply and a boost to inflation (more money without an increase in paid for goods/services). China already has a persistent problem with inflation because it imports currency and export goods (trade surplus). Any additional inflation lowers workers' real wages. And lower real wages causes rising nominal wages. Rising nominal wages lowers China's competitiveness as an exporter. China cannot afford to erode its only meaningful source of wealth creation. Therefore, although China's economy is slowing, the government cannot re-inflate the system without massive levels of inflation.
The government is holding the property curbs in place which I believe is evidence they realize the game is up. Many economists in China believe the government should pull back the curbs because so much of the economy is based on property development (i.e. China's economy depends on the bubble). The government is wisely concluding it is better to make the painful adjustments now as opposed to 2-3 years down the road when ~60-65% of the economy will be fixed asset investment.
Using GDP accounting, China is now slightly bigger than Japan but Japan's consumption is 2x that of China's (and Japan has a high savings rate). As a result, I believe China's accounting based GDP will ultimately contract by 10-30%. Also, expanding through fixed asset investment is not a competitive way to grow. Buildings do not make an economy competitive. IBM or Apple's ability to create value and take global market share has nothing to do with the number of buildings the companies can purchase. It would be like a chess player training for a tournament by gaining significant amounts of weight. It just doesn't matter.
And, the majority of China's ultra high net worth citizens built their wealth in the property sector which indicates the country is under-investing in activities that truly drive economic growth (more of a symptom of corruption and the 45% investment / GDP ratio). Also, growing by building empty buildings is less efficient then basic wealth transfers. China should simply pay citizens cash not to work (or to do activities that do not require billions in cement and copper). By doing that, China could pay the workers more because the country would not need to purchase raw materials. The additional spending power would create an incentive to create products of value.