China Bears Gathering as Analysts Question Economy

January 17, 2011 Posted by China Briefing Reading Time: 4 minutes

Jan. 17 – U.K.-based hedge fund managers are increasingly questioning the real depth of problems with the Chinese economy as details of potentially serious risks are emerging from the examination of sovereign and corporate credit default swaps, interest rate and foreign exchange options. A trend to look at “shorting China” is developing as unease begins to spread about the extent of China’s sovereign debt and the development of a massive bubble economy.

“The data doesn’t add up,” the London-based Daily Telegraph quoted one manager saying. “We think we’ve experienced credit bubbles over the past few years, but China is the biggest. And yet the global economy is looking to China as not just a crutch but a springboard out of the recession. It’s crazy.”

Hedge funds especially tend to have exposure to greater risks and accordingly have very keen analytical skills as a result. However more of them are now turning to viewing China not as a burgeoning economy sustaining world growth, but as a potentially massive trouble spot.

Mark Hart of Corriente Advisors, famous for being the American hedge fund manager who made millions of dollars predicting both the subprime crisis and the European sovereign debt crisis, has started a fund based on the belief that rather than being the “key engine for global growth,” China is an “enormous tail-risk.” Hugh Hendry, former star of Odey Asset Management, also launched a distressed China fund at Eclectica Asset Management.

Other analysts are also becoming bearish. Lombard Street Research published a warning of China’s “already dangerously home-grown inflation,” while a recent study by Fitch concluded that if China’s economic growth falls to 5 percent this year, rather than the expected 10 percent, global commodity prices would plunge by as much as 20 percent. China is the global price-setter for oil, coal and base metals.

“Economists have contrarian views all the time. But these hedge funds have their shirts on the line and do their analysis carefully. The flurry of ‘distress China’ funds is a sign to sit up,” one economist told the Telegraph.

Similarly, Corriente Advisors stated: “We expect the economic fallout from a slowdown of China’s unsustainable levels of credit and growth to be as extraordinary as China’s economic outperformance over the past decade.” The financiers’ arguments center on the belief that China’s demand is not real but manufactured by the state.

Again, according to data from Corriente, China has consumed just 65 percent of the cement it has produced in five years, after exports. The country is outputting more steel than the world’s next seven largest producers combined. It has 200 million tons of excess capacity. In property, Corriente said it had found an excess of 3.3 billion square meters of floor space in China – yet 200 million square meters of new space is being constructed each year.

Despite the vast population, the property is generally out of the price range for most. House prices are around 22 times disposable income in Beijing. The IMF has said that housing prices in eastern cities have become “increasingly disconnected from the fundamentals,” but so far has said there is no nationwide bubble.

Professor Victor Shih of Northwestern University in Illinois estimates that Chinese banks have lent US$1.7 trillion to local state entities, many of which are not commercially viable and have used inflated land values as collateral.

However, two schools of thought are coming into play. On one side are the bears, who have argued about the dangers of China’s economy overheating for some time. But for many, the fact that hedge funds, particularly those with track records on previous crises, are launching specific funds is the sign that the bubble is close to bursting. Experts in China dismiss the hedge funds’ arguments as narrow and exaggerated. The Chinese government has implemented policy measures to curb credit and control inflation. Above all, they argue that China’s huge and modernizing population will fuel demand for years.

“I’m no economist, but I do know how to run a business in China,” states Chris Devonshire-Ellis, principal and founder of Dezan Shira & Associates. “Some of the projects I have seen across the country just do not seem to make sense – entire new cities, such as Ordos and Manzhouli with capacity for 5 million inhabitants yet with populations of just 150,000. Thousands of luxury apartments for sale in Chongqing costing US$2 million apiece yet for a local population with an average income of US$6,000 per annum. The boom in auto purchases also seems largely driven by state subsidies and cheap credit, and prices for even fairly basic facilities such as having a reasonably cheap drink and meal in a bar are now in excess of London or Paris. I’m told by economists that the space will be taken up by a migration of rural labor into cities, but I have seen no signs of this trend beginning. Instead, I see export manufacturers having to close in the south and a China losing employment to cheaper Asian destinations such as India and Vietnam. Much of it doesn’t make sense to me, it just doesn’t feel right, and I’m concerned that China may be concealing a larger problem. We are looking at growth this year from India, while for China we are adopting a far more prudent sense of development.”

However, even the hedge funds concede that their timing might not be perfect. Corriente warns that investors, who are required to put in a minimum of $1 million each, should brace themselves for an estimated burn-rate of 20 percent a year until the theory pays off. But it’s a risk that plenty seem willing to take, and many now seem to be accepting the occurrence of such a scenario as a matter of when, rather than if.

Our complimentary, 41- page report outlining some of the concerns and some of the development trends that are likely to take place in China in 2011.

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