Is ‘smart money’ dumb to bet against China?

On a visit to the US in mid-February, HSBC’s global equity strategist Garry Evans was struck by a curious and widespread reversal in investor sentiment towards China. Almost without exception, fund managers — who had all been very bullish on China barely a couple of months earlier — had turned extremely bearish on Chinese stocks.

“They believe that inflation is becoming a big threat, which will lead to sharp monetary tightening,” he notes. “They fret about long-term structural issues, such as a bubble in the property market and the chance of a rise in banks’ non-performing loans (NPLs).” And, he adds, “They are especially nervous about a rapid deterioration in US-Sino relations and what that might mean for the renminbi.”

In particular, Evans recalls, the one name that was on the lips of many fretful fund managers was hedge fund investor Jim Chanos, who has in recent months been publicly talking of “shorting” China on the grounds that “China is Dubai times 1,000.”

Much the same “climate of alarmism” greeted JPMorgan chairman of China equities Jing Ulrich when she met investors and corporates recently. She posed three questions to them — whether they were concerned about a property bubble in China; if they expected an increase in NPLs; and whether they expected further monetary tightening. About 90% of the respondents said yes to all three.

Ulrich cites comments from Chanos and investor-blogger Vitaliy Katsenelson (who recently labelled China “the mother of all black swans”) as being at the root of the “current climate of alarmism” about China.  

Is ‘smart money’ right in worrying about China, or is it being less than smart in buying into —-and advancing — theories about “the coming collapse of China”?
Both Evans and Ulrich — and other analysts — emphatically assert that although the Chinese economy is not without structural vulnerabilities, fears of a systemic collapse are vastly overstated.

For instance, Ulrich points out that there is a “layer of truth” to the concerns that property price increases in some big Chinese cities are “untenable” and are probably partly fuelled by misdirected bank loans. “However, there are crucial differences between China’s real estate markets and those of the US — and indeed Dubai.” Chinese household debt, for instance, accounts for only 17% of GDP — compared to about 96% in the US and 62% in the euro area.  

And China does not face a situation as in the US, where a combination of excessive leverage and mortgage securitisation were at the epicentre of the sub-prime housing crisis, Ulrich notes. “Homebuyers in China are required to make minimum downpayments of 30% before receiving a mortgage, and at least 40% for a second home purchase.” And in fact, homebuyers typically put down even higher than the requirement, thanks to their “massive amount of savings”, and high growth in urban household income.

UBS economist Jonathan Anderson emphasises the significance of the absence of leverage in China. “If there’s one lesson we’ve learned over and over again in the emerging world, it’s that leverage growth is the single best predictor of unsustainable activity and pending trouble,” he notes.

“And despite a record-high headline investment ratio and double-digit average growth over the past six years, the simple fact is that the mainland credit/GDP ratio fell outright from 2002 through 2008, which puts China at the far low end of emerging market experience.”

Ulrich concedes that there are “pockets of overheating” in some regional property markets. “But we see this as a symptom of a new urban wealth being put to speculative use, rather than the profligate use of leverage.”

Likewise, Evans dismisses fears of an overheating of the Chinese economy or fears of an excessively rapid monetary tightening to combat inflation. “For the moment, we see the risk of dramatic further tightening as low —- although a gradual withdrawal of monetary accommodation is likely to continue throughout the year.”

Anderson adds that the common “super-bear arguments” about China —- centred around fears of overinvestment, capital misallocation, property bubbles, anaemic domestic consumption, and overdependence on exports - are “significantly exaggerated and outright wrong.”

“In contrast to those who see China as the next big crisis call or the ‘new Japan’, on a structural basis we see nothing that would remotely suggest a collapse,” notes Anderson. However, he adds, “this doesn’t mean we’re relaxed about the economy on a cyclical basis.” China’s current momentum “is patently unsustainable”, and there are “strong near-term risks” if the authorities don’t act soon to tighten policies.   

Ulrich points out that the Chinese government has already begun that process. “Economic planners are already aiming to achieve a slowdown in infrastructure investment, shifting focus towards completing existing projects rather than funding new construction” And China’s banking regulator, she notes, “has ordered banks to closely follow lending guidelines to ensure that all lending to local government investment companies are backed by actual projects and that project risks are properly accounted for.”

In Evans’ estimation, even the fears of a derailing of Sino-US relations —- to the detriment of the economy —- are exaggerated. “The relationship is too important for both sides to be allowed to deteriorate too far… We expect that there will be further fallings-out and threats, but nothing serious enough to upset equity markets too much.” In fact, he sees a contrarian “interesting buying opportunity” in China. “We remain overweight China in Asia-Pacific.”