Reverse Migration: Why Bulls Should Quit the China Shop

Statistics identifying how many of China’s 130 million migrant workers are heading back to their villages today due to factory shutdowns in the once-booming urban centers are still filtering in. But there two other significant developments which are certain to accelerate the reverse migration process which, in turn, will force the Beijing government to focus less on monetary policy and more on the 800 million Chinese in the vast agricultural hinterland.

Firstly, following the announcement of the $585 billion stimulus package, farm-based factory workers see the opportunity to make quick profits from sales of agricultural land to hundreds of infrastructure-related projects. Secondly, in order to boost domestic demand (as opposed to exports to America and Europe), Beijing has taken the unprecedented step of departing from the fundamental notion of collectivisation to dramatically improve the negotiation capabilities of land-use rights. Taken together, the stimulus funds and the land reforms promise deep-rooted structural changes inside the Chinese economy.

A strong short bias on China ETFs (FXI, GXC, PGJ) is warranted for some very specific and well-founded reasons. Primarily, the structural changes are certain to consolidate an already ongoing corruption-ridden land-accumulation process which will turn at least 90% of China’s rural breadwinners into landless peasants working on road, railway, housing, electricity and building projects without any minimum-wage protections and without guaranteed access to education and health-care. The current unrest in the country’s industrial belts will, for all practical purposes, shift to the agrarian provinces.

Besides, when and if internal consumer demand shows any appreciable growth rise remains an open issue; Beijing expects disposable family incomes to double by 2020. But what is clear is that Chinese corporations are being hit extremely hard on two fronts: shrinking domestic consumer demand and sharp reductions in export orders (which cooled by a whopping 15% in November). So until more reliable data on this stimulus-cum-land reforms experiment unravels, Chinese asset valuations must continue to deteriorate.

The case for shorting China ETFs through the first half of next year is also boosted by the real prospects of the incoming Obama administration supporting legislation imposing countervailing duties (CVDs) against China if it engineers deliberate falls in the value of the yuan to gain a trade advantage and if it utilizes its stimulus packages to provide subsidies to the export sector. American textile manufacturers, for example, are warning about further contractions in American industry if China is not checked very soon.

Finally, political risk underwriters and credit default swap specialists are not sure what to make of the impact of the reverse migration process and the changes in land-usage rights on the ability of China’s government and corporations to meet contractual obligations on a timely basis. “The last time we priced a land-reforms-driven economy, we got badly burnt,” commented one Asian CDS trader this morning, citing the examples of Bolivia, Venezuela and Ecuador.

While medium-term political risk quotes, for comprehensive risk coverage, are hard to come by today for any of the emerging markets, 5-year CDS spreads for Chinese companies range from 400bp to 900bp, depending upon the quantum of sovereign and foreign involvement. But, most definitely, the trend is to trade China risk within the prism of solid negativity at this juncture, as the market braces for a spate of Johnny-come-lately rating downgrades across the Chinese business spectrum in forthcoming weeks.

Disclosure: Author holds a short position in FXI

Comments

[HaavBline:]

Author’s recommendation to short FXI for 1H09 may turn out to be correct. But his arguments regarding rural land reform seem flimsy.

Rural land reform will start next year, few details about execution is available so far. But one major objective of the policies is to improve the existing “corruption-ridden land-accumulation process” to give farmers a better deal in a land transaction. Prices of rural land transactions in the past are dictated by local officials, which FOR YEARS, has caused numerous and increasingly violent protest in rural areas. By contrast, “current unrest in the country’s industrial belts” becomes a problem only recently, as a result of export factory closings. The reform clearly gives the farmers a better deal.

The major risk of land reform for1H09, at worst, is confusion at the initial stage of implementation of the reform policies, not 800M landless jobless peasants as the author seemed to suggest. In any case, these are long term structural reforms that will bring more economic activities to the country side, bring improved urbanization process, but it is hard to see major negative impacts the land reform policy might have toward member companies in FXI before 1H09.

Chinese government is taking aggressive actions now to support the economic growth targets (8%) and the stock market. It seems not wise to go against a governments that has plenty of policy options and very well-stocked of ammunitions.

As for political risk, Bespoke (B.I.G..) provide some data in a recent article in this space. Almost all countries are suffering from worsening CDS spread, China’s about average in absolute value and in trend. Not a great factor to short FXI either.

Shrinking export, trade war, worst-then expected collapse of real estate value are major short term risks. But it has been reported that recent sinking export may partially due to credit availability problems for foreign importers which is relatively easy to address.

2008 Dec 05 02:17 PM