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Nassim Taleb's book popularized the notion of a black swan -- a highly improbable event -- that can wreck havoc on an investor's portfolio. The recent financial crisis had its origins in one such black swan: the nationwide decline of housing prices in America which invalidated a lot of the assumptions behind the CDOs and CDSs that many investors had bet on.

Corriente Advisors LLC is one of the few hedge funds that benefited from this black swan by betting against U.S. subprime mortgages and delivering a six-fold gain to investors. Corriente also profited last year by betting against the sovereign debt of the weaker European nations such as Greece. Now, Corriente is betting against China.

Corriente's basic logic is laid out in this article, and can be summarized as follows:

Raw materials: Corriente says China has consumed just 65pc of the cement it has produced in the past five years, after exports.

Property construction: Corriente reckons there is currently an excess of 3.3bn square meters of floor space in the country yet 200m square metres of new space is being constructed each year.

Property prices: The average price-to-rent ratio of China's eight key cities is 39.4 times this figure was 22.8 times in America just before its housing crisis. Corriente argues: "Lacking alternative investment options, Chinese corporates, households and government entities have invested excess liquidity in the property markets, driving home prices to unsustainable levels." The result is that the property is out of reach for the majority of ordinary Chinese.

Banking: As with the credit crisis in the West, the banks' exposure to the infrastructure credit bubbles isn't obvious because the debt is held in Local Investment Companies shell entities which borrow from Chinese banks and invest in fixed assets. Mark Hart, Corriente's lead manager, reckons that "bad loans will equal 98pc of total bank equity if LIC owned, non-cashflow producing assets are recognised as non-performing.

Fiscal strength: Hart says that the market belief that the Chinese government has "ample resources" to bail out its banks is flawed. Corriente's analysis of the ratio of China government debt to GDP comes out at 107pc five times higher than official published numbers. The hedge fund says this number uses "conservative assumptions" and the real figure could be as high as 200pc.

If the bubble bursts, Corriente believes that the Chinese government will devalue the yuan in order to prop up exports and prevent economic growth from slowing due to the deflationary after-effects of the asset bubble collapse. Mark Hart believes that the best way to play this bearish scenario is to buy puts on the Chinese yuan. Hart notes that these puts are quite inexpensive since everyone is convinced that the yuan appreciation trade is a one-way bet, now and in the future.

Corriente's bearish views on China are shared by many other hedge fund managers, including Jim Chanos who has been quite vocal about the potential real-estate bust in China. But Hart's pure-play bets again the yuan are unique. Basically, Hart feels that this will be a replay of the Asian currency crisis in 1997 when currencies such as the Thai Baht and the Korean Won cratered. Ironically, the Chinese yuan was perhaps the only Asian currency that retained its value in the aftermath of that Asian currency crisis. This time, Hart believes, that the yuan will lead the crisis.

If Corriente is right and China is forced to devalue the yuan, that will indeed constitute a black swan. Many foreign and domestic investors, both institutional and retail, have been investing in yuan-denominated assets including real-estate in order to gain from yuan's appreciation. For example, yuan-denominated bank deposit accounts have been a major hit among depositors and savers in Hong Kong. If the yuan goes the other way, even temporarily, this can lead to panic selling and massive unwinding of these gigantic bets. Capital outflows could result leading to further pressure on the yuan.

One of the reasons for betting in favor of yuan's appreciation is inflation in China. Yuan appreciation is one way for China to control inflation. However, if the bubble bursts, and China's growth slows, commodities will take a beating. Since commodities are the primary source of inflation in China, the government will be able to allow yuan depreciation without fear of stoking inflation.

To protect yourself against this Chinese black swan, you could buy puts on currency ETFs such as CYB and CNY. These would be pure-play bets against the yuan. In addition, you could also buy puts on China equity ETFs such as HAO, GXC, FXI, CHIQ, ECNS, and TAO. If this black swan event were to occur, all these ETFs will suffer, since the economy will tank before the currency is allowed to depreciate.

Having raised this possibility, I must say that I personally do not believe that this event will occur. In any event, if you are a long-term investor in China, you should use any such downturn as an opportunity to go long these ETFs. I am personally long all these ETFs, especially the CYB. I do not hold any short positions, and don't plan to initiate any. However, given the track record of investors such as Hart and Chanos, it is worthwhile to watch out for this black swan and at least be cautious. Let us just hope that yuan devaluation does not occur.

Source: Use ETFs to Protect Yourself From Yuan Depreciation