The China Debate: Bulls Vs. Bears

Includes: AA, BIDU, CAF, CHL, CLF, FCX, FXI, X
by: Sammy Pollack

The economic outlook for China is among the most debated issues today. Bulls argue that inflation has slowed and the Chinese authorities are ready to embrace growth oriented policies. Bears argue that China is heading for a crash landing as a massive real estate bubble deflates. Interestingly, both the bullish and bearish case center around one part of the Chinese economy - banks.

First the bearish case. The bearish case for China is predicated on the idea that real estate was in a bubble similar to the housing bubble in the U.S that led to the great recession of 2008. Bears argue that banks are sitting on billions in loans that will go bad, thus putting the banking system at risk. Famous China bear Jim Chanos recently told Bloomberg, "The Chinese banking system is built on quicksand and that’s the one thing a lot of people don’t realize." Chanos believes that the banking system in China is in need of major capital injections to stay afloat.

The capital injections is where the bullish case comes in. China bulls tend not to dispute the fact that real estate is in some type of bubble, but they do not believe the bubble will cause a meltdown in China. The bulls believe that the Chinese authorities will manage the banking system in a way to engine a "soft landing." One reason to believe that China will enter a soft landing is the fact that the Chinese government is a major owner of many large Chinese banks. The government ownership of the banks makes it so that it is extremely unlikely that we see major bank runs in China. In 2008, when bank loans went bad in the U.S, the loans led to a loss in confidence in U.S banks. Chinese banks can essentially afford to take unlimited loses on loans so long as the government stands behind the institution.

At this point, it appears that the bearish case is winning out more so than the bullish case. Below is a chart of the Shanghai Composite Index year to date. (CNBC)

Clearly, the Chinese stock market is siding with the bears. However, one must consider the weakness in China with weakness in equity markets in the rest of the world. A global slowdown appears to be upon us, from Germany to Greece to America, growth seems to be slowing down. Though the Chinese stock market seems to be siding with the bears, government actions may be making the case for the bulls. As of October 10, the government run Chinese investment authority has been buying shares in the four largest Chinese banks. The buying of bank shares certainly supports the thesis that the Chinese government will not allow the banking system to collapse.

The best way to play the Chinese paradox depends on whether you are bullish or bearish. Bears should be shorting large commodity plays such as X, FCX, CLF, AA, etc... Bulls who believe that the real estate collapse will be contained should play China via companies that will continue to do well regardless of housing. Possible buys might be FXI, CHL, BIDU.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.