Why The China Bears Are Wrong (And Right)

Includes: CAF, CNY, EEM, FXI, USO
by: Oriental Trader


In this report, I will attempt to explain step-by-step why I believe mainland Chinese stocks (NYSEARCA:FXI) (NYSE:CAF) are likely to rise sharply in the next few months. This will also lead to a strengthening of risk sentiment in the short run in emerging markets (NYSEARCA:EEM), oil (NYSEARCA:USO) and maybe even copper. It will be a combination of many theories and observations I think to be relevant. For whatever it's worth, I am currently based in Shanghai.

The bears are pouncing on the great Chinese bubble, which some have called "a thousand Dubais." JP Morgan, Credit Suisse etc. have analysts that wrote something bearish on Chinese stocks/economy lately. Jim Chanos (nice bearish PPT by him here) and David Einhorn have joined the fray as well. Bearish interest on a major Chinese ETF is at a multi-year high.

Even though I hold tremendous respect for successful investors like Einhorn, I believe they are all wrong on this issue. Their assessment of the situation is correct but they forget that the real world is dynamic. Most critically, they forget the tools a large economy can use to influence short-term trends, even if long-term fundamentals are worrisome. For example, the European Central Bank's mere promise to activate the OMT has contributed greatly to calming fears over European sovereign bonds and a Eurozone breakup. This is not Lehman 2008 when things fell apart, this is more comparable to New Century Financial March 2007 (one of the early milestones of the subprime crisis) or BNP Paribas August 2007 (another mini-panic that saw S&P hit new highs two months later).

I will start by outlining the main points of the bears, go on to discuss a key underpinning of the financial system, and what all this has to do with the prospects of stock market gains.

Part 1: The Perpetual Machine

The bears are not just full of hot air. They have a very strong case based on what's been going on in the last decade.

Simply put, there are a few things going on in China now that are salient to us. Some of them may seem cliche, but since this will be a complicated and perhaps somewhat convoluted framework, let's begin with the fundamental building blocks.

1) Boom in Fixed Asset Investment

Source: National Bureau of Statistics of China

It is often said that investment is 50% of Chinese GDP. This is pretty close to truth. Two-thirds of "investment" as represented by gross fixed capital formation is infrastructure and property related. There has been much talk about surplus capacity from over-investment in cement, steel etc. It is logical that there are diminishing returns from investment and it is plausible that 50% of GDP investing in mostly the same things is not sustainable.

2) Unstoppable Money Supply Growth

Money supply as defined by the M2 statistic has grown at mind-blowing speed, sparking fears over high inflation domestically. Money is a major focus later on, so I'll be brief here.

Source: People's Bank of China, numbers in hundred million yuan

3) The Debt-Money Nexus and Ponzi Finance

Why is there such high money supply growth? Investment is often fueled, directly or indirectly through bank loans, which create bank money. Some would argue that the rapid rise in external surpluses are a contributing factor, and this is partially true. But external surpluses have largely been sterilized by raising the reserve requirement ratio.

Why is there high investment? This is partly due to high money supply growth. In such an environment, the returns on an asset = profits/rents + price appreciation (money supply growth- real GDP growth is a crude approximation). If everyone is conditioned to the monetary boom, then returns on an asset = profits/rents + price appreciation (current money supply growth + discounted money supply growth - real GDP growth). Factor in a multi-year bull market and the emergence of Ponzi Finance (i.e. borrowing that relies on asset appreciation to pay interest and principal) is understandable.

4) Institutional Inertia by the Main Actors

The center wants growth and certain achievements, local magistrates are judged based on growth, and massive investment spending provides lots of "opportunities" (if you get my drift). This is funded by the banking system that provides loans at preferential rates to local authorities, big state-owned enterprises and so forth. Even if some projects are earning economic returns, there is much incentive and little downside to borrow until returns are way lower than cost of funding. This fuels rapid money supply growth. It's sort of like combining Ponzi finance and the promotions game.

Private and quasi-private actors know this (if they don't, they will after a few years' observation) and borrow (if they can) to invest in real estate, which Chinese have a special affinity for. For Chinese, the appeal of real estate is a mixture of the properties of gold (safety), diamonds (exquisite and forever), Audi cars (status) and Old Masters (can be passed on).

The current financial system still has some of the vestiges of the planned economy and inefficiencies are not a small matter. Consider how there were deep worries about Chinese bad loans even in 2003. The historical record is not encouraging.

Source: "Factions and Finance in China" by Victor Shih

Assuming that the incentives for the public and private actors as well as the banks haven't changed that much, it's not unthinkable that the debt-crisis scenarios Chanos and Einhorn point out are valid.

There is strong inertia and incentive for the aforementioned entities to continue this path. And extrapolating based on historical data, the future truly looks bleak.

Game Change

Something seems out of place here. There has to be more to it than just a few investment percentages, money supply growth figures and bad loan projections. In Part 2, we'll go through the looking-glass. Things are indeed not as simple as they seem.

Part 2: The Money Illusion

The money illusion refers to the tendency for people to think of money in nominal rather than real terms. Currencies in developing countries undergo less visible inflation and alternative benchmarks are difficult to come by. Do we use the price of gold (which fell throughout the 1990s)? Some people might like to use Dow/Gold ratios etc. but the dollar has experienced long enough periods of relative and perceived stability that mental accounting in gold doesn't catch on. However, I believe this theory was based on observations of industrialized countries. A person in Argentina or Ukraine or any other country that has experienced truly devastating inflation will probably not be easily mislead by nominal gains.

Yet this is very pertinent when it comes to China. Real estate prices have increased tremendously over the past decade and it is a bit incredible that a $500,000 apartment is commonplace. But there is an underlying assumption here that has been taken for granted and is perhaps not even entirely realized by many market participants.

That assumption is $1 being worth 6.2 Chinese Yuan (NYSEARCA:CNY).

The significance of this cannot be underestimated. If $1 was worth 25 CNY now, few people would be feeling wealthy from real estate investments, they'd just be glad about beating inflation. But since the CNY has actually gained against the dollar in the past decade (from $1=8.3CNY to $1=6.2CNY), many upper middle class Chinese in megacities can make it into the 1% of America, at least on paper. Ten years ago Wang Four-eye was a manager in a state-owned enterprise drudging along. Now he can send his children to a top US university for the price of a bathroom.

Such a stable exchange rate with an upward drift has not been seriously questioned. Yet it is the linchpin underpinning notions of financial wealth and investment returns.

The Transmission Mechanism

How can this be? If the CNY is undervalued as Western nations often believe, how can it also support such bloated notions of wealth?

Well first off, the CNY is getting closer to becoming fairly valued. More importantly, there is a dichotomy between the asset market and the goods market.

A rich guy uses a loan or profits from business and invests it in real estate. There is a fair amount of evidence, anecdotal and otherwise that construction costs for new residential real estate are very low compared to sales price. Little of the money entering real estate trickles down to the guy on the construction site. Money invested in real estate/financial assets, largely keeps getting recycled in said assets (the portion that enters state coffers is spent or invested in infrastructure, some of which end up as income for workers, or "missing in action" and finds itself into real estate again). Some of the newfound wealth floods into Rolexes and sports cars, but not apples and oranges. Real estate goes up double digits annually while producer/consumer inflation is more moderate, which has been one of the main reasons why China has retained export competitiveness over the years despite a monetary boom and an appreciating currency. Since prices for tradable goods/services are the most obvious factor for exchange rate determination, there is a basis that supports an appreciating CNY.

Hard Constraint: Forex Reserves

Something doesn't seem right. What underpins such ever-expanding financial wealth?

The answer is in the forex reserves.

Source: State Administration of Foreign Exchange

Let's say you're a rich person with the ability to surpass capital controls. You got yuan in the hand. What do you do?

Well, you observe real estate prices rising at double-digit percentages annually as the money supply and economy booms. On the other hand, dollar inflows are flooding the country in the form of trade surpluses, FDI and hot money. There's no reason to diversify away from the yuan into dollars at this point.

So naturally, you invest that money in real estate or other financial assets, reap the full gains of the monetary and economic boom while watching the yuan appreciate.

But when returns on investment start falling and dollar inflows start drying up, you figure, maybe it's time to sell some assets and/or convert some yuan into dollars.

Limits to Growth

Even with a dichotomy between asset and good markets, there is still some leakage. Local authorities invest a substantial amount of revenue from land sales in infrastructure, which spreads that money throughout the economy. People feeling wealthy from asset appreciation start to spend more on goods. This fuels economic expansion at first.

But at some point, further monetary expansion will create more problems than profits. Asset appreciation slows down while expected inflation and monetary expansion remains high. There has to be some price at which people start thinking, "maybe I'll start selling some of my houses and exchanging yuan for dollars."

Combine that with inevitable slowdown in forex reserve accumulation and at some point, you get capital outflows as seen in 2012.

In Summary

Well that was a mouthful. Let's summarize before we make the next leap. I created a flow chart below.

The Virtuous Cycle:

Institutional Inertia-> Higher investment<-> High M2 growth

=>High ROI

Capital Inflow + High ROI => No Incentive to Sell Yuan

No Incentive to Sell Yuan+ Relatively Low Consumer Price Increases => stable USD/CNY

The Vicious Cycle:

High M2 Growth => Higher Asset and Consumer Prices

Higher consumer prices => real CNY exchange rate appreciating

Higher asset prices => Capital outflows from diversification

Slower forex reserve growth + diversification outflows => Net capital outflows

Higher asset prices => Slower asset appreciation at some point

Slower appreciation + Net outflows => Decreased Yuan demand+ lower expected returns and high expected inflation => Full on capital flight

Part 3: Why this matters and what's going to happen

This is economically significant not just because a classic debt crisis seems to be at hand, but also because it changes the calculus of the actors.

Once capital flight takes place, this increases uncertainty and lowers asset returns from appreciation, which leads to further capital flight. The longer this goes on, the harder it is to stop. Capital flight is also damaging to the economy as actors begin to think about preserving wealth instead of investing in future growth.

Moreover, further monetary expansion does not seem appealing as nominal gains lose their luster and actors are more concerned with converting money to dollars than investing in real estate.

At a certain point, continuing the monetary boom brings decreasing gains in terms of paper wealth and increased economic uncertainty, with the latter outweighing the former. I believe that point is near and there is evidence policymakers see it as well.

If we accept that the elites have an encompassing interest in keeping the system intact and after a certain point, and that this interest outweighs the temporary benefits of monetary boom, then we must consider how such collective action is enforced. After all, no one wanted the Financial Crisis of 2008 to happen, but most of the actors had a much bigger stake in the upside than the downside and ultimately no one was really directly accountable for the build-up of the crisis or had enough influence/power to meaningfully change the trend. So the bandwagon kept going until it fell off a cliff.

China has had a record of successfully preventing hyperinflation, as Victor Shih argued convincingly in his book.

Source: "Factions and Finance in China" by Victor Shih

There were periods of rapid money growth and high inflation but retrenchment periods that followed made the monetary problems manageable. This may be due to the way elites are structured and perhaps a bit of it historical accident, but the record is there and the same structure endures.

If we accept that 1) the Chinese elite has an encompassing interest in controlling the monetary boom that has grown to be bigger than the short-term gains from continuing the boom; 2) the structure of the elites allows for a high probability successful retrenchment, then we can proceed to figure out what steps will be taken.

A) Debt Securitization

If we consider the banking system as a whole, take the following example.

Assets Yuan
Cash 200
Loans 800
Deposits 1000

Let's say banking system sells 200 yuan of loans to individual investors, who buy them after cashing in deposits.

Assets Yuan
Cash 200
Loans 600
Deposits 800

Voila! Deposits are 200 yuan smaller and so is money supply. Of course, the moneyness of securitized debt can be debated (e.g. the ECB includes debt securities up to 2 years in its M3 calculations), but right now keep in checking apparent money growth is the main concern. People aren't going to buy houses or dollars with 10-year corporate bonds.

This is a very simplified version of what's going on right now. Basically, debt is being securitized either through bonds or through the shadow banking system. Depositors get a better deal because the loans/bonds pay a higher interest rate than bank deposits.

It is likely to led to credit and a whole host of problems down the road, but it's one step in the right direction.

B) Internationalization of Yuan

This isn't my focus in this article so I'll be brief. By encouraging direct trading of the yuan (Australia), foreign central bank yuan holdings (Aussie again) and free trade agreements (Iceland), the yuan is held/used more often and this increases the demand for money as an exchange vehicle.

C) Stimulating the Stock Market

Finally! After all those appetizers, we get to the entree. Stimulating stock prices will be very useful for many reasons.

1) Changing Perceptions

The Chinese stock market has been languishing for years. Stimulating a rise in stock prices would change expectations of future returns. If you've been watching stock prices go up a bit then fall more for 4 years, you probably don't have that high expectations of future returns. But sizable returns for a few months, a year? That'll change perceptions. It'll also change perceptions of the economy, at least in the short term, giving us a break from bearish worries.

2) Stabilizing Capital flows

If money supply growth is slower, then real estate appreciation will slow dramatically (since it was discounting future rapid money growth). Higher expected stock market returns will lead wealthy people to stick around and see if there are opportunities instead of cashing out to dollars.

Capital inflows are also being encouraged by attracting foreign institutional investors (here and here). Foreign institutional investors are initially attracted by a credible reform program (lower money growth, removing capital controls in X years, national pension funds investing in stocks etc). Later on as the rally gains momentum, more dollars are likely to come as institutions fear not being on the bandwagon and underperforming the benchmark.

By increasing expected returns on investment and dollar inflow, people with money will have less incentive to sell for dollars. This stems capital flight and buys time for reform.

3) Foster Equity-Issuance Friendly Environment

There is a large backlog for companies going public on domestic exchanges. It's difficult to issue so many shares in a bear market. The pump has to be primed to get an equity-issuance friendly environment. This is not a minor point, as equity-issuance access is very important for influential interest groups.

Q: But I thought the market has a will of its own?!

A: Well, China is a very special place. There is a nice fundamental story for gains in stock prices: large caps are trading at an average P/E of around 10. There are also attempts made to transform from an investment-export growth model to a consumption-oriented one. These can both provide bullet points for an investment thesis. In addition to that, very little capital has to actually be deployed to get the market moving. As long as the determination for reform and driving up stock prices is strong and credible (at least in the short run), you can get people in-the-know piling into stocks, which gets more people piling into stocks and a bandwagon effect sends stock prices soaring. With valuations at these levels and few serious imminent worries on the economic horizon, there is little to stop gains from compounding into further gains. Um, isn't that what the ECB did with the OMT?

In conclusion, I believe Chinese policymakers have a strong encompassing interest and effective structure in controlling money supply growth and stimulating stock prices will be one of the policy instruments to increase net dollar flow and gain time for further reforms. That is why I think we are nowhere near Lehman 2008 - there are still many policy instruments at the disposal of policymakers and they can create a bandwagon effect that will send up stock prices and increase expected returns.

I'll end with a personal story. I remember I was short commodities in late 2007 and early 2008. I just couldn't understand why commodities would keep going up after short spikes downward. One day, the ECB makes a 500 billion euro liquidity commitment and a few weeks later the Fed cuts rates 75 bps. When it was really time to go short commodities in the summer of 2008, I had lost hope in the trade already. I learned that it is important to wait until all apparent policy tools are exhausted and a real catalyst appears.

Disclosure: I am long FXI, CAF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Actually long mainland Chinese shares but no ticker for that.