China On The Verge Of Deflationary Crash: Primary And Secondary Plays

| About: iShares China (FXI)

Money printing is like a drug. Once an economy gets hooked, it can't get off it without severe withdrawal symptoms. Why? Because the new money must always go somewhere, and it always goes into the capital goods sector first; stocks and real estate, mainly. But those in the consumer sector end up having to pay more eventually as the money filters down. Since consumers never get the new money first, they get poorer to the point where demand dries up. Then, a deflationary crash begins and prices must be reset. Such is the business cycle.

Then why print money? The reasons central banks do it is that they want to increase asset prices (stocks and real estate) so their country's wealth looks like it's increasing, when it's actually just making banks bigger. The problem is, there is no "wall" between asset prices and consumer prices, and trying to inflate asset prices without suffering the inevitable consequences of consumer price inflation is like trying to soak only one ply of a two-ply tissue.

When asset price inflation starts to bleed into consumer price inflation, consumers generally go from happy to angry, and then a central bank has one of two choices: It can either keep asset prices inflated with continuous money printing and risk hyperinflation, or it can stop money printing and even further, soak up liquidity in reverse repo operations and risk an asset price deflationary crash, but keep consumer price inflation under control.

In the case of the US, the Federal Reserve has clearly decided to keep printing for now, its "tapers" being merely token and probably reversed soon. With consumer price inflation muted for now, it will keep on doing this until the CPI explodes, but by then it will be too late.

I have pointed this out before, but there are two main reasons that consumer price inflation has stayed low in the US. One is that the dollar is the reserve currency, and foreign central banks keep buying US treasuries, sopping up inflation by keeping the dollars they buy at bay. The other is that banks are simply not putting any of the QE money into the economy. The new money continues to pile up in excess reserves, with no end in sight. Last May, when I covered this, excess reserves at the Fed amounted to 58% of the monetary base (Total - Required) / Monetary Base). They now amount to a whopping 65% of the monetary base as of February 6, increasing in absolute terms by 40% in 9 months. To put this in perspective, the only other time in US history when banks had any excess reserves at all was during the Great Depression, and a negligibly small amount right after the September 11th attacks.

For these reasons, price inflation in the US economy is muted, but not so in China. The Chinese renminbi is not the world's reserve currency, and more importantly, excess reserves in China are negligible. China's Central Bank, the PBOC (People's Bank of China), last reported excess reserves at only 1.7% of the monetary base as of last May, a very far cry from where the US was at 58% at the time. Any rapid money printing in China has the chance of pushing directly into the CPI, and the PBOC knows it.

The PBOC Has Said "No" to More Inflation

In every period of money printing, there is always a point where a central bank must decide, either hyperinflation or crash. There is no such thing as a soft landing. And all the recent evidence points to the PBOC choosing the latter. The major signs include:

  1. Officials at the PBOC stating, in November, that "It is no longer in China's favor to accumulate foreign-exchange reserves."
  2. Sizeable Chinese liquidity drains beginning last September. This is essentially QE in reverse.
  3. Chinese M2 money supply growth forecast is currently only a 6% annual growth rate in comparison to 18% over 2010 and 2011 (see graph below - 85,159/62,561). The Chinese CPI reflects this, as in 2010 and 2011, consumer price inflation was above 4% annually. It is now around 2.5%.

(Source: Trading Economics)

All in all, the PBOC is clearly following a policy to strengthen the renminbi and curb its monetary expansion. I have pointed out before that the September 2008 crash occurred precisely when money supply growth went negative on September 18. See the averaged M2 numbers, 13-week especially, for the week before the crash went full speed.

If the PBOC is really going to follow through with this policy, namely, to continue sopping up liquidity and slowing money supply growth, a crash is inevitable. A prudent but potentially very profitable way to play this is to buy out of the money put options on the iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI), with the safest being the January 2016 LEAPS. As options are wasting assets, a 5% to 10% max will do, and if the PBOC follows through, the gains could be very large. If the PBOC changes its mind and decides to increase printing, you can only lose what you put in. And again, waiting two or three weeks or so until technicals reset may be prudent to get a better entry price. China is probably oversold in the short term and is due for a dead cat bounce.

(Source: StockCharts)

FXI has the highest liquidity and trading volume, and other plays are not as wise, in my opinion. YXI, for example, is the inverse of FXI, but buying a short ETF requires more capital than an options position. Since inverse ETFs are also wasting assets anyway, one may as well get the one that requires less capital for the same risk/reward. There are also other China ETFs, but liquidity is an issue on the options spreads, and there are no LEAPS available on puts with China Financials (NYSEARCA:CHIX) and the SPDR China ETF (NYSEARCA:GXC). Leveraged short ETFs like YANG or FXP are out of the question for this strategy, as a timing error will ruin the trade, and I have no timing theory other than to say the PBOC will follow one road or the other by 2016. Hence, the LEAPS.

Stevia a Secondary Play

For those who don't trade options and would rather not hold wasting assets like inverse ETFs, or for those who just don't like the idea of shorting, an indirect way to profit from a Chinese collapse would be to invest in US-based stevia companies.

What does stevia have to do with the price of tea in China? Simple. The vast majority of global stevia production comes from China. Even US-produced stevia is currently sent to China for extraction and processing and returned. This means that even domestic stevia is essentially a Chinese export.

If the PBOC is really set on lowering its foreign exchange reserves, sopping up liquidity, and keeping Chinese consumer price inflation under control, the renminbi will rise significantly, putting a temporary but severe drag on Chinese exports. Chinese stevia will become more expensive for importation, giving US-based stevia companies a serious boost, ability to raise funds, and a financial incentive to rev up production.

The stevia investment selection is rather thin, but there are some encouraging prospects that could benefit significantly from a rising renminbi, which I have written about previously. One is Stevia First (OTCQB:STVF), which is the only company with an approved patent for microbial fermentation-based stevia. Fermentation-based stevia, as covered in my earlier article, is basically genetically engineering a yeast strain to convert sugar into steviol glycosides, the sweet compounds in the leaf, bypassing the agricultural step. If Stevia First succeeds in this, then it will be able to undercut Chinese stevia regardless of what the PBOC does. Additionally, Stevia First is investing in the straight-up agricultural approach to stevia production, announcing a pilot program in California in December. It is the agricultural approach which will directly benefit from a rise in the renminbi.

Investing in Stevia First is similar to an options play on FXI in terms of capital required and risk/reward. As a small cap of $30M, STVF requires little capital for investment. The risk/reward is quite high as well, since if the company's fermentation technology succeeds (and a prototype is already out there, as per my previous article) OR the PBOC does follow through and stevia agriculture takes off in the US to pick up the Chinese slack, the potential upside is very large. As for the downside, like FXI puts, you can only lose what you put in.

The other favorite of mine is Evolva Holding (OTCPK:ELVAF), which has the benefit of working with Cargill, which is working with Coca Cola on the debut of Coca Cola Life, the stevia-flavored Coke in the US. Evolva is a Swiss company, but its US partnerships will be affected by any Chinese monetary earthquakes, in turn affecting Evolva. Evolva does have a possible issue with patents, as I previously discussed (Stevia First has the only approved patent on stevia fermentation), but its business partnerships are solid and should not be overlooked due to a patent issue. One never knows how a court may intervene in such cases.


The safest and most logical way to short China is to wait for short-term oversold conditions to subside in FXI, and in a few weeks, go out to 2016 in out of the money (but not too far out) puts. Don't be distracted by other short ETFs, as they are wasting assets with larger capital requirements for investment. As a secondary play, the stevia market in the US is poised to take off if China, the chief stevia exporter on the planet, does enter a period of serious deflation.

The two stevia companies mentioned here, while speculative, are on the cutting edge of Stevia technology, and could see a significant rise based on fermentation technology regardless of what happens in China. But if the PBOC does indeed follow through on taming monetary expansion, both Stevia First and Evolva will receive a huge tailwind.

Disclosure: I am long STVF. I may initiate a short position in FXI over the next 72 hours. 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.

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