"Shorting is not a criminal trial. It doesn't have to be beyond a reasonable doubt. There just has to be a preponderance of evidence." -- James Chanos, February 2011 interview
China's Coming Crisis
"We certainly weren't the first on this idea," Chanos tells me at his offices in April of 2011 about the biggest short position of his life: The People's Republic of China. Chanos first spoke publicly about his grand stake in China over a year and a half ago on CNBC's Squawk Box in December 2009. "Right now, we're as bearish on China as we've ever been," he says. He followed that with a presentation at St. Hilda's College, Oxford in January 2010, "The China Syndrome: Warning signs ahead for the global economy."
Chanos argued that China, fearing a sharp slowdown from the financial crisis, pumped credit into asset growth -- mainly real estate but new roads and high-speed rail, too. There were "classic pockets of overheating, of overindulgence" he said in his presentation. Fixed asset investments as a percentage of China's gross domestic product (GDP) were exceeding 50 percent -- a "sh-a chén bào" (sandstorm) of money, he said. The stimulus was massive: $586 billion, or 14 percent of GDP (the U.S. package was $787 billion, or 6 percent of GDP). With state-owned enterprises controlling 50 percent of industrial assets, and not being driven by the need to make profits, and local party officials dictating the real estate development process, large-scale capital projects were growing "sillier by the day," including rising industrial and manufacturing overcapacity. There were empty cities, such as Ordos, and lonely malls, such as the New South China Mall. News reports showed new buildings toppling from shoddy construction. It was the latest chapter in China's history of credit-fueled booms and busts. China was "letting a thousand Dubais bloom," he quipped. "Go to Dubai and see what happened. It was... what I call the 'Edifice complex.'"
This all raised questions in Chanos's mind. Would generational savings be destroyed, exacerbating a ticking demographic time bomb? Another roadblock to developing China's consumer economy? What would happen as a consequence of the unfunded liabilities and government guarantees? Is the $3.0 trillion "security blanket," the foreign reserves, full of holes? And what would the global consequences be, such as the impact on prices of construction materials and interest rates for U.S. and other sovereign debt?
At first, Chanos saw immediate backlash against his thesis, with many saying there was no real estate bubble in China. A year and change in, the Central Bank of China has acknowledged there's a real estate bubble and that the country is facing issues. So, too, has the International Monetary Fund. "What people don't realize is that China papered over its last two credit bubbles, those in 1999 and 2004. The banks were never bailed out -- they just exchanged their bad loans for questionable bonds from quasi-state organizations. The Chinese banking system is built on quicksand," he says.
The country's capital markets have failed to modernize to meet the demands of China's domestic economy and role in the international economy. Political pressure to stimulate the economy during the financial crisis resulted in massive loans to local governments and real estate developers. These loans are turning increasingly insolvent as the borrowers find it hard to repay them as a consequence of the stagnant or failing demand for housing, declining prices, and the evaporation of land sales, a principal source of cash for local governments. Alternative banking networks are collapsing. Given the lack of transparency and inadequate, if nonexistent, corporate governance, it's hard to determine the enormity of the debt and the likelihood of its repayment.
This means untold risks for China's banks, and that deep government reserves are keeping things afloat -- at least for now.
"The question, now, is how is China going to manage its way through it," he says. "The excesses that we saw a year and a half ago have only built up since then."
Presently, Kynikos is short the property developers in China through the H-shares in Hong Kong as well as most of the larger Chinese banks, which the firm believes are going to need ongoing injections of capital, much of which will come from Western investors. The fund has been short an oddball collection of one-off Chinese companies, such as Chinese Media Express, that have floated issues in the United States. Chanos has dubbed casinos "long corruption, short property." But his overall short in China stands as one of the highest exposures he has had to a single theme. China is one thing he's betting against in a big way -- it currently stands as the highest exposure he's ever had to a single theme in the portfolio.
Although one economist estimated that 64-million apartments are empty, "what we do know is that if you drive by all kinds of tier one, tier two, and tier three cities at night in developments that are completely sold out, most of the buildings are dark at night, so there are a lot of empty apartment buildings in China. We just don't know how many," says Chanos.
So Chanos's team developed a proprietary index of property transactions in the first-, second-, and third-tier cities. It was the first time they turned around a time series and made an index out of it, and Chanos explains the process. "Interestingly, the problem is not the amount of data available about China. It's the quality of the data in China." Even though the data may be flawed, the firm finds it a useful indicator. "If we keep it consistent by using the same data, we can at least get an idea of some trends," says Chanos. For the last few years that they've been tracking this across 50 percent of China's urban population, this reasonably significant statistical sample was at first flat and more recently (late 2011 to early 2012) has turned down. So for all the increase in development, by unit sales, transactions have been fl at to falling. Chanos deduces, "If you're not selling the same number of units with more and more coming down the stream, there are going to be many units stacking up in the system. And that is a major warning sign."
What they've seen recently for the first time is that price cuts have not been met by an increase in sales whereas historically, every time price dips in the market, activity has usually spiked a little bit. "We're keeping an eye on that pretty closely, too," says Chanos. "Because if that continues, there's going to be a real problem."
The question everyone asks, however, is when. "If I were good at timing, I probably would have retired a long time ago," says Chanos with a chuckle. "It's certainly happening though. Inflation is bubbling through the economy there faster than I think anybody thought. And now you've got the authorities that are behind the eight ball on two fronts."
Added onto the credit expansion and property bubble, consumer and wholesale prices experienced a sharp rise. It's a situation where China scrambled from behind to tighten credit before signs of a slowdown since the summer lead to credit easing in November. "We're hearing stories of hoarding and shortages and inflationary behavior like rapidly rising wages. It's another wild card we didn't expect a year ago."
What Chanos sees about China though is a two-fold story of credit-driven excess in the country as well as potentially dangerous situations for investors in many Chinese companies. Drilling into individual companies, Chanos is amazed at just how dicey almost every company they analyze looks. Some examples include odd transactions -- lots of profi ts never show up in cash and/or suspicious-looking affiliated deals with third parties. "Almost every company we look at exhibits one or more of those characteristics," says Chanos. "So I think it's very problematic for Western investors to make money in the share market in China. Not only because I think the macro's bad, I think the micro's bad, too. You're basically being fleeced as the Western investor in many of these companies." Chanos points to examples of companies that suddenly stop trading, or corporate headquarters that don't exist when Westerners fl y out for a visit. "If you can borrow the stocks and get short them, it's basically a field day for the short-seller over there because many companies look like they are fraudulent."
Part of the problem in understanding China, Chanos says, is the prevailing myths. One is that the country's balance sheet is healthy in that it doesn't show much debt. That's because the state-owned enterprises and local governments use special off-balance-sheet financing vehicles, with borrowing that has been growing very quickly, he says.
"We estimated that China's total debt reached about 180 percent of GDP in late 2011. If we assume that China will grow total credit this year between 30 percent to 40 percent of GDP, and half of that debt will go bad, that is 15 percent to 20 percent. Say the recoveries on that are 50 percent. That means that China, on an after write-off basis, may not be growing at all. It may have to simply write off some of this stuff in the future so its 9 percent growth may be zero."