Why Chanos Is Wrong About "China"

Many know Jim Chanos of Kynikos Associates for his famous and ultimately very successful bet against Enron. But this short-seller is back in the news again, and making rounds in the media, publicizing his current bet against China. While Enron was a big, fast-growing company, China is the biggest, fastest-growing country in the world. Should it collapse, and Chanos has said that it will and that it will be bigger than Enron, the world would have a serious problem on its hands.

Yet I believe many are misinterpreting Chanos on China, and I further believe Chanos is making the mistake that many Westerners do in thinking of China -- to borrow from a profile by Patrick Chovanec in The Atlantic -- as a "monolith." In fact, China is a diverse nation of 1.3 billion -- many of whom remain very poor and very rural. Or as James Fallows put it after spending years living in the country, "the big country of 'China' is really a fluid congeries of interests and ambitions."

What this means for Chanos
To Chanos' credit, it has been mostly the media characterizing his recent short bet as a bet against "China." As he clarified in a recent, must-watch interview with Charlie Rose, he is betting specifically against Chinese real estate. This, he noted, is a "world-class property bubble" that has been stoked by the "heroin of real estate development to keep the numbers going" (which is just a fantastic line). It's this excess capacity in high-end condos and office buildings, he believes, that will bring a reckoning to China by the end of 2010.

And he's not off base here. Chinese property prices have more than tripled since 2001 while capacity has almost doubled. Put that together with reports of lots of vacant space in Beijing and Shanghai, and it's not farfetched to believe China's tier 1 real estate market is due for a fall.

Yet China is bigger than its tier 1 cities, and economic fundamentals -- even in the real estate space -- remain far more sustainable in tier 2 and tier 3 cities. Consider, for example, that while housing in Shanghai was selling for more than 18 times average annual income in Shanghai in 2008, it was selling for a much more reasonable 5.3 times income in Xi'an. And Xi'an is no backwoods outpost. It's a city of almost 8 million located near major centers for agriculture and coal mining. That city also happens to be the base of China's "Go West" policy to encourage needed infrastructure and economic development in heretofore depressed provinces such as Gansu and Xinjiang. Lesser-known cities such as Chengdu, Lanzhou, and Yinchuan strike similar profiles -- a distinction that tier 2 real estate developers such as China Housing & Land (Nasdaq: CHLN  ) have been quick to draw in recent, crowded investor presentations.

Why this matters
If Chanos were to say that he is shorting tier 1 property markets in Shanghai and Beijing or even industrial property in a city like Shenzhen, I would have no problem. Given the record rates at which Chinese banks were loaning money for these types of projects in 2009, he's also right to be short Chinese banks (incidentally, those banks dominate the top holdings of the very popular iShares FTSE/Xinhua 25 China Index (NYSE: FXI  ) , so that's also one to avoid). But given China's human capital, its 700 million rural citizens with aspirations of upward mobility, and the still-sane tier 2 and tier 3 markets supported by viable industrial and agricultural businesses, I just don't buy the argument that China -- all of it -- is headed for an epic crash. The short positions Chanos is rumored to have in miners such as BHP Billiton (NYSE: BHP  ) and Rio Tinto (NYSE: RTP  ) and steel companies such as POSCO (NYSE: PKX  ) may be misplaced, given the need for rails, roads, and affordable housing infrastructure in Western China.

Similarly, I don't buy the argument that there is no bubble in China. There is too much evidence that markets in Beijing, Shanghai, and other tier 1 cities have gotten ahead of themselves, and we still don't have (and may never get) good insight into the quality of the loans Chinese banks were making in early 2009 to help China defend itself against the global economic downturn. As tier 1 markets correct, many of these loans likely will produce losses, and the government will have to act to stabilize the banking system. This will lead to volatility and likely to lower growth in its gross domestic product, but other aspects of the Chinese economy, particularly the growth of domestic industries such as agriculture and health care that the government is investing in, should help shoulder some of the burden.

How to proceed
There is always danger whenever one paints a complex situation with a broad brush and opportunity when one looks deeper into a complex situation. That's the reality facing prospective investors in China today, and it means that investors need to think long and hard about what part of China they're investing in before laying their money down in either direction.

Ultimately, both shorts and longs are going to make money in China -- that's the nature of investing in a volatile emerging market. My hope, however, is that the market overestimates the consequences of a downturn in tier 1 property markets in China later this year, as Chanos predicts. That would create an opportunity to increase our exposure to the tier 2, tier 3, and domestic consumer markets that we at Motley Fool Global Gains believe will create so much value for China -- as well as for investors in China -- over the long term.

Get Tim Hanson's Global View column every Thursday on Fool.com, or by following him on Twitter.

Tim Hanson is co-advisor of Global Gains. He does not own shares of any company mentioned. POSCO is a Motley Fool Income Investor pick. The Fool's disclosure policy is a monolith.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 15, 2010, at 1:06 PM, dibble905 wrote:

    Perhaps long tier 2 developers/property managers and shorting tier 1 developers/property managers would be a starting point? if you don't like the idea of having unlimited risk on the short, might I recommend a derivatives strategy where you short puts on the tier 2 group and long puts on the tier 1 group? net cost = somewhere close to zero.

  • Report this Comment On April 15, 2010, at 11:44 PM, CatFoodMoney wrote:

    Cool article.

  • Report this Comment On April 16, 2010, at 3:52 AM, jamb2 wrote:

    I live in one of the tier 2 cities mentioned in this article, though the housing prices are not as crazy as Beijing or Shanghai, they are no where near sane. The per square meter cost of the apartments where I live have quadrupled in the past 5 years, and there are many empty apartments in all areas of the city, especially the newer buildings. Many people buy apartments and then expect to flip them in a year for double the price. Is this sustainable? Who knows, but I'm not overly optimistic.

  • Report this Comment On April 16, 2010, at 7:54 AM, TMFMmbop wrote:

    @jamb2

    I've heard from both Jim Chanos and Patrick Chovanec since this article was published that pricing in tier 2 has gotten pretty out of control and am running down the relevant numbers. Which city do you live in? Regardless, it's probably not sustainable. I'm taking a more cautious view after hearing more about this from folks close to the situation, though not changing my overarching view that China needs to be thought of as a very diverse place rather than a monolith.

    Tim Hanson

  • Report this Comment On April 17, 2010, at 1:39 AM, meiroy wrote:

    @jamb2 , likewise, I'm living at a 2nd tier and working at a 3rd and you are spot on. Far from sane. The conclusion from these articles is that most investor should consider that almost all "consultants/advisors" are clueless about what's really going on in China unless they have been living in it for many years and can speak the language. This is not to say there's no bubble, or that when it pops it would be serious. I am 100% sure that if the prices drops a bit in tier 1, all those cash flashed people from 2nd to 100th tier will rush to buy property in tier 1. Bet my words on it. Plenty of CASH around waiting to be invested by plenty of Chinese who read the market well. Billions of it.

  • Report this Comment On April 17, 2010, at 8:32 AM, TMFMmbop wrote:

    We do spend a good bit of China and have lots of contacts. In other words, our Global Gains team is somewhat better than "clueless" and I believe the returns we've earned from China prove that.

    Tim Hanson

  • Report this Comment On April 17, 2010, at 9:24 AM, Tacomatight wrote:

    I don't know why all the people that say they live in China are so secritivce about what city they live in. I live in Xi'an (home of the terracota warriors), probably the most famous second tier city.

    The thing I can add here is that average Chinese income is always far from correct for city dwellers. Many people in SOEs (State Owned Enterprises) make 2000 kuai (around 292 dollars) per month on the books. Yet these are the same people that are driving a brand new Buick and living in a brand new apartment worth 100,000 dollars US.

    Curious...yes? If people make so little how can they buy so much?

    That's because of massive corruption which permeates Chinese society especially in the State run operations.

    When you include corruption an average worker most likely makes double or even ten times their stated wage (I don't have numbers to back this, just my own conjecture).

    So with this in mind...Chinese housing prices aren't as outrageous as they look on paper when comparing them to real (including corruption) median wages of city dwellers.

    -Tacomatight

  • Report this Comment On April 17, 2010, at 9:32 AM, Tacomatight wrote:

    Sorry...I forgot to mention the numbers for average wages in SOEs are for Xi'an.

    And I errored in saying 2000 kuai, actually closer to 2500 RMB, so u would have to up the dollar amount.

    also,

    kuai = RMB; kuai is spoken Chinese for their money just like we would say bucks instead of dollars.

  • Report this Comment On April 19, 2010, at 4:25 AM, JibJabs wrote:

    I live in a 3rd tier city, Xinyu, (if there is a 4th then it should qualify) and there is massive overproduction- the nicest housing complexes sit empty and rapidly dilapidate. I would not short China because that involves timing but I sure won't invest in it. My coworkers spend their office hours looking at the squiggles on a computer screen as the real estate market fluctuates. When people at that level of the chain are speculating, it's a sure sign that the saturation point is drawing nigh.

    @Tacoomatight: I agree completely but that can only account for so many apartments.

  • Report this Comment On April 19, 2010, at 5:07 AM, meiroy wrote:

    Tom Hanson,

    I know quite a few of clueless Chinese and heard about gazillions who made millions in stock investment in China. The fact that you did as well does not say much. Bottom line the article is incorrect to say the least.

  • Report this Comment On April 19, 2010, at 10:09 AM, TMFMmbop wrote:

    Gazillions made millions?! I can't even do the math on that.

    TIM

  • Report this Comment On April 22, 2010, at 10:31 AM, JakilaTheHun wrote:

    You're setting up a straw man. I don't think too many people believe that *ALL* of China is going to crumble --- not even Chanos. Moreover, Chanos hasn't disclosed what precisely he's shorting; but has suggested it was businesses that export a lot of goods into China. Hence, he might be shorting certain commodity producers.

    I think you're also overlooking the macroeconomic picture. Just because there's not much of a property bubble in some Chinese cities, doesn't mean the RE bubble won't drag down the Chinese economy for awhile. Property in Raleigh, NC wasn't all that overvalued in 2007 here in the US --- it doesn't mean that the US avoided a dramatic recession. Or even that Raleigh wasn't affected. Just that Raleigh was hurt less than ... say ... Charlotte or Phoenix.

  • Report this Comment On April 22, 2010, at 10:56 AM, JakilaTheHun wrote:

    http://www.businessinsider.com/qa-with-jim-chanos-part-ii-ch...

    "There is a big misconception that has been posted out there, but our China call is a simple one: there's a property bubble going on. I'm not making a call on the Chinese economy, although it will have a problem when the property bubble bursts. We're not making a call on the currency

    on whether it'll appreciate or, god forbid, depreciate. What we're simply saying is you are seeing an epic building boom in China and more interestingly, an epic high-rise building boom in China.

    It's not just high speed rail and airports and new roads. That's only a very small part of their infrastructure spending. This is primarily a story about people putting up high rise office buildings and condos in the big cities. That's what it is.

    So when you look at it like that, the data supports it. I mean, people have taken a shot at us because "Mr. Chanos has never been to mainland China." Well hell, I didn't work at Enron either. Or "Oh, but he doesn't speak Mandarin."

    Whatever. It doesn't matter. Using the Chinese government's own numbers as well as some western entities that are on the ground there, the numbers are what they are. The square footage being built is what it is. You can see it when you go there. It is a high-rise construction boom.

    So when you look at it through that prism, you can begin to make some assessments. We've seen similar bubbles in Dubai, Miami - scores of other entities have gone through this and it never ends well.

    Now, the real argument in China seems to be - the argument I think carries the most water for the China bulls - is somehow the government is going to be able to manage this. That they're going to let the air out of the bubble gently. That 9 guys who sit on the central committee of the country who got us into this mess are going to get us out of this mess. I wouldn't want to bet on that."

  • Report this Comment On April 22, 2010, at 11:50 AM, TMFMmbop wrote:

    If Chanos is betting against companies such as Posco and Rio Tinto, then he's betting the infrastructure building in tier 2 and tier 3 China is going to stop amid a massive construction downturn. My argument's not a straw man at all. Rather, I'm just saying if one wants to short tier 1 Chinese real estate, I would focus that exposure more.

    Incidentally, I learned from an email exchange with Chanos that they are assuming 45 sq meters of living area when calculating housing costs for people in tier 2 and tier 3 China. The reality for most of these cities is actually closer to 20 to 25 sq m of per capita living area.

    Tim

  • Report this Comment On April 22, 2010, at 2:21 PM, JakilaTheHun wrote:

    Tim, I think you're being unrealistic on this.. Once again. look at what happened here in the US. Cities like Raleigh, Memphis, Knoxville, and Columbia (SC) didn't have particularly inflated real estate markets in 2007. It doesn't mean they weren't affected by the aftermath.

    For the most part, the vast majority of our inflated RE properties were located in a few major markets. This is how property bubbles always work.

    The reason why this is true is simple --- real estate is subject to the same laws of supply and demand as anything else. Cities with massive populations and geographical or infrastructural constraints have more limited supply. More limited supply means that prices become more volatile. In a bubble, that means those properties are the ones the most overvalued.

    However, the effects of the bursting of the bubble are not limited to these markets. We live in a global economy. At the very least, a RE bubble burst in the "tier 1" cities will weigh down the major banks of China. This will create credit contraction throughout China --- not just "tier 1" China.

    Things are also complicated by how much of China's economy is dependent on construction. Once that is eliminated, there's suddenly less money for everything.

    I don't know that Chanos is shorting Posco; but it's hardly a stretch to suggest that a China RE bubble burst will have a very negative impact on them. Even the bursting of the American RE bubble had a very negative impact on them.

    There's an interconnectedness here. To suggest that commodities will keep pouring into China once the impetus is removed simply doesn't make much sense.

    The "Tier 1", "Tier 2", "Tier 3" thing is completely irrelevant to the issue. All that means is that "Tier 3" China may be less adversely affected. But so what? That doesn't mean the commodities producers won't suffer in a major way, still.

    You're also missing the really big issue ... all this infrastructure is dependent on the Chinese government. A massive collapse in "Tier 1" China will create problems for the Chinese government and may not allow them to pursue all of their ambitions in the rest of China.

    Implying that everyone who believes that China might see a major RE collapse views China as a "giant monolith" is very much a giant straw man. I haven't seen too many people argue that. You seem to be assuming that there's no interconnectedness between the various parts to reach this conclusion --- this is not an assumption of myself, Chanos, or any other China RE bears that I know of.

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