Hey, Jim Chanos, Short This!

You can only get famous by making big predictions, and a little more than a year ago, famous (or infamous) short-trader Jim Chanos made it known he was bearish on China. Headline writers and finance-TV producers translated this into "Chanos Is Short China!" Perhaps they used a few more exclamation points, but you get the point.

At the time, Tim Hanson, co-advisor for The Motley Fool's Global Gains newsletter, pointed out that Chanos' stance was slightly more nuanced, but still missed the true nature of China's economic situation. A year on, the Shanghai Composite Index is down 14%, almost the opposite of the S&P 500's strong 13% return. So was Chanos right?

Not that easy
Unfortunately for those trying to follow Chanos' lead, you can't easily short the Shanghai Composite because only domestic Chinese investors can invest in the shares represented by that composite (A-shares), and shorting has only recently been allowed by Chinese regulators and is still very limited.

To get around this, Chanos hinted that he was looking at widely traded companies that would be significantly affected if China's bubble popped. These likely included natural resource producers such as BHP Billiton (NYSE: BHP  ) , Rio Tinto (NYSE: RIO  ) , and Peabody Energy (NYSE: BTU  ) . Over the past year, these three have returned 29%, 43%, and 46%, respectively. Ouch.

Australia, which sends more than a fifth of its exports (most of them raw materials) to China, could also be affected by a slowdown in demand from China. In 2010, the Australian dollar has appreciated 14% against the U.S. dollar. Again, ouch.

Not over yet
However, there is growing sentiment that China is overheating and could see a slowdown in growth this year. The argument goes like this: As China's central bank attempts to cool rising inflation by increasing interest rates, it will result in slower growth and less demand for imported goods (mostly raw materials). If this comes to fruition, 2011 could be the year when resource-producing companies and resource-rich countries take a hit.

As it happens, the Global Gains team will be heading to Australia in a few weeks to meet with several Aussie companies. Let's check in with Tim and the other members of the team to see where they stand on the prospects for China and what they will be looking for as they explore Down Under.

Tim Hanson: China's growth is expected to slow in 2011 to 9%, but it could be slower than that if China reins in the loose money that's been spurring fixed asset investment. Because as Michael Pettis pointed out in his recent China Financial Markets newsletter, China has not yet succeeded in spurring sustainable consumption. "Of the four fastest growing areas of retail consumption [in China in 2010]," Pettis wrote, "the first (gold, silver, jewelry) is really more likely to be a proxy for investment than consumption, while the second and the fourth (furniture and household appliances) are related to real estate investment, and so might also be considered as much an indication of soaring real estate investment as of rising consumption." Such a slowdown would lead to a decline in commodity prices and Australia -- given how much the economy there relies on commodity exports to China -- would be a natural short to profit from.

But it's likely that Jim Chanos and I can both be right about China and, therefore, Australia. The reason is that we're contemplating the situation over very different time horizons. Chanos has been looking for a sharp, near-term drop, and while he's been waiting well more than a year for that to happen, he continues to reiterate his thesis at conferences and in the media. I, however, am taking a longer-term view and think patient investors will be rewarded for maintaining exposure to China's growing economy and to the commodities it consumes for the next decade or more. I'm hopeful we can get some good company research done on the ground in Australia, enabling us to buy our best ideas if we do experience a downturn this year.

Nathan Parmelee: I won't be surprised if China's growth slows below the forecast 9%. With so much of China's economy tied to real estate and the government focused on cooling that market down, it will probably be hard to avoid. That will probably slow China's demand for the raw materials that Australia provides, but any slowdown should be temporary because China still has years of growth ahead of it, and its neighbors will be more than happy to pick up many of Australia's resources at more attractive prices.

Ask CLP Group what its biggest challenges are in getting a new power plant commissioned in India and you'll hear that getting a consistent supply of natural gas or coal is near the top of the list. When it comes to natural gas, India isn't the only company looking for consistent supplies. Japan and South Korea have next to no oil or natural gas resources within their borders and have been quick to lock up coal seam gas supplies from Royal Dutch Shell (NYSE: RDS-A  ) and BG Group as they become available.

Similarly, Australia should find a ready market for its agricultural products in Southeast Asia and the rest of the world because of current grain shortages and tightness in agricultural commodities. So while China's growth might slow from its rapid pace, it should recover and many of Australia's export industries should still do well while China gets its house in order.

Nate Weisshaar: It looks like we're unanimous in thinking China's growth will surprise to the down side in the near future. I'm going to be totally unoriginal and say that this should only be a short-term fact, though, as China and India and the other developing nations of the world have a lot of urbanization and infrastructure development ahead of them.

However, I'll be original in saying that my concerns with Australia are more significant. The country has one of the highest household debt levels in the world, a housing market that has generally seen prices rise for nearly 10 years, and has skated through the global financial crisis largely because of China's continuing demand for resources.

Australia's banking system is highly concentrated with four banks, Commonwealth Bank of Australia, Westpac Bank (NYSE: WBK  ) , ANZ Bank, and National Australian Bank, completely dominating the market. More worrying is that these banks' loan portfolios are dominated by mortgages. Even if these are high-quality loans, paying a mortgage becomes tough when you're unemployed. With unemployment currently at 5%, this isn't much of a worry, but with 7.5% of the economy driven by demand for natural resources, even a short-term drop in demand would be painful. Just think of all the knock-on effects a slowdown in the mining sector could have on Australia's economy.

If you want to follow the Global Gains team and receive their thoughts as they travel through Australia, visiting local companies and talking to their management teams, just click here for more information.

Nate Weisshaar is a senior analyst for Motley Fool Global Gains. He does not own shares of any company mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy and dreams of koala infestations.


Read/Post Comments (3) | Recommend This Article (13)

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 January 31, 2011, at 4:16 PM, slpmn wrote:

    Would it be safe to say China is due for a cyclical set back, but the long term, secular trend is positive? If we were omniscient (I know Weisshaar comes close) and had China's growth chart laid out, I have to believe its current position would be somewhere in the middle of the "rapid growth phase". Right now, it's a growth management issue. Fundamentally, China still has a command economy, and I think the commanders are doing a pretty good job. Nice call on Australia, it makes sense.

  • Report this Comment On February 18, 2011, at 4:56 PM, Aristophrenia wrote:

    Um, the long term trend on China is wrong. Why, oh why oh why do people not take the long term trend of resource scarcity, particularly energy and Global Warming into account ? The peaks in 2007 were precisely the catalyst for the GFC, we have reached a natural barrier. Already countries are scrambling for energy and that is at capacity levels of three years ago - imagine another ten years of growth - no way - the limit of price for demand on resources is going to put a ceiling on things. Secondly global warming is striking with vengeance - and it absolutely MUST be taken into forecasts. Wheat, sugar, Maize has gone through the roof, China is already looking to increase imports, and what of next year, or the year after ? What happens when food no longer represents 40% of peoples income but 80-90% ? Thats a potential down turn of 40 or 50% of available consumption. Further economic growth returning oil to 2007 peaks through demand also feeds through into higher food costs - so global warming and high oil will guarantee high food costs - and that will guarantee not just a cap, but a significant downward trend on growth. The game is no infinite - when will people realise this ?

  • Report this Comment On May 21, 2011, at 7:11 PM, DankCastle wrote:

    Australia's realestate collapse is happening at a rapid rate. Most Australian citizens live in a economic situation they neither comprehend nor gain from. The reality is realestate speculators sowed the seeds of their own downfall by bidding up home values using unsustainable leverage and easy credit -- a way of life that become entrenched in Aussie culture until every idiot out there was certain house price can't drop back to past levels when average wages could afford average homes. Check out the ridiculous comments from property spruikers on forums such as the <a href="http://australianpropertyforum.com/blog/main/3221465"&g... property investor forum</a> to see how entrenched is this "property prices always rise" myth in Australia!

    Australian governments have a woeful record in providing a fair property market. Many European countries have better models that operate more equitably for everyone (the envy of Australia) yet even still, those Euro countries must still bail out their banking systems. Anyway, the moral is no one gains from home price inflation in the end, because bubbles always pop. Sure, we hear claims from the real estate spruikers that prices will rise forever, but when most FHBs are prices out of the market then something has got to give. Now the ponzi scheme is finally collapsing (it was inevitable), and so today's renters and first home buyers will have the last laugh when prices do drop up to 50%, which is happening already in many Australian cities.

    <a href="http://australianpropertyforum.com/blog/main/3489065"&g... Property Monitors</a>

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