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
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
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.