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The Buy Side

Where is the next bubble going to burst? I bet China Add to ...

Every now and then an obvious bubble appears, and after it bursts you always wonder how you'd missed it. In 2001, it was the Nasdaq; in 2008, commodities; in the early 1980s, gold. In my view, China is just such a bubble.

The Chinese market already plunged 70 per cent in 2008; then it regained half its losses. But bounces end as fundamentals win out, and many of China's bad fundamentals are getting worse: massive overproduction, un-repayable real estate loans, products selling below full costs, a dictatorship scared of its own people, rampant speculation.

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Until last year this was a sort of a lonely view, but no more. Jim Chanos, the legendary chief of Kynikos Associates who made a lot of money shorting Enron in 2001, has joined the China-bears' party. And his views are even harsher than mine - he's shorting China, big time.

What is he saying, specifically?



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Similar to my views, Mr. Chanos states that China has huge overcapacity in almost every sector - he's convinced that many of the official stats are hooey. For example, he points out that the huge reported jump in car sales can't possibly jibe with the low growth in gasoline consumption. He is sure that state-run companies are buying millions of cars and storing them - just as they did with appliances and metals before the Chinese market dived 70 per cent in 2008. And he quotes eyewitness testimonies of empty malls and factories, not reported in the press.

How bad can the next Chinese market tumble be?

Mr. Chanos thinks it could be worse for global markets than the U.S. housing debacle was. My own view is that it would be bad, but not as bad as that. But whether awful, or just bad, is a mere quibble. And, you might say, even if both Mr. Chanos and I are right, shorting bubbles is tricky: The bubble may continue to soar before it tanks, so you must get the timing right. And why do I think the fizzle-out is near?

For the following reasons:

First, just two weeks ago China told its banks to lend less - evidently its leaders understand the bubble must burst, and prefer this to happen from a lower height. If the U.S. Federal Reserve had ordered U.S. banks to lend less, the Dow would melt. When it's China, no one seems to care. Yet.

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Second, a month ago China walked away from contract talks with Potash Corp. and other producers, as the country demanded what the company called an unrealistically low price. Such a walkout has not happened before. Can it be that the Chinese negotiators knew their economy would be weaker, so they'd need less potash later and could pay less?

Third, there are signs the Chinese leadership is getting really scared of its own people. Besides Soviet-style pervasive media and Internet censorship, China recently forbade the showing of the movie Avatar . Apparently, "natives fighting exploiters" is too close to what the Chinese authorities are doing to landed peasants. A government fearing an uprising due to a movie? Would you invest there?

At the same time, minions of this scared leadership allegedly hacked Google's g-mail to find out which of its citizens are peeved. But Google is fighting back, threatening to walk out of China, and for the first time, the U.S. government is supporting this courageous stance. None of this is good for the Chinese market, especially with its huge overcapacity overhang.

How to play the Chinese bubble?

First is to recognize that its bursting would impinge on all markets, and start hedging with shorts.

Second, one can short the Chinese market directly via its exchange-trade fund - the FXI. There's also a negative ETF, the FXP, but I'd rather short the long ETF, if it can be borrowed cheaply.

What of individual stocks? It's hard to sleuth them from afar without knowing the lingo and the terrain. But China BAK Battery looks ripe: Its revenue growth is not matched by internal accounting figures - which to me always rings alarm bells. Besides, the story of lithium batteries seems over-hyped.

What of counter-arguments?

Jim Rogers, the famed China and commodities expert, thinks Mr. Chanos, despite his prescient call on Enron, is all wet here. Check both their views, and decide for yourself. As for me, I am a China bear here.

Special to The Globe and Mail

Avner Mandelman is a director of Venator Capital Management and author of The Sleuth Investor. You can reach him at Amandelman@venator.ca

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