ISHARES FTSE CHINA 25 INDEX FXI S
April 16, 2012 - 8:57pm EST by
jcp21
2012 2013
Price: 37.08 EPS $0.00 $0.00
Shares Out. (in M): 100 P/E 0.0x 0.0x
Market Cap (in $M): 100 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • China
  • ETF

Description

China Is Already In A Recession - A Fact Drive Proof and Why Now
 
The short China thesis is several years old. However, there has been a significant amount of new economic data released in China that supports the original China short thesis from Jim Chanos. As a result, I am posting a new short China thesis that depends not just on predictions of a collapse (as the Chanos thesis did) but rather a description of one that is already taking place. My primary goal is to get feedback from a) China bulls b) investors who are not bearish enough to short but are considering it c) China bears who are short. I am heavily short China and want to add size and conviction to my various positions as I believe Europe's return to crisis mode implies a Chinese stock market collapse will occur in the next several months (Europe is China's largest export partner, see below on timing). 
 
Also, I realize many value investors do not consider macroeconomic ideas but I do believe this specific idea is a value driven short. In other words, it depends heavily on the techniques that one needs to find either a hidden gem or a dramatically overvalue company (discerning economic reality carefully, etc.). And, unlike many macro ideas, it does not depend as much on opinions about growth or activity in the future but rather on an accurate estimation of the current situation. 
 
Reasoning and New China Data

In economics, there are many opinions but only one set of facts. And, when reaching economic conclusions, the more necessary deductive analysis based on facts (i.e. a bank with more liabilities than assets must have negative equity) relative to judgments based on chains of reasoning linked (assumptions) by facts the better (i.e. consumer spending is strong therefore the U.S. economy will continue to expanded through 2014).

The facts about China's economy were released last week and allow for a significant amount of necessary deductive reasoning:

China's economy expanded by $526.5 billion (8.1%). China's fixed asset investment grew by $609 billion (21%). Therefore, China's economy ex-fixed asset investment shrunk. Given that China's growth depends on fixed asset investment, it is necessary to conclude that if fixed asset investment is not true economic growth than China's economy is in a recession.

 

Defining Economic Growth

Economists define economic growth as an increase in the amount of goods and services produced by an economy over time. To further define and measure what growth is economists count only the sale of final goods to end consumers. When the Soviet Union was producing 800,000 brooms per year for 200,000 in demand, the true growth was 200,000 units multiplied by the price of the brooms (it is worth noting that the Soviet Union GDP was ~45% fixed asset investment).

Because the necessary precondition for growth is the production of something that is actually useful, it is worth estimating how much of China's fixed asset investment useful production is. And, before making this estimate that I will get from China bulls (the one part of my analysis that is not necessary deductive reasoning) it is worth pointing out that China needs at least ~85% of its fixed asset investment to be legitimate economic activity to conclude the country is experiencing economic growth.

(math: Without fixed asset investment, the economy shrinks. Therefore, more than 100% of the prior year's fixed asset investment growth is needed to keep GDP at the current level. See below:

  % Weight Prior    New Weight Current   Prior  
Fixed Investment 45.0% 2,909   50.4% 3,520.4   2,997  Needed
Growth         21.0%      
Non-Fixed Investment 55.0% 3,556   49.6% 3,468.6   3,469  
Growth         -1.2%      
Total GDP   6,465     6,989   6,465  
Growth         8.1%      
Needed / Actual 85.1%              


More Necessary Deductive Reasoning - Understanding Property Investment
The primary purpose of either a residential, commercial, industrial or retail fixed asset investment is to facilitate non-fixed asset economic activity. In other words, if everyone in the world was building buildings, there would be no sources of cash flow to pay rent. Rent requires money which is earned through the creation of goods and services. Therefore, if buildings are growing much faster than the economy ex-property development, the value of the investment is highly questionable. 

Making a Subjective Judgment Based On Facts

In the U.S., new building construction composes roughly 1-5% of the existing stock of real estate. This activity is in the context of relatively low / declining vacancy rates and steady economic growth ex property investment. In contrast, China has very high vacancy rates and negative non-fixed asset investment growth so it is safe to assume some of China's investments are unnecessary. 


Key Point

Arguing China needs more investment than the U.S. because of China's faster economic growth is circular. The only net cause of China's growth is fixed asset investment. 

 

Logical Conclusion Using Bullish Economist Estimates

If one were to conclude that more than 85% of China's fixed asset investment is legitimate economic activity one can conclude China's economy is experiencing some economic growth. But, if more than 16% of China's fixed asset investment is not needed due to the country's 10 years of housing supply, 100 billion square feet in empty real estate, and shrinking economy ex-fixed asset investment, one can only conclude that China's economy is shrinking.

I am not able to find economists who were willing to conclude that over 85% of China's fixed asset investment is necessary (even China bulls). I have a hard time imagining that even 50% of the investment is worthwhile. Property sales are down 18% y/y but property construction is up ~20%. It does not take an economist to conclude that China's inventory of empty buildings is growing at an accelerating pace. 

And, China has very high depreciation rates due to poor construction standards (partly due to corruption). There are many stories and YouTube videos of relatively new buildings completely fall over. And, putting aside construction standards, empty buildings depreciate faster relative to non-empty buildings. Furthermore, condos are being sold in China for $300,000 (way too high for urban workers making less than $20,000 per year) but require an additional $30-50k to put in floors, walls, etc. And, a typical vacant building requires millions in CAPEX to get ready for rentals or condo sales. Therefore, even if China is building these structures for growth in the future, it will be a very expensive and inefficient process. Also, because of these factors, real estate prices in China have a very long way to fall (75%+ to align with incomes). 

Also, as over 50% of China's 2012 economy is now fixed asset investment it is worth pointing out that the country needs to investment 7-10% of its economy just to keep up with depreciation. A normal economy requires ~20% investment / GDP so if China doesn't completely rework its economy soon (via a massive contraction that I am predicting) it will be forced to keep investing a growing amount of its resources just to replace depreciated asset. It would be like living in a big house and spending all your time and money on cleaning and maintenance.

Furthermore, a growing amount of consumption depends on wages earned engaging in fixed asset investment. As a result, there is a growing circularity that can only lead to a massive economic contraction.


Implication

All this implies China's true economy is dramatically overstated. Using GDP accounting, China is now slightly bigger than Japan but Japan's consumption is 2x that of China's (and Japan has a high savings rate). As a result, I believe China's accounting based GDP will ultimately contract by 10-30%. 

Also, expanding through fixed asset investment is not a competitive way to grow. Buildings do not make an economy competitive. IBM or Apple's ability to create value and take global market share has nothing to do with the number of buildings the companies can purchase. It would be like a chess player training for a tournament by gaining significant amounts of weight. It just doesn't matter. 

And, the majority of China's ultra high net worth citizens built their wealth in the property sector which indicates the country is under-investing in activities that truly drive economic growth (more of a symptom of corruption and the 45% investment / GDP ratio). Also, growing by building empty buildings is less efficient then basic wealth transfers. China should simply pay citizens cash not to work (or to do activities that do not require billions in cement and copper). By doing that, China could pay the workers more because the country would not need to purchase raw materials. The additional spending power would create an incentive to create products of value. 

China's longer-term challenge remains building brand power and taking share in global markets for products domestically designed and marketed. I do not know the precise figures but China's manufacturing base takes a very tiny slice of every dollar of revenue it helps produce (commoditized service). The key to growing income per person is to provide the majority of a product's value chain that is marketed to a population base much larger than your own (see Switzerland, South Korea, etc.). Sadly, China has been distracted by the perceived grandeur of high economic growth rates, rail systems, mega malls, and tall buildings while the rest of the developed world focused on improving operating efficiencies, cultivating innovation and increasing value creation. Whenever I talk to China bulls they tell me about the amazing structures and transportation systems in China (this was before 2011's transportation issues). I mentally compared this to, for example, IBM's various locations and production facilities. They are not exceptionally impressive yet the company has successfully navigated more technology cycles than any company in history. 

 

Timing

Many people believe China can put off the day of reckoning for several years due to foreign currency reserves and a large sovereign wealth fund. That is not the case. First, when China pays people to build buildings that are not purchased, there is an addition to the money supply and a boost to inflation (more money without an increase in paid for goods/services). China already has a persistent problem with inflation because it imports currency and export goods (trade surplus). Any additional inflation lowers workers' real wages. And lower real wages causes rising nominal wages. Rising nominal wages lowers China's competitiveness as an exporter. China cannot afford to erode its only meaningful source of wealth creation. Therefore, although China's economy is slowing, the government cannot re-inflate the system without massive levels of inflation. 

The government is holding the property curbs in place which I believe is evidence they realize the game is up. Many economists in China believe the government should pull back the curbs because so much of the economy is based on property development (i.e. China's economy depends on the bubble). The government is wisely concluding it is better to make the painful adjustments now as opposed to 2-3 years down the road when ~60-65% of the economy will be fixed asset investment.  

Other Sources

J.P. Morgan's Mowat: Chinese economy already in a hard landing - http://www.bloomberg.com/news/2012-03-14/chinese-economy-already-in-hard-landing-jpmorgan-says.html

Australia's exports down in February - http://au.ibtimes.com/articles/324204/20120405/australian-exports-down-2-february.htm

China HSBC PMI falls - http://www.reuters.com/article/2012/04/01/china-economy-hsbc-pmi-idUSB9E8D700T20120401

Investment Implications 

- Avoid investments exposed to a serious China slowdown.
- Short companies supplying China's unsustainable building boom.
- Short copper as its marginal cost of production is much lower than the current price (copper prices are inflated by China's fixed asset boom and could fall 50%+)
- Short the Chinese market.
 
I welcome any substantive disagreement. 
 
Disclosure: Short FXI among other financial instruments

Catalyst

 Europe's recession, China's significant slowdown, rapidly falling property prices (to ultimately fall 50-75%+), declines in property sales, and local government revenue shortfalls due to fewer property sales. 
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