Chanos calls China syndrome

So what’s the evidence on China? Sitting in front of a whiteboard that takes up a whole wall in Kynikos’s boardroom in midtown Manhattan, Chanos argues that not only are many Chinese companies, including banks, hugely overvalued, but so are Western companies that have been swept up into the bubble—building contractors and resource producers and the like. And there’s more. Chanos and other shorts say that many of the hottest Chinese investment plays may be out-and-out bogus, particularly so-called reverse takeover stocks—companies that do most or all of their business in China, but which have secured listings in North America.

In June, Sino-Forest Corp. (TRE-T4.81—-%), a company listed on the Toronto Stock Exchange that owns and manages timberlands in China, garnered worldwide publicity when its share price plunged by almost 90 per cent after a report by a mysterious young U.S. short-seller, Carson Block, alleged that it is a massive fraud—a charge that company executives strenuously deny. Chanos wasn’t short Sino-Forest, but he says it fits the pattern.

Chanos says he and his analysts first began digging deeply into China’s economic statistics in the summer of 2009, after seeing that commodity producers were relying heavily on Chinese demand. In one favourite anecdote, Chanos says that one of his analysts reported a Chinese government forecast that the country would build 2.8 billion square metres of Class A office space over the following couple of years. “I said, ‘You’re off by a factor of 10.’ And he said, ‘I thought the same thing, and I’m not.’” It helps to convert the number to square feet, says Chanos. “That’s basically a five-foot by five-foot office cubicle for every man, woman and child in China.”

Or there’s this one: Chanos says the value of China’s housing stock relative to GDP is about 325%, comparable only to Japan in 1989 and Ireland in 2007—that is, just before their real estate bubbles burst. Then there are the news stories about empty new high-rises, shopping malls and stadiums. Chanos has plenty of slides of these empty buildings in his presentations.

As in the U.S. and European real estate busts, Chanos says that China’s property bubble is infecting its banking system. The country has already had to cleanse and recapitalize its banks twice—in 1999 and 2003. Basically, it took non-performing loans off the banks’ books and put them into specially created asset management companies, which then issued long-term bonds for them. “And guess who bought the bonds?” says Chanos. “The banks.”

Many China bulls say that Chanos’s numbers and anecdotes don’t add up to disaster. A notable one is Mark Mobius, executive chairman of Templeton Emerging Markets Group, who oversees more than $50 billion in emerging-markets mutual funds. “Of course there are ‘see-through buildings’ that have been recently built and are empty,” says Mobius.

But there are several fundamental differences between China’s real estate boom and the property debacles in the United States and Europe, Mobius argues. First, the surge in commercial and residential demand in China is mostly real, not just a bidding-up of asset prices. “If it’s a bubble, why are so many people still living in substandard housing in China?” he asks. And he doesn’t buy that there’s the same toxic spillover to the financial system, either—China doesn’t have the credit default swaps and other ersatz real estate-linked securities that triggered the market collapses in the West in 2008. “The subprime crisis was a derivatives crisis,” Mobius says.

Yes, Beijing has had to recapitalize its banks twice, but to Mobius that shows strength, not weakness. Chinese leaders dealt with problems, rather than letting them fester. “The government will bail out the banks at a moment’s notice,” he says.

He and Chanos could both be right. History shows that many emerging economies and stock markets have grown exponentially over the past two centuries. But there have been plenty of frauds, bubbles and crashes for the cynics to feed on along the way.

CHINA: THE SHORT STORY

Say you agree with Jim Chanos’s thesis on China, and you want to know how you too can short the country. If, and only if, you feel you could bear the risk (shorting is not for the average investor), the most obvious targets this past spring were so-called Chinese reverse-takeover stocks in North America. Many Chinese companies obtain stock market listings here by buying dormant shell companies, thereby getting around the more onerous regulatory hurdles for new issues.

Short seller Carson Block’s scathing report on Toronto-listed Sino-Forest Corp. in June alleged that there were more “China frauds” among this class of stocks. Is every Chinese stock listed in North America bogus? Just some? Just one? Whether Block’s allegations were justified or not, they triggered a panicked sell-off across the sector. There are 17 Chinese issuers with stocks listed on the Toronto Stock Exchange, 38 on the TSX Venture Exchange and reportedly more than 350 in the United States: Many of them got sideswiped by the Sino-Forest scandal.

But Chanos says that targets among those stocks are limited. “The problem is that they’re extremely difficult to borrow because they have very limited public floats,” he says. Instead, Chanos has identified targets such as Poly (Hong Kong) Investments Ltd., a subsidiary of a large mainland developer. But there aren’t many similar large Chinese companies that foreigners can short directly. He’s also set his sights on big global commodity producers that sell into China, such as Brazilian mining giant Vale Inc. (which owns Inco). But China is only a portion of its business.

Shorting what looks like a sure loser is often harder than buying what looks like a sure winner.

Chinese stocks listed on the Toronto Stock Exchange