China is in the midst of the biggest real estate bubble in human history—“Dubai in 2007 times 1,000.” And Sino-Forest, the less-than-meets-the-eye Canadian forestry play in China? That fits a pattern: Promoters “find a different investment hype, a story, to get people excited. In the 1990s, it was the Internet, and now it’s China. Unbridled growth.”
Why should we believe this prophecy of imminent calamity in the market that we were all counting on to buoy us for decades to come? Well, Jim Chanos—who uttered both of those quotes—has a pretty good record in doomsaying. And in profiting from that doomsaying.
Chanos, 53, is the most renowned, or, if you prefer, notorious, short seller on Wall Street. He runs Kynikos Associates, the world’s largest investment fund devoted exclusively to shorting. It manages about $6-billion (all currency in U.S. dollars except where noted).
Chanos’s fattest, juiciest-looking target for the past several years has been China. Yes, China’s GDP is still expanding by about 9 per cent annually, but embarrassing cracks are appearing in the official high-growth façade, particularly the evidence of boom-time overbuilding of condos, offices and infrastructure.
Chanos sees himself as a sort of watchdog. But others see short sellers as the undomesticated type of canine: jackals who wait for the stragglers of capitalism to show the slightest weakness, so they can attack in a pack and run them to death, profiting obscenely in the process.
It’s a debate almost as old as financial markets, and it cranked up to high pitch in early August as stock indexes around the world plunged. Shorts are a convenient scapegoat during a crisis, and France, Italy, Spain and Belgium quickly imposed temporary bans on short selling.
But the financial mainstream, both the big players and the rule makers, no longer enjoys a reputation for omniscience and infallibility. Is it now the smart thing, even the right thing, to run with the wolves?
As Chanos tells it, his career is one of those that had the benefit of an early epiphany. In 1980, the Milwaukee native, freshly armed with a degree from Yale in economics and political science, landed a job as a junior analyst at the Chicago office of the brokerage firm Blyth Eastman Paine Webber.
At the time, the firm was trying to convince McDonald’s, the most important company in the city, to issue bonds at 12 per cent to fuel its expansion. A veteran partner quietly suggested to Chanos that the fast food giant’s earnings per share would actually grow a lot more if it bought back some of its own shares instead of issuing a supersized portion of expensive debt.
Chanos ran the numbers. The veteran was right. McDonald’s would be better off with a buyback, although that would also mean lower fees for Blyth Eastman. Chanos presented his findings to the firm’s banking partner. “Who authorized this analysis?” the partner asked, then told him to shelve it.
“That’s when I knew I was not going to be a banker,” Chanos says. “They’re not interested in truth or what’s best for the client, but in making the sale with the least amount of work.”
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
|% price change June 1 to Sept. 1, 2011
|Asia Bio-Chem Group Corp.
|Boyuan Construction Group Inc
|China Gold International Resources Corp. Ltd.
|GLG Life Tech Corp.
|Hanfeng Evergreen Inc.
|Hanwei Energy Services Corp.
|Harmony Asset Ltd.
|Minco Gold Corp.
|Minco Silver Corp.
|Mundoro Capital Inc.
|Pacrim International Capital Inc.
|Silvercorp Metals Inc.
|Spur Ventures Inc.
|Sunwah International Ltd.
|Zongshen PEM Power Systems Inc.