Soon after the global financial crisis began to recede in 2009, an analyst at Kynikos Associates gave a presentation on China to the hedge fund’s management, led by James Chanos. What he said made their jaws drop.
The analyst estimated that at the time there were 5.6bn sq m of high-rise buildings under construction in China, a number so high — the office space alone equalled a small cubicle for every man, woman and child in the country — that Mr Chanos assumed the analyst must have mixed up square feet and metres.
But when the analyst said he had double-checked the numbers, the hedge fund manager was shocked. “We realised, wow, this is a once in a lifetime kind of thing,” he later recalled.
The silver-haired iconoclast rose to fame for being among the first to realise that Enron was a fraudulent house of cards, betting against — or going “short” in Wall Street parlance — the energy company. And in China, Mr Chanos thought he had found Kynikos’s next big short. He started betting against companies that would suffer if China crashed back to earth, and talked loudly about the dangers lurking in its massively indebted economy.
“Bubbles are best identified by credit excesses, not valuations . . . there is no bigger credit excess right now than China,” he told CNBC in December 2009. A horde of fellow hedge fund managers — many of them with high profiles in the media — soon piled in as well, including Eclectica Asset Management’s Hugh Hendry, Hayman Capital’s Kyle Bass, John Burbank at Passport Capital and Crispin Odey of Odey Asset Management.
Fast-forward to 2018, and the bears have mostly been forced to eat cold porridge. Although the Chinese economy has slowed from its double-digit growth rate of a decade ago and there have been bouts of turbulence in 2015 and 2016, the turmoil dissipated each time. The debt implosion and currency collapse that many predicted have failed to materialise. Chinese gross domestic product grew 6.9 per cent in 2017, its fastest pace in two years.
“There was a great deal of momentum built up in the [short China] trade. But they missed the fact that China both had the will and the wallet to deal with these issues,” says Michael Gomez, a Pimco fund manager. “That turned the tide.”
As a result, many sceptics have thrown in the towel. Mr Hendry turned positive on China in 2016, but had to shut his hedge fund last year; Corriente Advisors’ Mark Hart gave up on his own Chinese short in September. Mr Burbank closed his flagship fund in December. Even Mr Chanos says he is now the least short on China he has been since he implemented the trade.
Betting against China was particularly painful last year. Investors that shorted Chinese companies listed in Hong Kong or the mainland suffered losses of more than $35bn in 2017, almost half their stakes, according to New York-based data provider S3 Partners.
Why were the China bears so wrong? Did they fail to understand the way the Chinese economy works or were they just too early? In markets there is often little difference. But for the global economy this is one of the most important questions to answer in 2018.
Even with strong headline growth, some analysts and investors are once again worried that Beijing’s stop-start attempts to tackle its alarming credit boom could cause problems this year.
Indeed, some of the biggest bears remain undeterred by China’s thus-far graceful slowdown in growth. Kynikos’s bets against China largely paid off, Mr Chanos says. And the hedge fund manager — as well as a handful of other prominent investors and economists — remain convinced that China’s economy is still on the road to ruin.
“Nothing has changed,” Mr Chanos says. “They’re just doing what all governments do, kick the can down the road. And in China’s case it’s a giant, borrowed can . . . I don’t know when it will end, I just know it’s unsustainable.”
Xi Jinping, China’s president, announced a “new era” for the country at the Communist party congress in October, where he exhorted colleagues to “work tirelessly to realise the Chinese dream of national rejuvenation”. A large part of that dream has already been fulfilled. Three decades ago, China’s gross domestic product was about $250bn, roughly the equivalent of Finland or Chile’s current economic heft. Today, just the economy of Shenzhen — the mainland city north of Hong Kong — is a third bigger at current prices. The country’s overall GDP has grown to nearly $12tn.
However, China’s post-crisis growth was juiced by a borrowing binge. Its overall debt-to-GDP ratio — including the government, households and local companies — has risen sharply over the past decade to 256 per cent, according to the Bank for International Settlements. The Chinese banking sector’s assets have swelled to 310 per cent of GDP, up from 240 per cent five years ago.
This was the central concern of hedge funds gunning for China, such as Hayman’s Mr Bass. In early 2016 he laid out his case for why “China’s back is completely up against the wall”.
“The unwavering faith that the Chinese will somehow be able to successfully avoid anything more severe than a moderate economic slowdown by continuing to rely on the perpetual expansion of credit reminds us of the belief in 2006 that US home prices would never decline,” he wrote.
Mr Bass argued that China would have to burn through its foreign currency reserves to rescue its financial sector, which was bloated with bad debts. This would force it to devalue its currency, the renminbi. At the time China had already rattled markets by letting the renminbi depreciate against the dollar, and betting on a deeper devaluation became the popular trade for hedge fund managers.
For a period it looked smart. About $1tn of China’s reserves evaporated in 2015-16, and by the end of 2016 the renminbi had slipped by over 12 per cent to an eight-year low versus the dollar. Yet China held the line. The renminbi bounced back in 2017, reserves are again on the increase and the shorts have been remorselessly flushed out.
“The government is very sensitive to having the renminbi shorted and considers it some kind of national disgrace to have foreign funds be able to outflank them,” notes Anne Stevenson-Yang, director of research at J Capital Research. “The Chinese government sees itself as master of the house — the house being the Chinese economy.”
Some China bears — such as Mr Chanos — still made money by eschewing the currency trade and focusing instead on companies that were indirectly exposed to its slowdown and rebalancing, such as Brazil’s Vale, Australia’s BHP Billiton and other commodity groups. But for many investors the big China short became what traders ruefully call a “widow-maker”.
Mark Kingdon, a veteran hedge fund manager who has been investing in China since the early 1980s, says many bears simply misunderstood the country. “With all the noise, it’s sometimes easy to forget that China is a managed economy, that they owe all the debts to themselves, and they have trillions of dollars in reserves,” says the head of Kingdon Capital Management. “I’ve been following China for a long time, so maybe I’m drinking the Kool-Aid. But it is astonishing what they have achieved.”
There are signs the authorities are getting a handle on the credit boom. Morgan Stanley estimates that China’s overall debt-to-GDP ratio rose by only 4 percentage points in the first nine months of 2017, a “significant improvement” compared to the 42 percentage point increase in the ratio from 2015-16. JPMorgan estimates that the debt-to-GDP ratio fell in the second quarter last year, the first outright decline since 2011.
Beijing’s success is underscored by the diverging performance of two exchange traded funds appropriately called Yinn and Yang that are managed by Direxion. Yinn, which is a three-times leveraged “China Bull” ETF, returned nearly 130 per cent in 2017: the Yang “China Bear” ETF lost two-thirds of its value.
However, the factors that unnerved the pessimists remain in place. In its latest outlook on the global economy, the IMF warned that “the size, complexity and pace of growth in China’s financial system point to elevated financial stability risks”.
Even Zhou Xiaochuan, the central bank governor, has warned that China faced a possible “Minsky moment” — referring to US economist Hyman Minsky’s theory that stability breeds a complacency that ultimately disintegrates into panic. Last week Guo Shuqing, the chief banking regulator, also warned that a “black swan” event could threaten China’s financial stability.
In the lead-up to last year’s party congress, Beijing unveiled a “regulatory windstorm” that was aimed at taming the shadow banking system. The possibility that this might escalate into a clampdown that could imperil growth even triggered some unease in Chinese markets last month.
Cracking down on the unrulier corners of finance is overdue, argues Arjun Divecha, head of emerging market equities and chairman at GMO, the Boston-based investment group. He compares the Chinese economy to a forest where the undergrowth — the shadow banking system — has grown too quickly.
“It needs to burn that away without burning down the trees. There’s a risk that happens, but they have the tools to deal with it,” he argues. Mr Bass did not respond to requests for comments on Hayman’s short position, but he appears determined to hold his ground. On December 29, he tweeted a Reuters article about China’s shadow banking sector, calling it a “total financial disaster”.
Mr Chanos says Beijing is unwilling to take action that would risk a sharp slowdown and imperil the Communist party’s grip on power. “The treadmill to hell hasn’t ended, they just keep investing,” Mr Chanos says. “Whenever they tap the brakes the economy wobbles and they reverse course.”
At the moment, investors are basking in the broadest spell of global growth in years, helping spark a global market rally. China’s rebound has played a significant role in this, and most investors expect it to continue.
Mr Gomez says Pimco spends “an extraordinary amount of time” assessing China, visiting every month to assess its health. And while there are still some dangers, he believes the authorities have largely handled the challenges well. “We have not let down our guard. But at the moment our assessment is that the issues are contained,” he says. “They’re driving with one foot on the gas and one foot on the brake.”
Nonetheless, long-term bears argue that there is little reason to relax.
Patrick Chovanec, chief strategist at Silvercrest Asset Management and a former professor at Tsinghua University in Beijing, says “they’ve kept the show going for a lot longer” than he expected at the cost of “unimaginable” debt levels.
He adds: “If you have cancer and the doctor gives you three months to live, and you live much longer than that, you still have cancer. You wouldn’t stop by your doctor and laugh at how wrong he was.”