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China's First Recession

Time to Short China?

Written by Geoffrey Pike
Posted January 24, 2014

China is an unbelievable example of what freer markets and property rights can do for a society.

It was a poor and primitive place. Compared to the U.S., it still is in many ways. But the last three decades have been phenomenal for the people of China.

While it's still labeled a communist country, the policies are mostly not. In some ways, China is actually a freer country — economically speaking — than the U.S. There is far less red tape.

As policies changed toward more freedom over the last three decades, hundreds of millions of people have been lifted out of extreme poverty. Of course, hundreds of millions more still remain in poverty, but it is a vast improvement.

Yet while the so-called communist leaders of China allow some semblance of property rights and freedom, they are still mercantilists. The economic policies are far better than they were 40 years ago, but they are still bad.

Prior to 1980, China did not have recessions (unless you want to count communist rule as one giant recession). You can’t hit rock bottom when you are already there.

But as the country begins to move up, that is no longer the case. Based on my observations and my knowledge of the Austrian Business Cycle Theory — China is about to see its first major recession.

China Loves Monetary Inflation

While China’s currency seems to be gaining some respect around the world, it is not going to become the world’s reserve currency anytime soon. It's not even a freely floating currency, which alone makes this impossible.

In addition, the Chinese central bank has been creating significant monetary inflation over many years. It does this, supposedly, to keep the yuan from getting too strong against the U.S. dollar.

This is why the people centrally planning China’s economy are a bunch of mercantilists. While it is possible they are enacting these policies purely for personal gain and power, I really believe they are just economically ignorant.

They think it is a good strategy to depreciate the value of their currency so the U.S. dollar doesn’t weaken too much against it. They do this to help their export sector, ensuring Americans can buy inexpensive goods from China.

And while this does help the export sector in China, it also hurts all Chinese consumers by making domestic goods and services more expensive than they would be otherwise. China manufactures a lot of goods, but it sends most of them off to America and other places for consumption. Meanwhile, many people in China still live in poverty.

The policies of China are a major subsidy to American consumers. They also benefit the U.S. government, as China continues to buy U.S. government debt at low interest rates.

China's Real Estate Bubble

But all this monetary inflation by the Chinese central bank in the name of mercantilism has caused a serious side effect: It has created perhaps the biggest real estate bubble in history.

The bubble in China may eventually make the previous U.S. real estate bubble look small in comparison.

Last year, 60 Minutes ran a piece on China’s real estate bubble. It showed empty cities — modern-day ghost towns — where huge buildings sit empty and shopping malls that have been built don't sell anything yet.

Some of these places are selling for prices close to American real estate prices... yet the average Chinese person still only makes a few dollars a day.

Because not as much leverage is used in China, some believe real estate prices won’t fall as much or the bust won’t be as bad. Chinese people will put most of their savings into a house or apartment and will have a much bigger down payment.

However, this doesn’t prevent prices from going down due to an oversupply of housing. It does mean prices will have to fall further before we see massive defaults — but they still could fall that far.

Even if someone puts a down payment of 50% on a place, it doesn’t mean he can’t be underwater one day. Prices could easily fall by more than half.

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When the Austrian Business Cycle Prevails

I am a believer in the Austrian Business Cycle Theory, which states that when there is massive monetary inflation and artificially low interest rates, it causes unsustainable booms.

Eventually, the boom must turn into a bust. Either there will be runaway inflation, which would turn into a bust anyway, or there will be a slowdown in the pace of monetary inflation, which will reveal all of the previous malinvestment.

Regardless, there will be a bust... even if it takes several years.

When the loose monetary policy and artificially low interest rates lead to an unsustainable boom, it is not uniform. Some sectors will do better than others, and the ones where the additional new money is flowing will experience bubble activities.

In the case of China, it seems rather obvious that real estate is the major sector where the new money is flowing. It is a classic bubble.

Barring some economic miracle, this bubble will turn into a bust. At this point, it seems to me it is just a question of timing.

Shorting China

If and when there is a major bust in China, it will obviously have its effects throughout the world.

It is possible it could actually end up weakening the dollar if the Chinese “leaders” finally decide to stop piling up U.S. government debt. It might also mean American consumers would not see as much in the way of inexpensive goods coming out of China.

Interestingly, you can actually speculate in a Chinese bust, but I will warn you it is a risky investment. You can short Chinese stocks, assuming Chinese stocks will likely go down with a real estate crash.

There is an exchange-traded fund (NYSE: FXP) that actually takes an ultra-short position against Chinese stocks. This means the fund is inversely related times two.

It is a short against the FTSE China 25 Index, which has 25 large Chinese stocks that are listed on the Hong Kong Exchange. If the index goes down by 2%, then the fund should go up approximately 4% — assuming the fund managers are doing their job well.

This is risky because of the timing. It can oftentimes be surprising how long governments can drag things out. Maybe the Chinese government can prevent a bust from happening for a few more years before the inevitable hits.

But if you are in the mood for some risk and the potential of a good reward, FXP may be something to look at.

China's Big Bust

The Chinese real estate bubble cannot go on forever. It is possible the Chinese central bank will up the ante and increase its monetary inflation to keep the boom alive, but either way, it won't end up turning out well.

The Chinese have seen a great increase in living standards due to a turn towards freer markets and stronger property rights. Unfortunately, China still has a government that tries to centrally plan the economy...

The nation is going to have its first modern-day bust, and it will likely be a bad one.

Until next time,

Geoffrey Pike for Wealth Daily

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