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TheStreet Open House

Beat Stampede to Short 'China Miracle'

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NEW YORK ( RealMoney) --China bears were once few and far between. But with Time magazine running a story on the bubble in Chinese property this week, the views of hedge fund managers like New York's Jim Chanos and London's Hugh Hendry are slowly creeping into the mainstream media.

China's announcement on Monday that an arm of China's sovereign wealth fund bought shares in four major Chinese state-owned banks to prop up their share prices only reinforces the notion that we are near a tipping point. And the consequences ain't gonna be pretty for China, or the rest of the world.

It's time to short the dragon, before the stampede begins.

Jim Chanos has stated that if anything, he is not bearish enough on China. And that's after famously calling it "1000 times worse than Dubai." He recently noted that the demand for real estate in China has collapsed by 50% to 60% just in September. And that's during strongest month of the year for the sector.

Hendry made himself a viral star on YouTube with a video tour of China's empty skyscrapers. I think the picture of a solid gold, one-ton bull in a 1,076 foot skyscraper constructed in a Chinese village of 2,000 just might become the iconic symbol of a market top.

While Chanos and Hendry make a compelling and visually vivid case for the collapse of the Chinese real estate bubble, I actually think China's economic problems run much deeper.

In college, I showed how state-owned enterprises (SOEs) misallocate resources when they work with soft budget constraints, such as when the government grants them cheap credit, subsidizes their inputs or allocates special favors based on bureaucratic lobbying. As a result, you get a massive misallocation of resources -- SOEs making investments they shouldn't, such as banks lending money on a non-commercial basis, and SOEs generate phantom profits. The economy can look good for decades, as the Soviet Union did. But economic growth rates eventually come to a screeching halt as the economy inevitably implodes under a huge burden of hidden debt and bad investment.

The parallels with China today are all too obvious.

Michael Pettis, a Shanghai-based investment banker and economist makes a similar point in his work, citing a growing body of research that confirms that the Chinese SOE sector today is behaving the same way as SOEs did in the bad old days of the Soviet Union. One study showed that a full 70% of profitability of SOE sector is due to monopoly pricing. Another study found that direct subsidies account for over 100% profitability of SOEs. A third study confirmed that "implicit guarantees" on loans made to SOEs, generally at a level of 90-100 basis points, account for 100% of SOE profitability. Add these and other factors together, and Pettis argues that the entire Chinese SOE sector, about 50% of China's output, actually subtracts many multiples of the economic value it apparently produces.

Throw in the analysis of Viktor Shih of Northwestern University, who tallied up the debts of just local governments in China in 2009 and found that they already equaled 70% of its much-vaunted reserves, and the case for a Chinese collapse becomes even stronger. And after an additional two years of a credit boom, China's debt picture looks much worse today.

When the China bubble bursts, you'll also make money shorting anything related to China. There are already a number of ETFs that allow you to do so. But I think the collapse in real estate and infrastructure will be especially nasty. So look at shorting the Guggenheim China Real Estate ETF (TAO) and the EGS INDXX China Infrastructure ETF (CHXX). These are small ETFs, but you should be able to borrow enough shares before the stampede to short the China miracle begins.

At the time of publication, Vardy had no position in any of the securities mentioned.

Nicholas Vardy is currently editor of Bull Market Alert, a trading service that focuses on making short-term profits in the hottest markets in the world, The Alpha Investor Letter, a monthly service focused on longer-term investments in global markets, and NickVardy.com, his personal blog. He is also chief investment officer of Global Guru Capital, where he manages separate accounts for high net worth individuals.

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