Chanos' China Correction Overstated

Chanos' hard landing view on China is off. At worst, the current property boom might result in a 30% correction.
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NEW YORK (TheStreet) -- Jim Chanos has been saying since last November that China is experiencing a property bubble.

On Monday night, he went on Charlie Rose with more colorful phrases about why China's property market will crumble by the end of 2010, saying "they're on a treadmill to hell." Chanos went so far as to suggest that the renminbi will actually decrease in value over the next couple of years because of soured real estate loans.

I disagree with Chanos' "hard landing" view on China. At worst, I think the current property boom might result in a 30% correction in which the government is forced to help banks and Urban Development Investment Corporations get bailed out. They have the fiscal strength to easily do that and allow China's economy to continue to grow.

Let's separate Chanos' rhetoric from the facts.

Chanos claim

: China's GDP is 50%-60% based on construction that is not sustainable. Chanos argues that China is addicted to property development like a drug addict to heroin. Because China's national and local governments depend on revenue from this growth, he says they will keep developing. This will, in turn, lead to bad loans for projects that aren't needed. Chanos notes that there is currently a project on the outskirts of Beijing "replete with 32 Broadway theaters." He draws a parallel between this one anecdotal project and excessive property development that occurred in Miami in 2005 and Dubai in 2007.

Rebuttal:

We know that China's GDP was 53% construction-related in 2005. If we accept Chanos' current number, construction activity has not changed as a component of China's overall economy in five years. It's flat -- even after the financial collapse of 2008 and the Chinese government's $600 billion (which some same may in fact be more like $1.2 trillion when you add in local government contributions) stimulus package that brought about what Chanos says is now a bubble. If Chanos' view is correct that rampant property speculation and silly (e.g., "indoor ski resorts") construction has increased because of a "Dubai times 1,000" bubble going on, wouldn't it follow that construction as a percentage of Chinese GDP has increased in the last 18 months compared to the middle part of last decade? It has not.

Is "construction" bad? Chanos believes having so much of the Chinese economy devoted to construction -- at least, by Western standards -- is terrible. But "construction" isn't limited to expensive luxury Shanghai condos that a farmer in Xi'an province can't afford. "Construction" is roads, railways, airports, sewers, high-end housing, low-end housing, commercial real estate, office buildings, distribution centers, manufacturing plants, etc. Is income "bad" that is derived by workers building these projects, or by local governments benefitting from increased tax revenue, or by farmers who sell their land for it to be developed into a large manufacturing plant? Of course not. These "construction" projects are laying the foundation for future growth and development for generations. This is not an economy like Dubai built only on real estate and debt. It is built on manufacturing, farming, exports and -- more recently -- internal consumption.

There are certainly expensive real estate projects in China. This is the second largest economy in the world with 1.5 billion people. It would be alarming if they didn't have expensive projects. Canada has the largest indoor water park in the world. What of it? Let's not bolster an argument with a titillating but inconsequential anecdote. Chanos is implying that the only development going on right now in China is expensive residential condos, at the expense of affordable middle-class housing. That's simply not the case. Even in Shanghai and Beijing, according to the Chinese equivalents of Craigslist, there are affordable two-bedroom apartments available at approximately 25 %-35% of an average couple's income.

Chanos claim

: From the Rose interview, when asked what makes China a bubble, Chanos said, "We define as a bubble ... any kind of debt-fueled asset inflation where the cash flow generated by the asset itself -- a rental property, office building, condo -- does not cover the debt incurred to buy the asset. So you depend on a greater fool, if you will, to come in and buy at a higher price."

Rebuttal:

Property prices have increased in China. In some cities, housing prices doubled from 2003 to 2007 and have doubled again since then. That's rapid acceleration, but there's no evidence to suggest the appreciation was fueled by debt. There's much more Chinese "skin in the game" in terms of cash down payment on primary or investment properties. Surely, there are many average workers now who are watching the price increases and believe they must buy now to avoid paying more for housing later. That is a sign that the market could and probably will correct. But, without the debt fueling the price increases (at least in the residential market), this is neither Miami nor Dubai and -- in my opinion -- suggests a soft landing, not a hard one.

Chanos claim

: With weariness -- and a hint of self-righteousness -- Chanos and other China bears often argue that bubbles have always existed in world history from tulips to Nasdaq 5000. He suggests China has all the telltale signs of a bubble, referring to the arguments laid out above. If he's pressed, there's usually a waving of the hands reference to Japan in the late 1980s or Hong Kong in the 1990s.

Rebuttal:

Yes, bubbles have existed since time immemorial. Yes, human beings have said "this time it's different" many times in defense of a bubble. Yet, we also need to look at the facts of what's going on now in China from a historical development perspective, as well as the government's position of fiscal strength if it was forced to deal with the issue of non-performing loans. Even if there was a massive increase in such loans tomorrow (and they're decreasing, not increasing, at the moment), the Chinese government's debt to GDP (including potentially problematic loans from the UDICs) is 60%. They can sop up a lot of Broadway theaters with that flexibility, and the government has an enormous will to do that if necessary.

I'm not telling you to buy property in Shanghai, but recognize that China is not Miami, Dubai or Japan. Every potentially overvalued company or country -- from Enron to Fairfax Financial to China -- must be analyzed on its own facts before assuming inevitability.

P.S. I emailed Chanos on Tuesday afternoon to comment for this article but he politely declined.

-- Written by Eric Jackson in Naples, Fla.

At the time of publication, Jackson's fund held no positions in the stocks mentioned.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. You can follow Jackson on Twitter at www.twitter.com/ericjackson or @ericjackson