China Bears Have Tools, Need Patience

JULY 4, 2011   the wall street journal

How can investors prepare themselves for a major Chinese slowdown?

Doubts are mounting about the health of China's property market, Beijing's ability to control inflation and the true extent of government debt. Last week, the central government disclosed that local governments owed debts equal to a quarter of gross domestic product. It's hard to imagine a large chunk of those borrowings won't turn sour.

View Full Image

Agence-France Presse

Lunch at a Chinese construction site.

All that means bets against China are attracting new attention.

Popular places to profit from a negative bet on China have gotten crowded. In recent months, some hedge funds have earned big money after borrowing shares of U.S.-listed Chinese companies, many with auditing or governance problems, in order to profit from their subsequent fall.

Several say the easy money has been made. More to the point, these stock bets aren't really a play on China's broader economic health but rather on specific company woes.

Some investors are shorting exchange-traded funds that invest in China's heavily restricted yuan-denominated "A-share" markets in Shanghai and Shenzhen—that is, selling borrowed securities to profit from their fall. But the underlying A shares are battered, with the main index off nearly 20% its post-financial crisis highs of August 2009. Hong Kong-listed Chinese shares are more accessible for shorts, some of whom have taken negative positions on the Hang Seng Index or individual stocks, but the market there for Chinese shares is also pretty beaten down.

Short Plays

Examples of how an investor can bet on a major China slowdown through currencies. If the option expires without hitting the strike price, the total investment is lost. However, investors can also sell the options before they expire. When the currency moves in the direction of the bet, the option generally rises in value.

"One-touch" options pay off a specified amount once the currency pair reaches a certain level. "European-style" options allow the investor to exchange currencies at a specified rate on a predetermined future date.

Australian Dollar One Touch 
Investor buys a one-touch option that pays US$1,000,000 if the Australian dollar falls to 70 U.S. cents any time within two years from its current level of around $1.07. The option now costs about US$120,000. If the strike price is hit, the investor makes a return of about 730%.

Australian Dollar European-Style Option 
Investor buys a European-style option to sell the Australian dollar at 70 U.S. cents when the option expires in two years. An option that allows the investor to sell US$10 million of Australian dollars at 70 U.S. cents now costs about US$160,000. The more the Aussie dollar falls below 70 cents by the expiry date, the greater the return.

Canadian Dollar European-Style Option 
Investor buys a European-style option to buy the U.S. dollar at 1.30 Canadian dollars in two years, compared to its current level of 86 Canadian cents. It now costs about US$80,000 to buy an option for US$10 million of Canadian dollars at C$1.30 cents. The more the U.S. dollar rises above C$1.30 by the expiry date, the greater the return.

Yuan Non-Deliverable European-Style Option
Investor buys a "European-style" option to buy the U.S. dollar at 8 yuan in two years, compared to its current level of 6.46 yuan. An option that allows the investor to buy US$10 million of yuan at 8 yuan now costs about US$50,000. The more the U.S. dollar rises above 8 yuan by the expiry date, the greater the return. With non-deliverable yuan trades, no yuan actually changes hands.

Source: WSJ Research

However, there are other ways to profit from a China implosion. While stocks have sagged, currencies and commodities subject to the country's huge influence over global demand are still hovering at levels that suggest nothing is wrong.

The Australian dollar has soared 75% against the U.S. dollar from lows set during the global financial crisis, in large part because of Chinese demand for the country's iron ore, coal, gas and other resources. It remains surprisingly close to its all-time highs, even as commodity prices have fallen back.

The Canadian dollar could be another, less obvious way to play a Chinese slowdown, particularly for those feeling gloomy about the U.S. and Europe and therefore expect weak demand for Chinese exports.

Like Australia, Canada would suffer from a drop in Chinese consumption of its oil, gas and minerals. If China sees both exports and imports fall off, it will have less money to buy Canadian government debt, too. That could depress the Canadian dollar, which still trades about 27% above its financial-crisis lows against the U.S. dollar.

A bet against the Canadian dollar is a bit cheaper than one against its Australian counterpart, in part because Canadian interest rates aren't as high, a main cost factor in pricing currency bets such as swaps and options.

Then there's copper. China is the No. 1 consumer of the red metal, which is used for pipes and wires in buildings. That makes it a proxy play on Chinese real-estate. On Friday, three-month copper prices fell as low as $9,345 a metric ton in London, down from $9,429 a ton Thursday, after the release of a soft Chinese purchasing managers index.

But prices remain more than double their levels from late 2008. And the last time China's Purchasing Managers Index was at current sluggish levels of around 50, copper was closer to $7,000 a ton, notes Patrick Perret-Green, a Singapore-based strategist for Citigroup.

Bets that rely on a China slowdown rippling through the corporate world are another avenue. Hugh Hendry, who runs Eclectica Asset Management in London, has taken an unusual short-China position by buying up credit-default swaps on Japanese companies he believes would suffer from a slowdown in exports to China, now Japan's biggest trading partner.

Perhaps the longest shot is betting on a fall in China's currency. That play has recently picked up some fans willing to defy the conventional wisdom that the yuan can only go up against the dollar. Bankers say hedge funds are buying cheap positions that will score huge profits if the yuan suddenly falls. But China's currency isn't freely convertible, and Beijing retains a lot of scope— $3 trillion in currency reserves, or the equivalent of 51% of GDP—to manipulate the exchange rate if it needs to. It's easy to envision a scenario where China's economy suffers while the currency doesn't budge. As one banker put it, these bets are cheap to make for a reason.

China shorts have been on a roll for over a year now. Hedge-fund manager James Chanos took a public beating early last year for challenging China's economic fundamentals, and asserting that it was in the midst of a "credit-driven property bubble." There's a lot more people agreeing with him these days.

They may not all be right. The negative China buzz could turn out to be a passing phase, and the chance to make money as a short has passed.

Indeed, some analysts argue that Chinese stocks are so beaten down that it's time for a rally. Royal Bank of Scotland predicts the MSCI-China index could jump as much as 80% through 2012 as Beijing shifts toward growth policies ahead of a change in China's leadership next year.

China proved naysayers wrong many times in the past. Even if things turn bad, it may take longer to happen than some might think. An investor who's right at the wrong time could lose a lot of money waiting to be vindicated.

Like long-term China bulls, the shorts may need to acquire a knack for patience.

—Alex Frangos contributed to this article.

Write to Peter Stein at peter.stein@wsj.com