Hedge Fund Managers Betting on China Bubble Bursting

 Econintersect:   The world seems to expect that China will be a springboard out of recession.  However, some hedge fund managers are betting that the recent growth rates cannot be sustained.  There is a growing list of hedge fund managers that are taking short positions with so-called “China distress funds.”From The Telegraph (January 16):

 There have been academics and analysts who have argued about the dangers of China’s economy overheating for some time. But for many, the fact that hedge funds, particularly those with track records on previous crises, are launching specific funds is the sign that the bubble is close to bursting.

One academic said: “Economists have contrarian views all the time. But these hedge funds have their shirts on the line and do their analysis carefully. The flurry of ‘distress China’ funds is a sign to sit up.”

More analysts are becoming bearish too. Last week, Lombard Street Research put out a note warning of China’s “already dangerously home-grown inflation”.

The list of hedge fund managers that have recently taken negative China positions includes  Hugh Hendry (Eclectica Asset Management) and Mark Hart (Corriente Advisors).  The Telegraph has an interview with another hedge fund manager working on shorting China who chose to remain anonymous.

Of course there are others, like Jim Chanos (Kynikos Associates), who have been negative on China for some time.  And there have been those who have contested Chanos.  From a Forbes article almost exactly one year ago:

The famed short-seller Jim Chanos has been making waves lately by saying he thinks China is in a bubble and ready to collapse in 2010. He argues that easy credit has let real estate and stock market prices shoot upward. He also says the Chinese government is cooking the numbers to show 8% growth in gross domestic products, when actually China can’t keep growing when the rest of the world has been hit so hard by the financial crisis.

Forbes contends that Chanos is wrong on his contention that Chinese real estate is bubbling, that he underestimates income in China, that he doesn’t recognize how much consumer growth there is yet to come and he doesn’t recognize that the yuan will weaken.

Of course, the shorts can always look in the rear view mirror for reinforcement.  The losses for the U.S. traded Shanghai ETF, FXI, are 38% from October, 2007, 1.8% from January 4, 2010, 3% from April 5, 2010 and 9.6% from November 8, 2010.

However, shorting the Shanghai market can be tricky for the U.S. retail investor.  A levereged ETF, FXP, which is designed to gain when the Shanghai market loses with a 2/1 leverage ratio on a daily basis has suffered major tracking error losses over much of this time for long time periods.  Even though the market has experienced losses from the reference dates above, FXP has only achieved gains (+6%) for the most recent time period from November 8.  Since January 4 FXP has lost 23% and from April 5 the loss is 15%.

Investors can get hurt investing in leveraged ETFs for more than short trading periods because of accumulating tracking errors.  Investors are much better off shorting the long ETF (FXI) if they intend to hold the position for months.  Of course, that involves using a margin account.

Sources:  The Telegraph, Forbes and Yahoo Finance.