China Infrastructure Short

(a farm laborer walks past the Chinese ghost city of Tianducheng)
1/29/2014
1
China Infrastructure Short – Thesis outline

1) The level of infrastructure investment in China is clearly unsustainable

...
China’s Infrastructure Investment is Clearly Unsustainable
• Infrastructure investment now accounts for 49% of China’s GDP...
Evidence of Excess Investment
There is widespread evidence of excess investment in China. A few areas of note are:
- Affor...
Evidence of Excess Investment
• Cement is a key component of virtually all infrastructure and as such, cement usage tends ...
Debt is the Result Excess Investment
• Excess investment invariably leads to excess debt as projects are funded that do no...
China 2014 vs. US 2007

• By almost any metric, China today appears significantly worse off than the US on the eve of the ...
The Chinese Government is Fully Aware of This
• The Chinese government is acutely aware of these issues and is taking step...
The Chinese Government is Fully Aware of This
There are several reasons to doubt that the government’s efforts will be suc...
Risks / Considerations
The main risks to this position are:
1) Extreme rebalancing: It is theoretically possible that Chin...
Upcoming SlideShare
Loading in …5
×

Chinese infrastructure short thesis

441 views

Published on

Published in: Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
441
On SlideShare
0
From Embeds
0
Number of Embeds
8
Actions
Shares
0
Downloads
16
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Chinese infrastructure short thesis

  1. 1. China Infrastructure Short (a farm laborer walks past the Chinese ghost city of Tianducheng) 1/29/2014 1
  2. 2. China Infrastructure Short – Thesis outline 1) The level of infrastructure investment in China is clearly unsustainable 2) The Chinese government (and every serious economist) explicitly recognizes this fact and is undertaking efforts to lower the economy’s dependence on infrastructure 3) If these efforts are successful, infrastructure investment will be lower and our short position will be profitable 4) If these efforts are unsuccessful, China will eventually be unable to support the debt created by unprofitable infrastructure. This will result in lower credit availability and less infrastructure build 5) In ether scenario our short positions will profit 2
  3. 3. China’s Infrastructure Investment is Clearly Unsustainable • Infrastructure investment now accounts for 49% of China’s GDP and has exceeded 40% since 2003 • This level of investment is without historical precedent • Past instances where investment exceeded 40% of GDP for a meaningful period resulted in credit crisis and recessions Historical Context of China’s Investment Level 3
  4. 4. Evidence of Excess Investment There is widespread evidence of excess investment in China. A few areas of note are: - Affordability: As shown below, globally Chinese real estate is now the least affordable by a wide margin - Investment-to-GDP ratios: Not only is China’s total investment well in excess of historical bubbles, but residential housing investment is also reaching a level only seen during previous bubbles - ‘Common Sense’ evidence: Failed projects such as ‘ghost cities’ and empty malls have been widely reported. This excess appears degrees of magnitude worse than even the largest infrastructure bubbles to date 4
  5. 5. Evidence of Excess Investment • Cement is a key component of virtually all infrastructure and as such, cement usage tends to closely track infrastructure investment • Cumulatively since 1900, China has consumed 19mt of cement per person vs. 18mt in the United States. This is despite having a per capita GDP only 12% of the US and an urbanization rate of 52% vs. 83% in the US • China now accounts for 56% of global cement demand • As shown below, China’s per capita cement usage well exceeds historical infrastructure bubbles China’s per capita cement usage is far above prior bubbles despite being a much poorer country 5
  6. 6. Debt is the Result Excess Investment • Excess investment invariably leads to excess debt as projects are funded that do not earn their cost of capital • This is exactly what happened with Japan in the 1990’s, the US and Europe in 2007/2008 and is happening today in China 6
  7. 7. China 2014 vs. US 2007 • By almost any metric, China today appears significantly worse off than the US on the eve of the 2007 financial crisis USA 2007 vs. China 2014 Residential construction % of GDP 6% 12% Total investment % of GDP 23% 49% Prior 5 year debt growth (% of GDP) 25% 55% Home ownership (% of population) 71% 80% 6x 22x Affordability of largest city (multiple of avg wage) GDP Per Capita $ 49,956 $ 6,091 Empty housing developments, empty strip malls Empty cities, office towers and large retail developments Institutions Robust, transparent legal and financial institutions Opaque system with limited history and questionable rule of law Government World's oldest democracy with independent central bank Volatile 60 year history of one-party rule Evidence of over-capacity 7
  8. 8. The Chinese Government is Fully Aware of This • The Chinese government is acutely aware of these issues and is taking steps to change the country’s growth model to become less dependent on infrastructure investment “China's leaders have said they want to remake the economy so it relies less on heavy investment in real estate, infrastructure and capital-intensive industries and exports abroad. They have outlined proposals to boost domestic consumption by giving peasants more rights to land and liberalizing the financial sector so more lending is directed to small businesses. There has been little movement so far on those fronts.” - Wall Street Journal, 1/20/2014 “China’s government recently announced ambitious plans that could make the Chinese economy more market driven, consumer driven, transparent, and prone to profitable investing. Implementation remains a significant challenge, but it is crucial to rectifying the country’s currently unbalanced system” - Deloitte Global Economic Outlook, 1/14/2014 ► If these efforts are successful, then infrastructure investment will fall and our shorts will work 8
  9. 9. The Chinese Government is Fully Aware of This There are several reasons to doubt that the government’s efforts will be successful: • The current growth model has benefited many members of China’s elite and thus efforts to change are likely to encounter resistance from powerful interests • The transition to a consumer-focused growth model could be painful for certain sectors of the economy and thus could be unpopular • The historical record for similar situations gives little reason for optimism With or without government action, unprofitable investment cannot continue forever as there is a limit to amount of bad debt an economy can absorb. Thus infrastructure build will ultimately be forced to stop due to debt constraints “What prevents China from pursuing these reforms is a combination of opposition from powerful entrenched interest groups – state-owned enterprises, local governments, the economic-policy bureaucracy, and family members of political elites and well-connected businessmen – and flawed political institutions. Unless Xi and his colleagues demonstrate their resolve to overcome such opposition and launch comprehensive reforms, their chances of success are not high” -Minxin Pei, 11/7/2013 ► If the party’s efforts are unsuccessful, then infrastructure investment will eventually fall due to a lack of available credit and our shorts will work 9
  10. 10. Risks / Considerations The main risks to this position are: 1) Extreme rebalancing: It is theoretically possible that China is able to grow consumption rapidly enough such that the economy rebalances even if infrastructure grows in absolute terms (albeit much more slowly than consumption). In this case infrastructure investment would only slow, not contract. → However, the stocks we are short appear to be pricing in some growth, so its not clear this would cause a loss. → Given how high the absolute level of infrastructure build is currently, I view scenario this as highly unlikely... 2) Company / industry specific risks: Even if our thesis plays out, it is possible that it the impact of lower infrastructure spending is outweighed by positive company-specific events such as successful development projects, cost rationalizations, etc. → Given the likely magnitude of the downside if our thesis plays out, I believe its unlikely that any company-specific news would be enough to offset the impact of lower infrastructure spending 3) Cost of carry: Between dividends / borrow the cost to carry this position is about 4% per year ► Some combination of 1+2+3 could cause a loss. However as noted above, I believe this is unlikely 10

×