5 Ways To Profit From A China Downturn In 2014

Asia Confidential's picture

Is China's economy headed for a crash in 2014? It's an extreme question that would be laughed at by many. After all, most believe that China is the world's new powerhouse off the back of near 10% annual growth over the past decade. And the vast majority of economists and policymakers are sanguine about the country's economic prospects, pointing to still healthy data and confidence in recently-announced structural reforms to steer China in the right direction.

But as Asia Confidential outlined in a recent postthe bulls' arguments are looking much weaker post two spasms of credit stress.  And there are four crucial things that these arguments seem to ignore: 1) the investment-driven, debt-laden economic model of China simply isn't sustainable 2) extraordinary credit growth is yielding less and less benefit as investment returns deteriorate 3) the recent spikes in inter-bank rates and high-profile debt defaults (China Everbright Bank) and bankruptcies (coal mining group, Liansheng Resources Group) point to severe stresses within the financial system 4) the structural reforms are a long-term positive, but short-term net-negative for the economy.

For the record, we're not predicting a China crash this year. We'll leave sure-fire predictions (which are often wrong) to others. What we are suggesting though is the odds appear to favour a more serious economic downturn in China over the next few years. And that those odds have increased given recent events.

Today we're going to look at the bulls' views in depth and what's wrong with them. We'll also delve into the countries and sectors which seem most vulnerable to a China downturn. While the Chinese stock market has been a dog for years and told a large tale about the country, many of those most reliant - either directly or indirectly - on China investment demand still seem to be priced for better times ahead.

The bull case
First, let's take a look at the bull case for China's economic prospects. In simple terms, it goes something like this:

1) GDP growth accelerated in the third quarter to 7.8%, up from 7.5% in the prior quarter. According to the bulls, this shows that the economy is recovering, or stabilising at worst, thanks to various stimulus measures and government interventions into the inter-bank market.


2) Chinese exports beat forecasts in November, up almost 13%. This indicates that the world's second-largest economy is benefiting from a recovery in developed markets. That's important given China's reliance on exports.


3) Despite all of the concerns about potential bad debts from the massive 2009 stimulus, non-performing loan (NPL) ratios remain low.

China NPLs -2013

4) The new Chinese leadership announced a bold reform agenda late last year, which should help re-balance the economy away from investments towards consumption. Those positive on China suggest this should be a smooth re-balancing and ensure strong economic growth for years to come.

China reforms - Nov13

5) Most, including this author, think Xi Jinping may be the man to make the tough decisions to propel China's long-term growth after the previous regime neglected much-needed reform. Clearly, he's been focused on consolidating his own power; economic reforms should come next.

6) If the economy does suffer a major downturn, China has ample resources to fight such an occurrence, in the form of almost US$3.7 trillion in foreign exchange reserves. This should ensure China doesn't have the so-called hard economic landing which critics predict.


What's wrong with it
The weaknesses in the bull case are the following:

  • Almost everyone agrees the that export-led economic model used by China over the past 30 years is unsustainable going forward.
  • Previous transitions from export-led models in Japan and South Korea have led to sharply lower economic growth.
  • Faith in government to engineer a smooth economic transition is also contrary to much historical experience.

Let's run through these one-by-one.

It's important to understand how China's economy got to be so big in a short space of time. The speed of economic ascent has no parallel in modern times and it's been the result of a classic export-led growth model.

What this means is that China has been able to mass produce goods on an unprecedented scale given the appetite for these goods abroad. This has helped lift industrial investment well beyond the level which would be needed if it focused solely on the domestic market. And it's been aided by a key competitive advantage on the global stage: cheap labor. The end result has been that China has been able to suppress domestic demand and pour resources into investment.

The reason why this export-led model is unsustainable is that China now produces so many goods that the rest of the world cannot possibly absorb them all. China's gotten to big for its own good, in crude terms.

When the 2008 financial crisis hit, Chinese exports plummeted and the limits of the model became apparent. However, China cushioned the blow by implementing massive stimulus measures. In effect, it sunk even more money into investments, such as infrastructure, property and factories. The problem to this day is there hasn't been the end-demand for these investments. In other words, export demand has remained soft and domestic demand for goods hasn't been able to pick up the slack.

And a bigger problem is that the much of the investments via the stimulus were debt-financed, principally to state-owned firms. These firms were deemed less risky by banks.

That's created an issue for small firms which haven't had access to bank financing. Given reduced export and domestic demand, they've had to resort to financing from outside the banks, the so-called shadow banking system. They've had to pay much higher interest rates as a consequence. And it's widely known that the collateral used for non-bank financing is less-than-solid, on average.

As you may be able to see from the above, the export-led model which China has used over the past 30 years is running into a dead-end. What the new leadership is now trying to do is transition the economy towards more domestic consumption, so that it can perhaps make up for the drop-off in export growth.

The history of transitions from export-led models doesn't make for pretty reading. These transitions for Japan in 1973 and South Korea in 1991 led to sharp slowdowns in economic growth, as seen in the chart below.

Investment transitions chart

Lastly, faith in the new leadership to deliver a successful transition appears misplaced. As noted above, we think Xi Jinping is the right leader to steer the country for the next decade. And many of his proposed reforms have merit and should help in re-balancing the economy.

However, the fact is that China has hemmed itself into a corner where there are limited solutions in the near-term. Cut back on credit-driven investment and GDP falls sharply. Keep the party going and risk a larger blow-up in the not-too-distant future. Moreover, the bulls conveniently downplay that implementation of structural reforms would be a net-negative for growth in the short run.

As for the argument that China can always use its foreign exchange (forex) reserves to provide further stimulus to prop up the economy, the people who purport this have little knowledge of basic economics.

If China were to use substantial forex reserves in this way, it would become a large net-seller of U.S. Treasury bonds. To prevent a spike in interest rates, the U.S. central bank would have to significantly step up purchases, funded ultimately by private citizens savings. Less of these savings would dampen U.S. consumption and ultimately, Chinese exports to the US.. In other words, a move by China to substantially cut forex reserves would not only be a disaster for the developed world but for China itself.

Are recent events a tipping point?
If you agree that China's current economic model is unsustainable and that any transition away from it will be difficult, the question then becomes when a more serious downturn may occur. The short answer is that no-one really knows. But recent events are beginning to show severe stresses in the economy. Perhaps a sign of things to come.

First, it's clear that China is trying to keep the investment boom going to aid GDP growth. Though overall credit growth has slowed somewhat, it's still likely to be up 20% in 2013. That's much higher than nominal GDP.

Fitch - China new financing

The continuing credit binge is why property prices in China have remained strong, even though many have seen a bubble in this space for several years.

The problem is that the credit boom is resulting is less bang for the proverbial buck (or yuan in this case). Recent manufacturing surveys have showed a slowdown.


The consumer price index and producer price index have also slowed. The latter indicates excess industrial capacity ie. too many produced goods chasing too little demand.

china producer prices

In addition, there are warning signs of serious stresses in the banking system. Two episodes of spiking inter-bank rates (where banks lend to each other) over the past six months suggest a very fragile credit system. With both, the central bank had to inject money to keep credit flowing, otherwise it would have risked skyrocketing inter-bank rates, resulting in a wave of defaults across the country. There is only so long bad debts from bad investments can be rolled over and covered up though.

Also, there has been widespread corporate credit distress. Coal miner, Liansheng Resources Group, has made recent headlines, ending up in court owing almost US$5 billion. China Everbright Bank has also belatedly admitted to a US$1 billion default on a loan back in June (coinciding with the first spike in inter-bank rates). There are many other rumours of corporates in trouble. This is hardly surprising with debt/income among corporates at 5x and total corporate debt to GDP being 125%.

In sum, you have still abundant credit-driven investment, but slowing economic output, softening inflation, inter-bank system ructions and corporate debt troubles. Hardly signs of a healthy economy.

Best ways to bet against China
If you agree that China's economy is in serious trouble, the next question is which markets, sectors or companies are most vulnerable to such an event? The fall-out from a China downturn would be enormous and widespread, but here is a list of things which appear most susceptible were this to happen (our favourite shorts in order of preference):

1) Australian banks. Mining contributed 50% of Australian GDP growth in 2012 and that's set to slow sharply. A China downturn would send that contribution into negative figures and that's a big deal when mining contributes about 9% to GDP. The Aussie banks are exposed to this slowdown, are among the most expensive banks in the developed world and have huge exposure to a mammoth property bubble which has ironically been driven by Chinese buyers of late.  Commonwealth Bank (ASX: CBA) is the most expensive bank in Australia and probably the most short-able.

2) China property developers. Given the risks to the bursting of the investment bubble, the good times for property developers are unlikely to last. State-owned China Resources Land (HK: 1109) appears one of the most at risk.

3) The Chinese yuan (vs USD). This will surprise many people given the yuan strength in 2013. However, the yuan is overvalued in my view and highly vulnerable to a downturn in the economy. Moreover, there's the added issue of yen depreciation which has to provoke a reaction from other prominent exporters, such as China, at some point.

4) Fortescue Metals. This Australian iron-ore miner is near 52-week highs as the price of iron ore has recovered nicely. But iron ore and steel are highly vulnerable to a China downturn in investment. Fortescue (ASX: FMG) isn't cheap, has high leverage and is therefore probably the best short in the iron ore space.

5) The Aussie dollar. Yes, the Aussie has pulled back a long way already. This could well be a market signal of trouble in China, by the way. But whichever metric you use, the Aussie remains overvalued and would end up much lower should a China downturn eventuate. The Australian central bank talking down the currency is an additional negative factor.

You'll probably notice that the list doesn't include large parts of the Chinese stock market. Keep in mind though that this market (Shanghai Composite) is already down more than 60% from their 2007 peak. This market has signaled trouble in China ever since 2008, but too few have paid attention. Put simply, much is now priced into Chinese stocks. There may be a strong case for the potential inclusion of some of China's second tier banks though as they're the most vulnerable in the financial sector to a downturn.

AC Speed Read

There are many signs that China's economy is in serious trouble.

- The signs include still booming credit growth but lower output growth, softening inflation, spiking inter-bank rates indicating stresses in the financial system, as well as large corporate defaults and bankruptcies.

- These things combined have increased the odds of a more severe China economic downturn this year.

- The best ways to bet on a China crash include shorting the following: Australian banks, China property stocks, the Chinese yuan and iron ore miners such as Fortescue Metals.

This post was originally published at Asia Confidential:

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thewayitis's picture



  Thats ok..........They have the GOLD.  hahahahaha



The Heart's picture

5 ways to profit in a world where your profits will not mean a thing in less than five years.

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thefirstabomb's picture


If China really does crack down on the shadow banking sector that could spark their own downturn.  We'll see what happens.  Definitely want a hedge in place

walküre's picture

8 million acres too poluted to grow food

...and counting. The biggest issue for China will be feeding Chinese people. They can fake about everything else but unless they poison the people quickly, they need real food production.

MFLTucson's picture

3 Trillion in foreign currency reserves and more Gold than any country on the planet versus a 17 Trillion dollar debt and no gold and we are discussing playing China for a fall in 2014?  Lol!

ActionFive's picture

Have to condition news before they intervene in the usdcny

Kina's picture

Everything reverts to mean eventually, average house price as a multiple of mean income.

Aussie house prices may not dive the way they did in the USA because of the dramatically different circumstances as noted above, and is quite valid all those points. And there is much more equity (thus cushion) in Aussie mortgaged homes.

And yes I think all home loans in Australia come with mandatory income protection insurance for the borrower...so for a time unemployed borrower gets income from that insurance that helps keep up loand or at least interest payments.


I think the big thing to hit the Aussie home market will begin with confidnece. People will stop borrowing and stop buying if the think the market is going to be soft, or even dive... which kinda makes it self reinforcing and gets the ball rolling a bit faster....and especially if it coincides with increasing unemployment. Markets can go very soft and fall some way on fear.



dinkum's picture

Quote from a friend down under with a UCLA MBA and successful career in general manager of opera companies and orchestras. 

"The Aussie housing market is safe because we have immigration of 200,000 per year and new housing starts of about half that, at best, which is the same low start rate it has been for 25 years. 
Mortgages are not sub-prime. 


  • Mortgages all have compulsory insurance built-in to protect the lenders. 
  • Nobody can walk away from their mortgage--they are full-recourse loans, unlike the U$A. 
  • Mortgages are not collaterialised and sent offshore.
  • Titles can be traced and found, and and not sold off to unknown investors offshore. 
  • Vast majority of mortgages are being paid off faster than terms required. 
  • Less than 30% of the population has a mortgage...40% have paid their home off in full. 
  • The remaining 30% rent.  
  • Mortgages in arrears for 30 days or more in 2013 is 0.9%.  
  • It has never been more than 1.5% in thirty years. 
  • Over 80% of all home buyers in 2013 were investment property buyers with the majority of them owning a first home that is paid off. 
  • They have capital, collateral, and most know what they are doing.  
  • Completely different than the U$A. 
  • I am sick of hearing American and other o/s hedge funders and know-it-alls insisting that the Aussie housing market is next to fall. 
  • The economy may be in a downturn, coming off the boil, but it is is far better shape than the GFC countries in 2005-2010. 
  • None of our banks required a dollar of govt bailouts, and we do not have a FannieMae or FreddieMac to worry about. 
  • The Defence Housing scheme is the only govt real estate pool and is considered tops in low risk and guaranteed returns.
mobydick's picture
Australia up to its eyeballs in the unspoken, festering secret at the heart of Shadow Banking: "Self-Securitization" ... With Central Banks

By now everyone has heard of securitization: the process whereby banks take risky assets on their books, package, tranche them, and then re-sell them to yield chasing fiduciaries of widows and orphans. The conversion process can be nebulous, usually involving a 20 year-old evil French mastermind working for Goldman, and a billionaire hedge fund manager, who select the worthless securities put into the weakest tranche, just so the abovementioned two parties can short it while misrepresenting their conflicts of interest, and make a boatload of money when the whole securitized structure implodes. The process usually takes place "off balance sheet" via Special Purpose Vehicles so it is completely unregulated, and as such allows massive leverage.

According to many, the hidden leverage embedded in the securitization pipeline is what catalyzed the 2008 near-death experience of the financial markets.

All of this is well-known to most.

What however is certainly not known, because until a few days ago the concept did not technicall exist, is what emerged deep from the bowels of the FSB's 2013 "Global Shadow Banking report", and what is barely even defined anywhere in popular literature, which thus we have defined as the "unspoken, festering secret at the heart of shadow banking."

Presenting self-securitization.

What is "self-securitization"? Go ahead and Google it: there doesn't exist any technical definition of this heretofore unheard of phrase.

Rather the term, conceived by the FSB as a means of making the total size of the $71 trillion shadow banking sector somewhat more palatable, is defined as follows:

Self-securitisation (retained securitisation) is defined as those securitisation transactions done solely for the purpose of using the securities created as collateral with the central bank in order to obtain funding, with no intent to sell them to third-party investors. All of the securities issued by the Structured Finance Vehicle (SFV) for all tranches are owned by the originating bank and remain on its balance sheet.

At this point alarm bells should be going off. And if they aren't, here is some more color.

The numbers for OFIs presented in sections 2 to 4 of this report include all financial assets of Structured Finance Vehicles (SFVs), regardless of who holds the securitised products. However, in a number of jurisdictions, some of these products are returned back onto the balance sheet of the bank that originally provided the asset to be securitised. This so called self-securitisation, or retained securitisation, is defined as those securitisation transactions done solely for the purpose of using the securities created as collateral with the central bank in order to obtain funding, with no intent to sell them to third-party investors. All of the securities issued by the SFV for all tranches are owned by the originating bank and remain on the bank’s balance sheet, so that third-party investors do not own any of the securities issued by the SFV. These assets should not be included in the shadow banking figure, as prudential consolidation rules consider them as banks’ own assets and as such subject to consolidated supervision and capital requirements.

 ...  some of the assets that are currently ‘self-securitised’ by banks may at some point be sold to third parties when financial conditions improve.

Wait a minute: a company is "securitizing" assets.... which it then keeps, but only after it has "obtained funding with a central bank"? What?

Judging by the countries whose shadow bank institutions are the most aggressive participants in "self-securitization", it gets clearer just what is going on here:

While Italy and Spain are clear, why is Australia on this list?

While the large increase in Australian banks’ self-securitisation of residential mortgage-backed securities (RMBS) started in 2008 (i.e. before Basel III was developed), the amount of self-securitisation is expected to stay high going forward as these securities are eligible as collateral for the Reserve Bank of Australia’s Committed Liquidity Facility (CLF). Indeed some banks are gearing up already for the CLF. Given the low level of government debt in Australia, the Australian prudential regulator has adopted elements of the Basel rules that allow banks to count a committed liquidity facility provided by the central banks as part of their Basel III liquidity requirements.

So that very strict Basel III requirements are permissive enough to allow... shadow "banks" to engage in self-securitization with their central bank? Just brilliant.

Finally, what amount of circularly (non) securitized, central-bank backstopped securities are we talking here?

Answer: $1,200,000,000,000.

That is the amount of unlevered notional that shadow (and regular) banks engage in circular check-kiting games with central banks for, and in the process obtaing "funding." As one trading desk explained it:

you take your worst assets... package up in an spv (which removes them from your gaap balance sheet) then flip to central bank for cash at modest haircut and boom revenues...

And presto: magic balance sheet clean up and even more magical "revenues."

But wait, there's more (spoiler preview: take the above quote and put in on constant rewind)

Where this mindblowing, circular scheme in which riskless central banks serve as secret sources of incremental bank funding, i.e., free money, gets completely insane, is the realization that these self-securitized assets can also participate in rehypothecation chains. Recall from our exposition yesterday on the permitted leverage resulting from collateral reuse in a repo chain which is fundamentally what shadow banking is all about: unregulated, stratospheric leverage.

We added:

So... three participants result in 4x leverage; four: in roughly 6x, and so on. Of course, these are conservative estimates: in the real, collateral-strapped world, the amount of collateral reuse, and thus the number of participants is orders of magnitude higher. Which means that after just a few turns of rehypothecation, leverage approaches infinity.

Which means that should these same banks that self-securitize with Central Bank X, then proceed to re-use the same security with the same counterparty - i.e., their host central bank, or the Fed of course - then this $1.2 trillion in assets, already carried off-balance sheet with Basel III's blessings, can get 2x, 3x, 5x, 8x, 13x or more turns of leverage on them, as for the shadow bank it is the central bank that is the (up to infinity) levered counterparty. And the central bank, as everyone knows, can always just print money if and when the worthless collateral backing the bank's self securitization ends up worthless.

The implication of this unprecedented shadow banking circle jerk, which could very easily make even the direct wealth transfer resulting from trillions in QE pale by comparison.


There are some hints here by Guy Debelle (RBA - Reserve Bank Aust) The Present and Possible Future of Secured Issuance - Address to Australian Securitisation Forum Sydney - 21 November 2011.

Other interesting things from a five minute trawl of the RBA's web site

Committed Liquidity Facility (used for RMBS repo's),and a list of eligible securities on its HERE.  Much more to look at...


Instead of creating money from thin air, "collateral" is created from thin air and used to secure a loan from a central bank (of money created from thin air).

This nonsense is just a fancy way of justifying leverage to the moon, or in other words, financial Jenga on steroids

Turn your trash into cash. This is all the more reason to audit central banks just to see what type of bubbles they are blowing using garbage securities to self securitize funding.

I guess we now know the dirty secret of the so called Canadian banking miracle

myne's picture

LMI is hardly a strong argument. Guess who underwrites the LMI.

It's no different to the theory of the derivatives time bomb. If one bank ever has to use their LMI, its own insurance division will fold and/or their counterparties (other banks and insurance companies) will collapse. It'll chain react.

Additionally, collapses occur at the margins. Is not that everyone fucks it up, it's that a few lose their jobs, can't pay their mortgage and sell for a reduced price. This takes away the confidence, and a few more lose their jobs.

Its never about price. It's always about cashflow.

nightshiftsucks's picture

Famous last words,if China takes a dump everyone will too.What a joke about the loans,if I don't income/assets then how do I pay a loan ?

Dr Benway's picture

His friend is a complete moron. He's in good company in Australia.

asiafinancenews's picture

For those who prefer to actually research the facts ... rather than simply "believe" ... here is a link to a comprehensive report on the structural underpinings of the Chinese economy:



Handful of Dust's picture

The neighbor down the block works for a title company. She said more then 70% of the closings are cash with Nigerians, Chinese and Middle East poeple. They send their kids over here and then transfer a few million to their bank account 'for school' and the kids then buy a few houses with the cashola. No questions asked.

The disappearing American Middle Class is squeezed out she said.

Interesting stuff and jives with what some authros have written here on ZH.

Freddie's picture

May I ask - what state?   U.S. colleges are such whores.  

asiafinancenews's picture

This Special Report on the Future of the Chinese Economy pretty much confirms the thesis of the article:


thunderchief's picture

And if this does not occur, should I go long all the above?
It's funny how the Aussie CB's only weapon is to "talk down" the Aussie dollar. They still have 2.5 interest rates and aren't QE-ing.
China can sell whatever they like if they are in trouble. At least they still have assets to sell.

sunnyside's picture

Tell me how any numbers/charts really matter if Greece is still kicking?



I'm thinking the game will continue until a non-paper full crisis hits, ie; world war, super-earthquake, full Fukishima meltdown, the Second coming, etc.  It will be papered over everytime until it can not be.

donsluck's picture

Fukushima melted down years ago. Cancer takes years to manifest. We are in a world "terrorism" war. We all know about Indonesias' super-earthquake (as well as Fukushima).

And what the hell is "the Second coming"?

TPTB_r_TBTF's picture

The Second Coming


is when you arrive home from your girlfriend's and

you find your wife is horny.

nightshiftsucks's picture

Also known as the dirty double.

Armchair Bear's picture

webbots predict something bad for china


'tears of red smoke'


It was the currency theft by banks in Cyprus that propelled Bitcoin to 266 FRNS/$. The desperation of crisis conditions has pretty much always been the motivating factor for large scale adoption of anything....thus TPTB like to 'motivate' with their 'fake crises' we all call 'false-flags'. Now, a very real, solid, and lasting crisis has begun. This crisis will take a week or so to burst out of the confines in which it smolders, but it will be very much un-Cyprus like, yet a billion times more motivating. Just to provide a lingusitic handle to this crisis that we will all recognize as it manifests into reality, we can call this one: 'The Tears of Red Smoke'. (12/23/2013)


Temporal markers falling now: "Tears of Red Smoke" - seems to be pointing to a [global stock crisis] that will [originate] in [china] that will be about [counterfeit stocks (and bonds) = FAKES] that are [loose in global stock markets]. Will reach the US markets in late Jan or early Feb and have the words [ > (greater than) HALF] of [ALL US STOCKS] are [FAKE (counterfeit)]. (1/4/2014)

fijisailor's picture

This author must be a shill for fomenting economic war with China.

0b1knob's picture

People have been predicting that "this year" the Chinese economy will collapse since about 2008.