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Investors pile into the bet against China

June 29, 2011: 10:35 AM ET

Manufacturing jobs are leaving China and returning to the U.S. But many investors are betting that that may actually be the least of China's problems.

Jim Chanos

Jim Chanos, China bear.

FORTUNE -- Jim Chanos is not alone. The well-known short-seller and vocal China bear spoke last month of not finding enough available shares to short some U.S.-listed Chinese companies with questionable accounting practices. Just a week after his interview, a short seller's report on a U.S.-listed Chinese timber company sent its stock tumbling 90%.

Indeed, the rush of traders making bearish bets on Chinese stocks is the latest evidence of growing trend among smart money: if you're not bearish on China, you're missing the next big trade.

"The market and foreign academics have both turned more pessimistic," says Dan Rosen, a partner at the Rhodium Group who follows U.S.-China relations.

Chanos started things off in 2009 when his analysts studied China's building boom, leading him to call it "Dubai times 1,000." Edward Chancellor at GMO in Boston and independent economist Andy Xie also began predicting that year that China would soon stumble.

More recently the chorus has been growing. Billionaire George Soros said this month China might be in a small bubble, Hong Kong's outgoing securities regulator called it "the new dot-com," and soothsayer economist Nouriel Roubini recently repeated his thinking that China's government will be powerless to stop a downturn caused by dubious real estate projects and poor fixed-asset investments after 2013.

Most of the arguments are some derivative of this: China's economy is screaming ahead at 9% GDP growth. The government may not be able to control inflation, and that could hurt growth. Meanwhile, there's a commercial and residential property glut that could hamper state-run banks for years and lead to deflation. Plus, the Chinese government has made other terrible investments across fixed-assets. (See also China's debt bomb)

Roubini's main point is that China's communist leaders have been fast and loose with money. He says when China's net exports declined during the 2008-2009 global recession, government actions boosted fixed-investments' share of GDP (think bridge building and new roads) to 47% from 42%. It was enough to avert a severe recession in China, but Roubini contends that exploding capital spending can't possibly keep going to useful projects. He visited China and saw newly built airports and bullet trains that are empty, ghost towns, and highways leading to nowhere. Commercial real estate projects and luxury residential buildings have been overbuilt, and automobile capacity has outrun demand. In the short run, says Roubini, this all leads to inflation—too much money chasing too few good projects. But eventually overcapacity leads to deflationary pressures, which typically begin in the manufacturing and real-estate sectors.

"The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity," he wrote in an April article for Project Syndicate.

Roubini uses the Asian financial crisis of the late '90s as an example of what happens when countries over-invest and under-consume. To avoid a so-called hard landing after 2013, Roubini thinks China needs to save less, cut fixed investment, reduce net exports' share of GDP, and start boosting domestic consumption.

"The trouble is that the reasons the Chinese save so much and consume so little are structural," he says. "It will take two decades of reforms to change the incentive to over-invest."

Last week George Soros used a recent appearance at an economic conference in Norway to say China has missed its opportunity to stem inflation. The billionaire investor told the conference that China is in "a bit of a bubble," according to Bloomberg. Soros added that the country was beginning to see the first sings of wage-price inflation, an indication to him that China's strategy for growing the economy was running out of steam.

Meanwhile, China's well-documented real-estate problems recently attracted the attention of two major ratings agencies. Standard & Poor's cut its outlook to 'negative' on Chinese developers on June 15 and the rating agency said tighter credit could drive down prices by 10% over the next year. Three months earlier Moody's also downgraded its outlook on China property market to negative.

Most economists still forecast China GDP growth to eclipse 9% in the second quarter, and settle around 9% growth for the full-year. This after rising at a 10% annualized clip for most of the past 30 years.

"I certainly think fear of a hard landing is much more palpable on Wall Street among investors than people who study the economy," says Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics. He's seen this story play out before, in the late '90s when China's consumer price index hit 25% growth. It didn't hamper future growth then.

"It's fair to say China was growing above its potential last year, and we see it play out in high prices," adds Lardy. But with monetary tightening reducing the money supply and "given the political sensitivity to high inflation, I think they're on a good trajectory."

The smart money around Wall Street says to bet against China, turning the sentiment almost mainstream. Now it's up to China's communist party to prove them right or wrong.

Read more from this Fortune.com special report:

Made (again) in the USA: The return of American manufacturing
Lost in a sea of troubling economic data is one bright spot: America is once again competing for -- and winning -- factories and manufacturing operations.

The secret role of energy in bringing U.S. jobs back
How a reliable grid can trump cheap wages

Why we left our factories in China
Fed up with the poor quality of having their products made in China, American businesses like Sleek Audio are moving production back home.

How to train U.S. workers back into manufacturing jobs  
Despite gloomy job prospects, many American manufacturers are on the prowl for top talent, but say that not enough workers are trained for the tasks.

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About This Author
Scott Cendrowski
Scott Cendrowski
Writer, Fortune

Scott Cendrowski is a writer at Fortune based in Beijing, where he covers business in China. He moved there in late 2013 from New York, where he wrote about Wall Street and investing. Before joining the magazine in 2008, he was a Pulliam Fellow at The Arizona Republic and an intern for Bloomberg News. A Detroit native, he has a B.A. in public policy from Michigan State University.

Follow Scott on Twitter @scendrowski

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