Reality meets Jim Chanos’s China bearish call

May 16, 2013, 8:01 a.m. EDT

Reality meets Jim Chanos’s China call

By Kirk Spano

Jim Chanos has been famously bearish on China for several years now. While Chinese stocks have underperformed during that time, their markets have not outright collapsed. Recently, Chanos pointed out that credit and capital issues in China have gotten worse. In short, credit has expanded into a slowing economy, setting up the potential for many creditors not to be repaid. But is Chanos wrong?

Chanos, in a recent presentation, noted a multitude of problems in China including, economic inefficiencies, real-estate and credit bubbles, questionable “audited” numbers, inflation, ghost cities, money laundering and broad corruption by the ruling elite, among other issues. All of these factors, Chanos says are leading to a greater dilemma, soon to come, in China.Funny math

A month ago, China reported lower-than-expected March inflation. Many pundits expounded that this gave China significant financial flexibility. At myAmerican Resource Boom Letter, I pointed out that was not likely as China’s inflation numbers were inherently unreliable and unsustainable.

Among the reasons I felt China inflation was a non-starter for economic stimulation by the Chinese, is that the number was simply a reversion to the mean; February inflation had come in higher at 3.2%. Food inflation, which is more heavily weighted in China’s inflation measures than America’s, also moderated to 2.7% from February’s unusual 6%. Sure enough, a few days ago, China’s April inflation came in at 2.4% and looks like it will trend higher on accelerating food prices.

China also announced that it ran a trade deficit in March on higher-than-expected imports and lower-than-expected exports — which still appear to beinflated. The harrumphs say that the higher imports show that the great middle-class-spending boom is on in China. People who know how to read trade data question that analysis — including me.

One key problem with the data appears to be that some Chinese companies are inflating their export numbers, particularly to financial center Hong Kong, and receiving investment money from foreigners who cannot normally invest directly into Chinese projects. This means that Chinese exports are lower than reported, which implies slower international growth.

Winners and losers

If you have watched China closely, you have noticed that they stockpile natural resources when prices are cheap and reduce purchases when prices drift upward — this can impact their producer-price index, which was lower last month, and, in turn, their consumer-price index. Expect China to continue to coupon shop for iron ore, coal, copper, fertilizer, etc. The impact on many corporations can be significant.

As it turns out, so far this year, resource imports from the U.S., Canada and Australia were a large portion of the import surge that China experienced.

One import that rose was fertilizer from Canpotex, which is owned by Canadian fertilizer companies Potash Corp (NYSE:POT) , Mosaic (NYSE:MOS) and Agrium (NYSE:AGU) . Canpotex signed a six-month potash supply contract with China in late December. The deal comes at a time when the potash inventory had accumulated to 29% above its five-year average, and prices were historically low. China found themselves a deal.

Expect the Chinese to back off on fertilizer again when inventory accumulates again. Potash Corp. late last year summed things up when they pointed out that down periods due to lower Chinese and Indian purchasing were generally followed by up periods in Chinese and Indian purchasing.

The cycle of strategic resource buying by China has also been felt by industrial mining companies. Take a look at the investor report from Cliff’s Natural Resources (NYSE:CLF) , they have an overwhelming reliance on China. This has led directly to a collapse in Cliff’s share price, which I don’t expect to rebound soon. If China’s construction boom really slows down a lot, many mining stocks could suffer even more.

The deeper impact

When Chanos’ major China correction occurs, it will be too big a piece of the global economy not to effect others. Importantly, the Chinese government will not care about any lost investment money from foreigners or those who poured hot money in lately.

Ultimately, China will do what is in China’s best interest — or at least in the best interest of ranking government officials. Other than a few issues reserved for domestic Chinese, growth of security asset prices is not a significant consideration to them. Neither is the effect of their economy on foreign companies or foreign investors. While China needs to keep growth high enough to thwart public unrest, they also need to maintain affordable cost of living for their citizens, a delicate balancing act to be very aware of.

Disclosure: Clients of Bluemound Asset Management and Kirk Spano own common shares of Potash Corp. Opinions subject to change at any time without notice.