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
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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
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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
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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
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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
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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
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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
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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
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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
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