Short Aussie banks to bet on a China crisis?

“And don't big Chinese banks look cheap, too?” Lex asked a couple of weeks ago. “If you are in the China might be about to blow camp, you can hedge them by shorting the overpriced Australian banks that would also be vaporised in a Sino-debt crisis”.

It’s a great line but no one seems to be buying it. Or shorting it, perhaps. According to the latest UBS “What’s short” report, Australian banks fail to figure in either the top five shorted stocks on the ASX or the top increases in shorts.

(Short selling being the most popular way for an investor to bet on pessimism, selling today stocks the investor thinks can be bought more cheaply before the trade is settled a couple of days hence, trousering the margin.)

The most shorted sectors on UBS’s watch list are consumer discretionary, information technology and industrials. More than 3 per cent of the market capitalisation of consumer discretionary stocks are shorted. Banks are in fact the least shorted at about 0.6 per cent of market cap.

The “China might be about to blow camp”, from what regional analysts are saying, has its tents pitched mainly in America. From across the Pacific, the Chinese economy, opaque and complex as it is, appears a black box.

The Australian economy – and hence its banks – looks like it is sitting right on top of that box.

There are two key elements to the “short Aussie banks to bet on a China meltdown” theme. The first is, fundamentally, whether China is about to blow. And the second is if it does, how much collateral damage would Australia and its banks suffer?

And obviously, given I work at ANZ which has the most entrenched strategic connection with Asia, these questions are particularly poignant.

Australia has definitely benefited from the China story both directly – in purchase of commodities – and indirectly through other sectors rising on the terms of trade gains driven by China.

Yet that connection can be exaggerated. According to Fitch Rating’s latest Asia Pacific Banking chart watch, Asia-Pacific (APAC) banks had accumulated about $US1.2 trillion of China-related exposure by the end of 2013.

“Hong Kong accounts for $US798 billion with 34 per cent of system assets in the territory exposed to China, which leaves its banks most vulnerable to a slowdown in China,” Fitch reasoned. “It is followed by Macao (20 per cent), Singapore (12 per cent) and Taiwan (7 per cent).”

Significantly, concentration for larger countries is low with Japan at 0.6 per cent but Australia also low at 1.2 per cent.

Fitch added the rider that in each of these markets, banks'  China-related exposure as a share of system assets has been rising since 2009. “Lending and other activities with Chinese corporates, including trade finance, has developed more steadily at an average growth rate of 39 per cent 2010-2013 compared with 78 per cent for bank claims.”

Unpicking the concerns about the potential impact of a China blow on Asian banking identifies three main strands of anxiety: unsustainable debt levels and dodgy collateral, both in corporate and provincial government borrowers; one sided bets on the appreciation of the Chinese currency with large exposures if the bet goes wrong; and a property bubble.

All these strands are real, hence the endurance of the about to blow theme. Take the latest scandal with the Port of Qingdao where traders had been mortgaging collateral multiple times so what appeared to be lower risk, short term trade finance was actually lending to something else – with little or no collateral.

My boss here at ANZ, Mike Smith, ran through these themes with the Australian Financial Review’s Chanticleer columnist Tony Boyd.

Smith identified two areas of concern with Chinese-exposed balance sheets. One was an exposure to provincial government and infrastructure projects in particular. But he doesn’t believe the central government would allow those to fail.

The other is the counter party risk to the shadow banking system. But that in Smith’s view is more an issue with smaller banks than larger and the numbers are containable even if more companies are allowed to fail than in the past. Some of those failures will certainly be property developers.

The view of ANZ’s economics team is while China’s financial system faces challenges – effective allocation of capital, rapid growth of unregulated elements, less effective monetary policy transmission – it is not about to blow.

As ANZ chief economist Warren Hogan says “there is no ’Lehman moment’ just around the corner”.

“China is, if anything, over-insured. It currently runs a savings rate of almost 50 per cent of GDP and presently has approximately $US4 trillion in foreign exchange reserves.”

Moreover, the government has been prepared to move against hot sectors like property by tightening  lending conditions and adding other curbs such as restrictive loan-to-value ratio targets for borrowers.

The key issue is China will be volatile – and particularly as the financial system opens up. A quick glance at ANZ’s insight 5 report, “Caged Tiger: The Transformation of the Asian Financial System” reveals the size of the seismic shift and seismic shifts come with plenty of temblors.

That said, recent signals from China are that the government might sacrifice some reform momentum to keep growth ticking over towards the targeted rate of 7.5 per cent. The latest data do suggest China’s economy is moving along at above a 7 per cent pace.

Meanwhile, not all hedge funds are short Aussie banks. In an interesting interview with the AFR, the boss of Pacific Alternative Asset Management Company(PAAMCO), one of the world’s biggest hedge fund managers with a $US9 billion fund of around 40 hedge funds, argued shorting Australian assets on the assumption the local economy will come under increasing pressure from slower growth in China was a bad bet.

“Shorting China is one of the most popular trades in the world at the moment and a lot of US hedge funds have been shorting the biggest Australian banks, miners, and the Aussie dollar as a proxy trade,” PAAMCO co-founder and chief executive Jane Buchan said.

Such punters though were “macro-tourists” she said, adding Asian and Australian investors had a much more sophisticated and sanguine view of what is happening in China than most hedge fund managers based in the United States and Europe.

“People in the northern hemisphere are so bearish on China due to a very simplistic view based on what has happened in other developing economies historically,” Buchan told the AFR. “The power of what a command-control government can achieve is being underestimated.”