How to hedge the China “super bear”

A new Morgan Stanley report looks today at how to hedge a China “super bear” scenario for investors:

The new government’s policy drive to deleverage the banking sector has become more apparent. In the three months preceding the spike in money market rates the CBRC/SAFE have announced measures to regulate interbank entrust payments, wealth- management products, leverage in bond investments, FX lending and interbank loan structures all with the aim of curtailing the widespread use of new financial channels to grow bank assets rapidly. We think this deleveraging will likely continue to unfold in the next 6-12 months.

• FX and credit hedges tend to be more cost-effective than equity hedges, although most hedges are still marginally more expensive than at the start of the year, due to the post-May sell-off as well as higher vol levels. Most markets are now down YTD, although with considerable dispersion.
• CNY (FX) puts have the highest reward/risk ratio, although we have some reservations about the actual effectiveness of the puts due to potential FX intervention and restrictions on capital flows. China sovereign CDS also looks attractive, although the possibility of an actual credit event looks extremely remote.
• The most attractive equity hedge are puts on the TWSE.

Not altogether useful for Australian retail investors but you get the idea. To my mind, MS significantly underestimates the returns available on a falling dollar. They are suggesting that it would bottom in the 70+ cents region in the “super bear” scenario, well above it’s GFC low of 60 cents.

I don’t agree. China growing at 4.5% for a year, as it unwound fixed asset investment in particular, would send iron ore and coal prices to unimagined lows, delivering an historic terms of trade shock and recession. Interest rates would fall to 1% as Australian bank cost of funds rose sharply. The budget would plunge into very deep deficit but no repeat of the GFC stimulus would be possible lest it challenge the AAA rating supporting the banks. We could expect some stimulus and ongoing deficits, as well as support from the LNG investment pipeline but mining capex would still plunge at 2% of GDP per annum.

Compounding the problem would be that the emerging China would be consumer driven so although bulk commodity prices would rebound as production was slashed, the terms of trade would remain much lower than currently thought likely, presenting Australia with an enduring income shock and constant risk of double-dip recession as the country devalued to slowly regain competitiveness in non-mining tradables.

We’d be OK in the long run as commodity volumes slowly rebuilt growth.

But the biggest shock-absorber would be the dollar and I find very hard to believe it would not be plumbing GFC lows. So, if you feel the need to hedge this scenario, simple dollar plays are worth looking at.