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Bear in China’s cabinet

18 June 2012 By Wayne Arnold

It’s no surprise Hu Jintao, China’s president, wants to talk up his economy. He spoke about continuing robust growth over the weekend as he headed for the G20 summit in Mexico. But the latest data showing city house prices down 1.5 percent, along with tumbling industrial production, suggest a slowdown.

Few doubt the world’s second-largest economy will keep growing. The question is how fast. Cautious investors have already punished stocks that rely on China growing rapidly, like Australian copper miner PanAust, which has fallen 19 percent in the past four months, and South Korean construction equipment maker Doosan Infracore, which has lost 23 percent since March 13. But there are still trades that offer protection for investors who don’t buy the party line.

First come put options on the Australian dollar. The currency is a proxy for China’s growing appetite for resources, and puts could pay big if that demand softens. Morgan Stanley estimates the Aussie could drop as much as 15 percent if China’s economic growth slips below 5 percent a year.

A similar logic applies to Taiwan dollar puts. This time the currency serves as a proxy for expanding investment and tourism in China, which would probably suffer if growth slows sharply.

Hedge number three is Korean credit default swaps. China is Korea’s largest export market, so the cost of insuring government bonds against default would rise if exports slowed, pressuring Korea’s current account balance and government finances.

A defensive long investment possibility would be construction stocks. Slamming the brakes on infrastructure investment helped trigger China’s slowdown. Now Beijing is stepping gently on the gas. That should help builders like Hong Kong-listed China State Construction International, which is trading below 12 times projected earnings for this year.

Finally, there are always bank bonds. China’s property slump should squeeze banks’ profits, but Beijing is highly unlikely to let them default on domestic or international debt. Industrial and Commercial Bank of China’s dollar-denominated senior notes with roughly 10-year maturity are yielding 4.35 percent. The Bank of China’s 10-year Hong Kong-dollar bonds are yielding 3.73 percent. Those yields may not look especially tempting now. But if China stumbles, bank paper could prove as good as gold.


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