China has to shift from an export-led economy to a consumer-driven one. Photographer: Tomohiro Ohsumi/Bloomberg
China has to shift from an export-led economy to a consumer-driven one. Photographer: Tomohiro Ohsumi/Bloomberg

(This is the fourth article in a four-part series.)

China's growing list of problems, including a slowing economy, rising militarism, messy corruption crackdown and increasingly troubled shadow banking sector, could provoke a major financial crisis. In the "never waste a crisis" spirit, a number of investment opportunities present themselves:

-- Short Chinese stocks. The Shanghai Composite Index is down 67 percent from its October 2007 peak. Even though Chinese stocks may seem inexpensive -- the price-to-earnings ratio for the Shanghai index over the last 12 months is 9.8, compared with 17.3 for the far more costly S&P 500 -- there is no obvious floor. If China has a financial crisis, the risk to Chinese equities is considerable. Bank stocks may be especially vulnerable. Investors who lack direct access to mainland Chinese stocks can use Hong Kong-listed equities and exchange-traded funds.

-- Sell commodities. Industrial and agricultural commodity prices took off in 2002, right after China joined the World Trade Organization. As manufacturers in Europe and North America shifted production to China, its thirst for commodities kept growing. Many producers of industrial materials, including base metals, iron ore and coal, also increased capacity as prices leaped.

Along came the global recession, which drove down materials prices in response to weak demand. Prices soon recovered, only to fall again in 2011, possibly in anticipation of slowing growth in China, which is embarking on a difficult transition from an export-led economy to one driven more by domestic spending. A financial crisis in China would no doubt further depress commodity consumption and prices.

-- Sell weak developing-market stocks and bonds. China’s reduced thirst for commodities would depress commodity exporters, especially the poorly managed emerging economies of Argentina, Brazil, Indonesia, South Africa and Turkey.

All five depend on continuing foreign-investment inflows and lack the cushioning effect of current-account surpluses to accommodate hot-money outflows, as happened earlier this year. Consequently, they were forced to raise already-climbing interest rates to attract new money and protect their weak currencies. Their falling stock markets over the last decade also reflect economic and financial weaknesses.

-- Sell commodity currencies. The currencies of weak emerging economies that depend on commodity exports for growth will suffer if China has major financial and economic woes. Developed countries' currencies, such as the Australian and Canadian dollars, are also vulnerable to declining commodity demand, which could result if China has financial troubles.

-- Avoid major country equities. Given the already meager economic growth in the U.S., Europe and Japan, financial difficulties and recession in China, the world’s second-largest economy, would probably spread globally.

-- Buy the U.S. dollar and Treasury bonds. These are the consistent havens in times of global uncertainty.

-- Short the Hong Kong dollar. If China has a major financial crisis, what instrument would be the destructive force -- the equivalent of credit-default swaps on U.S. subprime-backed securities? In the early- to mid-2000s, few expected major problems with subprime mortgages, making them very cheap to insure through credit-default swaps.

Because credit-default swaps are essentially put options (a type of contract that gives the owner the right, but not the obligation, to sell a security at a specific price), their downside risks were linked to the cost of the insurance. But when subprime mortgages collapsed, the value of the swaps rose to 15 to 20 times the cost of the original default insurance.

The Hong Kong dollar may be the parallel. It’s been pegged to the U.S. dollar since 1983. Over the three-decade period, it has fluctuated from 7.70 per greenback to 7.87, a tiny range of 2.2 percent. Few expect that peg to turn to sawdust, so puts on the Hong Kong dollar are, well, sawdust cheap.

This may be highly speculative, but suppose China's financial woes lead to a rush of money out of China and Hong Kong. The Hong Kong Monetary Authority would quickly run out of greenbacks to trade for the Hong Kong dollars that panicked investors would want to sell it. The next step would have to be delinking the Hong Kong dollar with the U.S. dollar. Given the low cost of one-year puts on the Hong Kong currency versus the buck, a 10 percent drop in the Hong Kong dollar would return more than 20 times the cost of the put.

Perhaps all of this is fanciful. China could successfully increase economic growth, transition smoothly to a domestic-driven economy, control its rising militarism, reduce corruption without major disruptions, cease manipulating the yuan, lower the risks in shadow banks without clumsy bailouts, slowly let the air out of the real-estate bubble and deregulate interest rates. Given the history of other countries with similar problems, I wouldn’t bet on it.

To contact the writer of this column: Gary Shilling at insight@agaryshilling.com.

To contact the editor responsible for this column: Paula Dwyer at pdwyer11@bloomberg.net.