China Needs a Hard Landing to Cleanse System: Fund Manager

After the U.S. and Europe, China's economy is going to be next in line for a major credit crisis and Chinese policymakers must allow a hard landing to "cleanse" the economy, Bill Smead, CEO and Chief Investment Officer at Smead Capital Management told CNBC on Wednesday.

"This cleansing is rotating its way around the world, and we're just getting the beginnings of the problems in China. Their equity index is down dramatically. But there's no real way yet to identify what the mark-to-market loans are doing in China. And once the light starts being shed there, that's when they're going to have very difficult things to deal with," Smead said.

Smead said the cleansing, though politically difficult, was necessary if China wants to become an even bigger economic superpower.

"The irony is we think China is going to be a great and successful economy, long-term. So an economy is like an oven. If you bake very spicy foods in your oven and you don't clean your oven, your cakes and pies and pastry start tasting like garlic and onions", Smead said.

Smead compares China's economic circumstances to what happened in the U.S. in the 1800s, when America suffered 18 recessions and three depressions.

"We constantly cleaned the system... A great historical comparison for China would be that the United States built the westward railroad system in the late 1860s and the early 1870s. There was a lot of fanfare and excitement, and then for 15 years no one rode the train and the Europeans invested in those railroad bonds and those railroad equities, and they got completely clobbered," Smead said.

"The United States had a three year, or four year, depression in the second half of the 1870s. But by 1890 we were the largest economy in the world," he added.

Recent Chinese economic data suggest policymakers have been successful in engineering a soft landing. House prices have crept lower and manufacturing has slowed. On the other hand, inflation, which has eased to a 15-month low of 4.1 percent year-on-year in December, is still slightly above the official target of 4 percent.

According to Smead, a hard landing for China would lead to a weaker yuan . He also expects softer commodity prices, which would help both the European and U.S. economies. In December, he told CNBC, the U.S. was a paradise for investors (watch the video here).

"It should be fairly positive for the most crippled European countries like Italy... to have a substantial cut to commodity prices at the time they go through their cleansing will be helpful. For the United States, it should be the shot in the arm, the kind of stimulus that the government would like to do," Smead said.

Smead advises investors to pay close attention to China banks for warnings signs of loans going sour. He sees a strong comparison between the Agricultural Bank of China currently and the state of failed American bank Washington Mutual back in 2008. He points out that Washington Mutual reported strong profits in 2008 even as its mortgage loans soured. On the other hand, Agbank reported record profits of 66.7 billion yuan ($10.4 billion) in the first-half of 2011.