China Headed for Recession in 2-3 Years: Fund Manager

Regardless whether China succeeds in taming inflation, the economy is headed for a recession, says Bill Smead, Chief Investment Officer at Smead Capital Management.

Sam Diephuis | Getty Images Bill Smead, Chief Investment Officer at Smead Capital Management thinks the Chinese economy will contract 3 percent quarter on quarter in the next 2-3 years.

"We think economic contraction in China - actual negative real growth numbers - sometime in the next two or three years," Bill Smead, Chief Investment Officer at Smead Capital Management told CNBC on Thursday.

He expects the Chinese economy to contract 3 percent quarter-on-quarter for two straight quarters in the short to medium term. Click here for full interview.

China, Smead explained, is in a "no-win" situation because to “kill” inflation, authorities would have to tighten credit enough to invert the yield curve.

"If you do that you're going to clobber the economy," Smead said. "If you don't invert the yield curve and you do these gentle quarter point raises you allow the bad behaviors to go on and it just means your bust is going to be bigger when you finally do it."

China raised interest rates by 25 basis points on Wednesday for a third time this year, bringing the benchmark one-year lending rate to 6.56 percent, and its benchmark one-year deposit rate to 3.5 percent. The move comes ahead of key inflation data due next week where the nation’s consumer price index (CPI) in June is widely expected to surge to a 3-year high of 6.3 percent, compared to May's 5.5 percent figure.

While analysts have been warning of the disastrous effects of a hard landing for China, Smead thinks the bust is exactly what China needs.

"For China to be a successful major player, they're going to have to go through the cleansing," he said, referring to the bad loans generated from the billions of dollars lent to local governments to boost growth. This week, Moody's said that China’s local government debt may be understated by $540 billion, and warned that bad debt could reach 8-10 percent of total loans.

These loans, especially those used to fund development projects, are like a ticking bomb, Smear warned. "Most of the time, you don't acknowledge the loans get sour till the projects get finished."

"The problem is when homes in the big cities trade at 12 times the average household income, they're already over-capitalized by a factor of 2 to 1," he added. "So the problem is we're going to wake up some time in the next couple of years and people who bought a house 6 months ago or a year ago are going to be 30 percent under water."

China’s bust will trigger a collapse in commodities as will as currencies that have enjoyed the "incredible boomlet" from the mainland, Smead said.

"We're in the camp that we don't want to own Australian bonds, we don't want to own Canadian bonds."