Inflation is probably the largest, and most rational, challenge facing the Chinese economy today.

We anticipated inflationary pressures while constructing the portfolio for our previous fund, LCP-2, and LCP-3’s initial investments in Pineapple and Jaw reflect, and are arguably benefitting, from this environment.

As we embark on building the remainder of LCP-3’s portfolio, our stance is that inflationary pressures are manageable but real, and that the opportunity to find attractive businesses at reasonable prices should rise considerably from current levels.

Inflationary Risks

Inflation remains a challenge and concern for the Chinese economy. Price pressures are being driven by rising food, labor, and land costs. Of note:

• Hog prices rose 6.5% MoM in February to RMB 15.04/kg;
• Wages in Wenzhou, a business hub in Zhejiang province, rose 17% YoY in February; and
• Leases on farmland in Shandong province have increased 56% over the past 5 years

The government has responded with efforts to curb lending and control liquidity. Over the past month, the People’s Bank of China (PBOC) has raised interest rates by 25 bps for the third time since October and has increased the Required Reserve Ratio (RRR) by 50 bps to 19.5%. We expect further tightening in the coming months.

Publicly, policymakers have appeared on both sides of the fence. Premier Wen Jiabao has repeatedly stressed inflation as a concern in recent addresses and has indicated that reform of the yuan’s exchange-rate regime may be on the cards to strengthen the currency and curb price pressures, but noted that any RMB appreciation will be gradual. Other policymakers appear noticeably more upbeat. At this past month’s National People’s Congress, Zhang Ping, head of China’s National Development and Reform Commission (NDRC), said the government would have little difficulty maintaining inflation at 4% YoY.

While we do not welcome inflation, rising labor and land costs on China’s seaboard are driving manufacturers to China's less developed, and less expensive, inland areas. A collection of leading indicators, including fixed asset investment, industry value-added, and export growth, show that industrial activity in China’s central and western regions is outpacing that on the eastern seaboard.

Tightening measures have also intensified the shortage of bank loans available to small private enterprises in China. While small-and-medium sized enterprises account for 98% of total enterprises in China and 65% of total GDP, they received just 39% of bank financing in 2009. Private equity funding has historically filled this liquidity gap.

Further, a comparison of the BRIC economies suggests that inflationary fears are perhaps being exaggerated.

Investment

While many of Lunar’s investments have benefitted from inflationary pressures (notably, Jaw and Pineapple), inflation remains a long term concern for China and a limited number of investments in our pipeline.

In response, we have redoubled efforts at existing portfolio companies to protect against inflationary pressures, although this is currently of limited concern in the case of LCP-3. More importantly, we have focused our due diligence efforts on understanding how target new investee companies will perform as interest rates rise, liquidity contracts and businesses adjust to an economic environment likely characterized by a strengthened RMB, rising input costs and higher funding rates.

As these pressures are digested in the coming 6-18 months, we believe the opportunity to find attractive businesses at reasonable prices will rise considerably from current levels.

We have been following the development of China’s 12th five year plan (2011-2015) with interest, as central government policy is a key driver of China’s economic development and the ability to align investment goals with high-level state objectives has generally been a positive tool for strategic planning. The plan will be announced in March and is expected to outline the following key objectives:

• Increased focus on domestic consumption
• Policies to encourage income redistribution and social welfare
• Industry efficiency and resource conservation
• Focus on increasingly value-added industries through R&D and technology
• Urbanization, inland migration and rural reforms

We believe that a number of these themes will be well aligned with our current investment strategy. In particular, we anticipate a greater emphasis on the development of lesser-developed Central and Western regions as a key method of narrowing the wealth gap and increasing domestic consumption.

CHINESE PRIVATE EQUITY ENVIRONMENT

In January, Shanghai’s Municipal Government announced its long-awaited Implementation Measures on Pilot Program of Foreign-invested Equity Investment Enterprises in Shanghai, which will create a unified authority to manage emerging operational issues related to RMB funds in Shanghai. In short, the measures will relax restrictions on foreign investment into RMB fund entities within Shanghai, an indication that China’s capital markets are liberalizing.

We expect the near-term effects of these measures to be minimal, despite the development of RMB funds being a clear long-term trend. Overall, we remain cautious on the activities of RMB funds in China. The behavior of these funds has disrupted the market in many respects, especially in relation to the valuation of smaller, more speculative businesses. RMB fund’s approach to valuations, due diligence and timing are not sustainable, and therefore we would neither expect nor suggest a rapid inflow of foreign money to these funds.

CHINESE PUBLIC MARKET UPDATE

China’s public markets performed well in Q4, with the SSE up +2.5%, the SZSE up +4.6%, and the ChiNext up +18.5%. Average P/E multiples across the three exchanges also rose during the quarter, from 20x to 22x on the SSE, 32x to 37x on the SZSE, and 64x to 77x on the ChiNext.

Performance was driven by:
– Real GDP Growth – rose from +9.6% yoy in Q3 to +9.8% yoy in Q4, with GDP growth for FY 2010 reaching 10.3%;
– Increased Economic Activity – industrial output growth grew steadily in Q4, up +13.1% yoy in October, +13.3% yoy in November, and +13.5% yoy in December;
– Retail Sales Growth – accelerated from +18.7% yoy in Nov to 19.1% yoy in Dec;
– Urban FAI Growth – up +24.5% in 2010 yoy.

We consider inflationary expectations the most serious threat to near-term economic growth. China’s central bank took steps to limit liquidity during Q4, hiking both its benchmark interest rate and banks’ reserve requirement ratio (RRR) by 50bps. Future hikes are considered likely if inflationary pressures persist.