Summary: Investors in China are experiencing a crisis of confidence driven by three concerns – corporate malfeasance, credit conditions and the macroeconomic environment. Good opportunities often emerge when confidence is low, and we remain confident in three long-term trends: the emergence of better-run companies, a growing consumer base and more equitable credit conditions. Lunar believes that finding and leveraging these opportunities will require focus and operational expertise.
China is experiencing a crisis of confidence. This is evident in both the equity and debt markets. The Shanghai and Shenzhen stock exchanges are down -13.1% and -15.6% YTD, respectively. This compares unfavorably with the United States (S&P 500 -2.6% YTD) and is largely in-line with Europe amidst the current debt crisis (Eurostoxx 50 -17.0% YTD). While debt capital markets remain underdeveloped, grey market lending rates have risen dramatically.
We see three concerns impacting confidence.
First, highly publicized cases of malfeasance have led to fear and panic. Outright fraud at companies such as Longtop and Sino-Forest has resulted in other businesses coming under increased scrutiny, such as Chaoda and Yurun. This is increasingly driving fears about entire industries, such as agriculture and food.
Second, credit conditions in China have remained extremely tight, especially for the small and medium-sized private enterprises that are viewed as the engine of Chinese economic outperformance. New loan growth in September dropped to RMB 470bn, far below the consensus estimate of RMB 550bn, driving grey market lending rates to levels in excess of 24% per annum with shorter term bridge loans costing 40-60%.
Third, there is growing concern over the condition of China’s macroeconomic environment; in particular, the potential for a debt crisis, the implication of RMB appreciation, recent inflation figures and falling demand for exports. Weak property markets and overdevelopment in commercial real estate have given rise to fears that state-owned banks are beset with non-performing loans. Exports slowed from 24.5% yoy in August to 17.1% yoy in September, and imports weakened from 30.2% yoy to 20.9% yoy. These concerns are exacerbated by the perception of unreliable data, opacity in operations, and a lack of clear operating metrics.
Given that the best opportunities generally emerge when confidence is low, we are mindful of certain long term trends that we believe will remain robust. Over the coming decade, we are confident of the following:
• First, Chinese private enterprises will become better governed, larger and more professional in the wake of recent frauds. Increased scrutiny by all parties in the investment process – lawyers, auditors, investment banks and investors – will accelerate this process.
• Second, credit conditions for small- and medium-sized private enterprises will improve. It is well understood that capital in China is currently misallocated, with bank lending available only to state-owned enterprises and usurious grey market lending the only solution for many SMEs. As the system rebalances, the market will evolve in a more balanced manner.
• Third, the number and spending power of China’s consumers will increase, driven by the newly urbanized from central and western China. In 2000, retail sales in China totaled RMB 3.4tn. In 2000 China’s consumer class generated RMB 3.4 trillion in retail sales. That number rose to RMB 15.4 trillion in 2010, with approximately 400 million people falling into the “consumer” class. We expect the number of consumers to top 800 million by 2020.
Spotting value in this environment is becoming easier, but stiffening our spine in the face of obvious risk is tougher. We believe that leveraging our differentiated focus and operational abilities is the best way to act upon attractive opportunities to deploy capital. Focused, operationally involved investors are the best positioned to spot value in the current environment and will have the transparency and expertise necessary to address fraud, governance and credit concerns in portfolio companies.
