Our attention this month is focused on the second wave of the financial crisis and its potential impact on China.
Risk of Contagion
China weathered the first wave of the financial crisis well. We believe this was due to the “bottoms up” nature of the crisis — a break down in the availability of credit and skyrocketing counterparty risk. As the Chinese system was far less intertwined with global counterparties than other major economies, maintaining liquidity and consumer sentiment was manageable. The current turmoil is top-down in nature as concerns have shifted from specific financial counterparties to the solvency of nations. Initial sentiment suggests that China is somewhat isolated from these risks. However, opacity in respect of Chinese debt levels and the quality of bank loans suggests that the risk of contagion is markedly higher than many believe. We remain particularly concerned about the most obvious risk – the misallocation of bank lending, and the preponderance of property-related leverage in the system.
China's Liquidity Position
Liquidity is undeniably tight. Our interactions with local lending operations lead us to believe that “providers of last resort” (effectively loan sharks) are raising interest rates dramatically, from the customary 3-4% per month to 6% and up to 10%. Local RMB funds that specialize in lending against local assets, primarily in real estate, report that their customers are struggling, particularly those focused on real estate development in first tier markets. Anecdotally, one such lender reported that in past years, their developer counterparties would see 10-15 pre-completion sales per month for a typical project, but are now lucky to see any. Although liquidity is very tight, asset prices have not dropped dramatically, and inflationary pressures persist. We
believe that this equation is not sustainable and anticipate seeing property developers in the market seeking financing on increasingly desperate terms.
Continued Inflation Risks
Inflation remains an enormous challenge for China, despite a marked liquidity tightening. We have seen isolated signs in our portfolio and pipeline that inflationary pressures are easing, but nothing that gives us conviction that we have reached the peak of price pressures. Inflation, and food prices in particular, will need to abate for China to move to ease liquidity.
Portfolio Positioning
We have been fortunate that our portfolio(s), and particularly our investments in forestry, fluorite mining, and juice, have generally proved resilient in the current environment. However, our investment in cement has been challenged by tight liquidity and inflationary pressures. The effect is harder to ascertain in our beverage packaging business, as well as in some of the retail-oriented investments we have in the pipeline.
Our conclusion remains that we should remain value seekers, prepared to solve operational challenges, and agents of positive change in our portfolio companies to address those risks beyond our control.
