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Seeing Shadows in the Dark? Fear Not for the Consumer

Inclusive of government, corporates and households, China’s debt to GDP ratio rose to 218% at the end of 2013, up from 87% in 2008. In response we have seen growing fears about credit addiction, with the State Council in December 2013 issuing guidelines for more aggressive regulation of the shadow banking sector.

This pessimism has affected valuations. ICBC now trades at 4.8x forward earnings. Most are aware that we have always shared concerns about the valuation of Chinese financials, but what surprises us is the recent impact on consumer businesses. Belle, a leading women’s footwear brand, trades at 8.2x 2014 EV/EBIT despite generating an ROE averaging 20% over the past 5 years. Chow Sang Sang, a large jewelry retailer, can be bought at 8.7x 2014 EV/EBIT despite having generated an ROE of over 16% for the past 5 years. There are many more examples.
This suggests that the market is pricing in an imminent liquidity crisis that will dampen consumer demand. We believe that such a crisis is unlikely, and that consumer spending will rise. Moreover, we remain convinced that the growing power of the Chinese consumer will be a key investment theme for the 21st century. The issues surrounding credit are a result of an economy undergoing well-anticipated transition, the size of savings, the need for liberalization in the capital markets, and changing behavior of the savers themselves, who are seeking out more for their money in much the same way they are becoming more educated about how they feed, clothe and entertain their families.

– China’s Shadow Banking Sector at a Glance
China faces a financing gap of RMB 3-5 trillion annually. As banks reigned in lending to non-SOEs and government entities post-2010, the shadow banking sector stepped in to fill the gap. Trust companies emerged as the largest players, tapping into growing frustration with bank deposit yields, which have been kept artificially low and have cheated savers out of their share of growth. Retail bank deposits range from about 2.8% for three months to 4.75% for five years, compared to Shibor having recently hovered around 7%. Through offering wealth management products, trust companies have grown assets under management at 51% CAGR from 2007 to 2012, with total assets RMB 10 trillion by the end of Q3 2013 — greater than insurance companies and second only to banks according to the PBOC. This contributed to the shadow banking sector providing more than 30% of the RMB 17.3 trillion of credit made available, up from 23% a year earlier.

Trusts have achieved this growth because they can market their products toward an enormous base of savers. China has the highest savings rate in the world across households, corporates and governments — a unique trifecta. The young save more than their parents, Household savings rates are multiples of most any developed country in most age brackets, and total savings, defined as GDP less consumption, is over 1.5x that of the United States.

– Past performance is No Guarantee of Future Returns
Investors are struggling with their search for yield, and will make novice mistakes. Certainly, and unfortunately, marketers of many trust products that have erroneously implied that their products benefit from state-owned bank guarantees, or a very high degree of creditworthiness. Underlying loans or structured credit products are often project-specific and highly concentrated, although many are loans to state-run or government affiliates that likely pose less risk in the long-term than loans to certain private enterprises. That notwithstanding, there is limited control and regulation over underlying asset quality, as evidenced by the collapse of “Credit Equals Gold No. 1” and its bail-out by an unnamed institution, and fears for others like “Bountiful Optimist”. Foreign commentators particularly enjoy highlighting Chinese trust product names. (Editorial note: There seems to be giddy excitement about trust product names, ie “Credit Equals Gold” and “Bountiful Optimism” – but to place this in its appropriate context, if you are reading this you probably have “Cloudy Month Investments” (Lunar Capital), may own shares in “Soaring Information Company” (Tencent) or may be reading this on your less dramatically named “Association” laptop (Lenovo).

– Alibaba’s “Yu E Bao”: The next “Credit Equals Gold”?
After years of growth and well understood risks, trust products are just coming under the spotlight of international investors. Meanwhile, Chinese savers are moving on to new internet finance products. These offerings, most notably marketed by Alibaba and Tencent, offer higher yield to individual savers with no required investment thresholds and convenient liquidity for purchases of goods and services through online payment systems. Rates offered are usually in line with Shibor, and therefore far higher than the artificially low rates offered by banks. While opaqueness surrounding asset quality is also a concern, it appears that internet finance is taking advantage of recent rate spikes and also the ability to pool small deposits and make larger institutional deposits in banks, which command much higher interest rates for amounts above a certain threshold, usually RMB 30 million, versus those offered to individuals.

This has fueled staggering growth. In the past year, Alibaba’s “Yu E Bao” has grown to be the 14th largest money market fund by AUM with RMB 250 billion under management and 49 million registered users – an average deposit per customer of just RMB 5,000. In the few weeks since the Chinese New Year Holiday Alibaba reported another 12 million customers. In late January, Tencent launched a similar product on its Wechat messaging and social media platform, called “Li Cai Tong”, which netted RMB 800 million in deposits within the first day of launch. In aggregate, recent estimates are that as much as 2% of bank deposits may have moved into these products.

– A Flight to Quality? Not yet…
While we see signs of fear on Wall Street, this sentiment has not yet arrived on Beijing’s Jianguo Road. The success of internet finance demonstrates there are limited signs that domestic savers have pulled back from proactively seeking out a fairer return on their substantial savings despite nasty headlines about trust products. Most logically this is due to huge pool of savings relative to their limited exposure in these alternatives.

To be clear, we are not yet ready to formally opine on the creditworthiness of internet finance products, and we anticipate many more trust failures to come, albeit in limited size and scope. We also caution that while to the extent Chinese regulators seek to “shake the tree” to educate domestic savers about investment risk, internet finance may be an easier target than trusts as it is in direct competition with banks for deposits. However, our guess is that China’s savers are not that worried because they simply have the wherewithal to withstand a few bumps in the road in their search for fairer yield. They have demonstrated that in the past, most notably during the equity market collapse of 2007. Moreover, the government has shown that it is not yet ready to rattle investor confidence, and will in fact live up to certain implicit guarantees in order to smooth the evolution toward a better regulated investment market.

– Proxy for Chinese Consumer Power?
While shadow banking has drawn plenty of negative attention, the positive liberalizing effects are not widely reported, nor are people highlighting the potential for Chinese households to do something more with those savings – like spend. Large savings and creative investment products are in many respects a further sign of just how powerful the Chinese household is becoming – whether as an investor or consumer. In our opinion the impact of savvier savers with more investment options and control over how savings are channeled is a very positive development for the consumer, capital markets and economy overall.

While it remains important to critique a system that has allowed the need for shadow banking to grow so large for so long, it is also worth applauding the innovation of certain market participants in their effort to challenge the status quo. Shadow banking has also helped shift domestic sentiment against favorable lending policies toward SOEs, and toward more choice for households, which will, benefit lending toward privately held consumer and service sector businesses over time. This is, in fact, in line with the new administration’s goals, which is why the State Council may have said it best when it recently announced “Shadow banks play a positive role in serving the real economy and enriching investment channels for ordinary citizens.” (State Council Document 107)

– The Fear is (Almost) Priced In
We close by noting that most astute market participants in China have been aware of the issues raised in this discussion for many years, including the misallocation of capital by banks, growth was running up against the law of big numbers, environmental issues, and challenges for capital markets. Nonetheless, recent shifts in sentiment have caused many to discard their entire belief in the future of Chinese growth, as evidenced by the dividend yield on the HSCEI, value of ICBC or pricing of Belle. At these levels, people aren't saying this is an interlude in the China story – rather they are calling into question all of their fundamental assumptions.

Goldman’s CEO Lloyd Blankfein recently reminded us that this is the nature of markets and traders. The natural fear of change, even with risks that were long anticipated, causes sentiment to overshoot. We probably have overshot, and always may overshoot further. Regardless, we believe that China and the Chinese consumer remains the leading story of the 21st century, irrespective of whether we have a few rough patches, just as America was the story of the 20th century despite a few tough years and many very similar challenges.

Lunar | February 20, 2014