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Crisis for some, opportunity for others

Crisis for some, opportunity for others 2008-11-01 Staff Writer I'm guessing that a fair number of you are wondering how China is faring amidst the turbulence that is roiling global financial markets. Is the meteoric rise of China's GDP ready for a long fall? Is it time for foreign investors to get out befor

I'm guessing that a fair number of you are wondering how China is faring amidst the turbulence that is roiling global financial markets. Is the meteoric rise of China's GDP ready for a long fall? Is it time for foreign investors to get out before we lose our shirts? Well, if I were a betting man – and I am – I'd say that now is the time to double down on private equity investments in China. Here's why.

First, let's look at the bad news: I have no doubt that a puckering recession is coming which, if not entirely global, will at least weigh heavily on the economies that most effect China – namely the US and the EU. And it's no secret that the meteoric rise of China's economy as of late has had much to do with its burgeoning trade surplus. So it doesn't take a rocket scientist to figure out that when the Western economies contract and reduce their consumption of toys, handbags and underwear – much of which is made in China of course – it's going to have a direct effect on China's economy.

I'm already seeing signs of this. Within the paper industry, for example, tightening credit has restricted the flow of capital that buyers typically use to place large orders. As a result, some of China's larger paper manufacturers have seen a decline in orders, which they have passed down the line to pulp producers and the suppliers of raw materials. I suspect that similar squeezes are being felt in other industries as well.

However, there are several reasons why foreign investors shouldn't run for the door just yet. Let's first put the importance of China's trade surplus to its economy into perspective. For those of you who managed to stay awake during Econ 101, you may remember the simple equation used to calculate a country's GDP:

GDP = consumption + gross investment + government spending + (exports – imports)

Don't worry, I'm not going to launch into a maths lesson here, but I want to make a point about the size of China's trade surplus relative to consumption and GDP. In 2007, China's GDP was $3.38 trillion. Total retail sales of consumer goods – the largest factor in consumption – was $1.22 trillion, or 36 percent of the total GDP. The trade surplus (exports minus imports), though a healthy $0.26 trillion, accounted for just 7.8 percent of GDP. In fact, it was the first time since 2001 that growth in consumption was the largest force behind growth in China's GDP. So while the West was busy borrowing money to buy Chinese goods, the Chinese were building a large, consumptive middle class. As a result, their economy is now less dependent on Western patronage.

But what about Chinese banks? Will we see the need for massive bail-outs or government intervention like we've seen in the US and UK? Well, China has relatively little direct exposure to the subprime canker which is sickening the world's economies. Very few, if any, Chinese banks had any of this now-collapsing asset class on their balance sheets. Further, at the time of writing, China's government is holding $1.68 trillion in foreign exchange reserves, owing much thanks to the profligate budget deficits run by the Bush administration. Of course, this capital can easily be brought to bear if any destabilisation of China's financial sector was to occur.

In fact, with China effectively inoculated against any direct infection from the subprime bug, a cooling of the economy resulting from a reduction in trade surplus may actually be good medicine. The fact that China's GDP has grown at an annualised rate of 10 percent for the last 30 years is shocking enough, but the 11.1 percent and 11.4 percent increases seen in 2006 and 2007 are off the hook. Most economists agree that this is an unsustainable pace that carries risks of spiraling inflation and economic overheating. Amidst the global economic slowdown, a reduction of the trade surplus, and an appreciating RMB, China's rate of expansion is projected to lessen to a more sustainable 9.5 to 10 percent, which will ease the strains on energy, inflation, and the environment.

As an investor, the motivation to ante-up under these circumstances is driven by the fact that the price for Chinese equity – both public and private – is at a three-year low, largely due to the collapse of the Chinese A Share stock markets, which have fallen-more than 60 percent this year.

So, while the US and most Western markets will be happy to eek out a two percent growth rate in the next couple of years, I'm expecting that a few bets, well-placed among the many Chinese markets that will grow at a more “subdued” 9 to 10 percent, will pay off handsomely over the next three to five years.

Robert Abbanat is Managing Director at M1 Capital Group and lives in Shanghai. M1 Capital Group provides growth capital to private Chinese companies by making direct investments and delivering merchant banking services to China's most promising small- and mid-cap enterprises. Rob can be reached at ra@m1capitalgroup.com.