Can China Attract The World’s Capital?

Posted October 3, 2008 

The once-fashionable debate about whether or not the Chinese economy is coupled to the weakening economies of the developed world is dead. It was a useful stepping stone into the puzzling landscape we face today. The acute global financial crisis, the high degree of Chinese interests in issues such as U.S. dollar debt, and the almost unique appeal of Chinese assets in a world of generally unappealing assets have drawn attention to the Chinese investment environment. What can we expect in a post-Olympic China, from markets, regulators and domestic competitors? As we enter the last quarter of 2008, there are many factors in flux that makes this an interesting and important but challenging question. I will try to address it by dividing the discussion into three parts, the external environment, domestic liquidity and market trends, and regulatory trends.

Moving Toward China

In the complex intersection of market fundamentals, regulation, and business structures, many factors are converging to shape the future of investment into China from the outside world. The severity and persistence of the global financial crisis will have several certain impacts. On one hand, broad deleveraging among financial institutions will curtail available capital on a global basis, but on the other hand, there are numerous types of well-funded investors who need urgently to redirect their capital to markets that provide the kinds of returns sought by their limited partners, pension holders or sovereign funders.

There is capital traveling in all directions—large sovereign wealth investors are looking for fair return, low risk investments in mature economies that are increasingly hard to find, while private equity, hedge funds, and venture capitalists hunt for high return investments that their LPs have become accustomed to. The emerging BRIC economies and the Middle East are awash in liquidity, and their large and mostly sovereign funds are seeking stable, long-term debt, suffering somewhat from the Fannie and Freddie shock, as well as results from their 2007 investments in North American and European financial companies.

Financial investors like private-equity funds, public pension funds, diversified insurers, and investment banks are forced by new risk assessments, tight credit, and tightening regulations into emerging economics with which they are generally not familiar and where new models and organizations are essential. But even as emerging markets appear to be becoming more accessible, emerging-market assets are now facing new competition from distress sale assets now appearing in the world’s mature financial centers. These are choices without a clear roadmap, and present powerful challenges to established global investors to develop new, adaptive strategies.

As part of the deep structural changes unfolding on Wall Street and around the world, the relationship between national treasuries and major financial market players is radically changing. The U.S. Treasury’s $700 billion bailout initiative totally eclipses memories of the sharp criticism governments such as the U.S. made even quite recently of China’s repeated intervention to shore up the largest Chinese banks when they were bending under huge bad debt loads. And the revelations that risks even in GSE assets like Fannie Mae and Freddie Mac were much higher than previously perceived will force more clarity in defining such assets and rating their risk, as well as ratchet up pressure to resolve the key trade disputes that have stalled the current trade-negotiation round. It’s ironic that the trend toward reregulation and deployment of public funds around the world is moving visibly toward a China model of state-market interaction.

Investors face the task of sorting out and envisioning the potential impact of more factors and more volatility than the world of investment and trade has experienced since the post World War II trading and investment system took shape. What will determine the future access to assets in China that might win exceptional high returns for cross-border investors? The answer will unfold from the volatile mix of consumer and investor sentiment, China’s transitioning growth patterns, global trade politics and policies, and volatility in every store of wealth, whether currency, gold, oil reserves, manufacturing assets, traded equities or real estate.

New Wealth, New Players

The first three quarters of 2008 were slow for cross-border M&A investors, down substantially from the previous year, by some estimates as much as 70%. In the first half of 2008, foreign investment continued to surge, but M&A was $10 billion, in contrast to inbound for greenfield plants of $72 billion. Also, control acquisitions were very few; most acquisitions were for minority stakes in companies needing growth capital, fueling expectation that growth equity will be the major opportunity moving forward. The impediment here is primarily from emerging domestic competition, which has played the major role in advancing China sustained reform goals of consolidation, commercialization and globalization.

It has been generally accepted that China’s domestic liquidity situation is very strong. In spite of a credit crackdown that has gone on for years, China’s state funded investors, locally controlled SOEs, and an increasing number of private family funds are vying for bargain assets across the spectrum from property development to basic industrial capacity. Insider status and yuan sources of capital are major advantages in grabbing the broad stream of attractive assets flowing along with China’s reform.

What are the drivers of China’s new financial investment activity? First, large current-account surpluses have driven domestic money supply upward, at an accelerating rate throughout the current decade. Mechanisms such as the China Investment Corporation can reverse this process, soaking up yuan and shipping dollars overseas or converting them to equity in large domestic enterprises. Secondly, there remain limited options for investment of available domestic capital. What until recently were attractive options are looking less attractive this year. A-share markets are far below their October 2007 peaks, and property is soft in the major coastal cities, dangerously so in Shenzhen already. Fixed-asset investment is impeded by excess manufacturing capacity, and the “thru train” that was planned to open up Bank of China windows for yuan purchases of H-shares never materialized. Thirdly, Chinese entrepreneurs are losing interest in the depressed IPO markets and are still not well-served by Chinese banks.

The new investors appearing in China have various sources of capital and various targets, but all in all they will both be competitors for foreign investors and, more importantly, potential partners and co-investors. At the top, CIC, through its subsidiary Central Huijin, has not only taken direct control of state shares in major banks but most recently bought shares on the A share and H share markets to support pricing. The NDRC has approved 10 new industrial investment funds to provide local and provincial governments a PE-like entity to fund local growth, and there will be more. These are in the $1 billion to $4 billion range, and the NDRC is preparing a set of regulations to guide them. New local municipal funds, and aggressive industrial investors such as Bao Steel, Shanghai Industrial Investment, Pingan Insurance and Cosco are becoming more active in domestic and international markets. Even family funds are supported by public money to invest in local development.

An optimistic factor for foreign investors, both strategic and financial, is that the results of Chinese funds have been mixed, especially in outbound investments, and especially in financial service companies. Investments made by Pingan, China Development Bank, CIC and Minsheng in 2007 have not been successful, resulting in a regulator-driven slowdown of approvals in 2008 that is reportedly responsible for withdrawal of Citigroup and Dresdner Bank bids. Where there has been an international cooperator, as in the Chinalco purchase of Rio Tinto equity or Industrial and Commercial Bank of China’s investment in Standard Bank of Africa, the results have arguably been better. There is an emerging appreciation that global financial and strategic investors bring experience, networks, and portfolios that exceed the value of the capital they bring.

There are risks to China’s high liquidity situation. Recently some estimates were published of potential hot money outflows as large as $1.7 trillion. These outflows could be triggered by a global perception that yuan appreciation has run its course or a perception that property capital gains are also slowing down. Major enterprises now face a requirement to pay 10% of their earnings to the state, which will dramatically reduce their retained earnings and investable cash. Finally, many industries are reporting intense margin squeezes, as producer prices rise faster than consumer prices, and enterprises that had their balance sheets enhanced by property and A-share gains in 2007 will not see that again in 2008. If the export slowdown cannot be reversed, it’s possible a general slowdown in GDP might create significant pockets of capital insufficiency in the domestic market. Were this to happen, it could drive more openness to foreign capital. . . .

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Ken DeWoskin is professor emeritus at the University of Michigan and a senior adviser with Deloitte Touche Tohmatsu.