Chinese back no-blame equity risk

2010-09-09Asia Times

BEIJING - Numbers in China are hard to come by, and statistics everywhere are notoriously worse than lies. However, the trend is certain - China is in the middle of a private equity (PE) craze.

State-owned enterprises set aside funds to finance their home-grown PE funds, foreigners line up to register yuan or dollar-denominated PE funds, private entrepreneurs pool their money to start up their own PE funds, and groups of friends even get their savings together to brave the new world. The funds invest in non-listed companies, with the ultimate goal of many being to cash in on their investment when the companies sell shares in an initial public offering and secure a stock-exchange listing.

Rough estimates reckon there are almost 1,000 PE funds with pledged capital of over US$100 million, and their could be more than 10,000 smaller PE funds. It is a world that may look like investment but is more like gambling, and the high stakes are what draw the crowds.

In August, China's gross domestic product overtook Japan's, and Beijing became capital of the world's second-largest economy, after that of the United States. While many countries are still faltering because of the lingering consequences of the 2008 financial crisis, China will probably end the year with a growth rate of about 9%, in line with the average of the past 30 years. Few in China believe the national growth rate will drastically drop in the foreseeable future.

Expectations for next year are that growth could marginally slow down to around 8%, as central authorities are reining in speculation in the real estate sector and overinvestment from local governments. Credit from banks has been partially squeezed, and this is being at least partially compensated for by the reorganization of local investment market with the birth of thousands of local PE funds.

Many opportunities are looming. While the national development rate is about 10%, some sectors are growing at twice or even three times that velocity, and within these are even better company performances with rates of 50% and above. So, who, with a little money, would not want to try their luck with these investments?

Things, though, are not as easy as they look.

The largest part of PE funds is founded by people with little or no experience in the financial market - many rush into investments relying on intuition and cunning, rather than analysis or hard-won experience. However, their presence in the market, with their careless and hasty actions, is drugging the overall investment climate.

Moreover, Chinese target companies (those receiving the investment) can be harder to decipher than their Western counterparts. Some can have serious problems of property structure or may have management expertise very different from those of comparable companies in Europe or America. And some are simply bad companies.

However, competition also pushes up costs in investment.

PE funds have to choose to hire unprofessional people for a relatively low salary - therefore taking higher investment risks, but lower fixed costs - or real professionals with experience in America and China who have mastered the Chinese language and the Chinese investment environment for a salary above international pay rates, thus lowering risks but increasing fixed costs.

These two factors, too many careless and clueless PE funds and too many "disorganized" target companies, are creating a bubble of price expectations. Meanwhile, money has run out of the stock market - the broad CSI 300 index of A-share stocks listed on the Shanghai or Shenzhen Stock Exchanges is still floating at around the 3,000-point mark, little change over the past month and still down from around 3,600 last November. In this situation, good companies expect very high prices for initial public offerings while similar listed companies trade at a much lower level in China and at even lower rates in the rest of the world.

Then, any given company wishing to get listed is wooed by a few potential investors - mostly unprofessional - driving up its price and expectations and ultimately wasting money.

This trend is not going to change in the short term. It will take time for many PE funds to either gain expertise or go bust and get out of the market, and it will also take time for Chinese target companies to improve their skills.

All in all, it looks like the next China bubble, after those in real estate and the stock exchange.

It is also the third wave of growth of private investment outside the official banking channels. The first was in 1990s with the growth of trust companies, the ITICs - international trust and investment companies - which collected private savings while promising high interest as they were lending for even higher returns. They were swept away with the 1997 Asia financial crisis, triggering a wave of protests from depositors who felt cheated because the state didn't back up the ITICs.

After that, a second surge sprouted quietly around a partial liberalization of pawnshops, which behind their front lent money at high interest rates. Those sometimes became underground loan-sharking agencies and were subsequently cracked down on by the police as people complained that the state didn't put a lid on the interest charges.

These two trends had the advantage of providing channels for investment for ill-compensated Chinese savers, but had the disadvantage of hurting the almost innocent depositors (the ITICs) or hurting the almost innocent loan-taker (the pawnshops). The PE funds have the advantage of hurting no innocents.

All risks are taken by people who cannot pretend to ignore the risks involved. The people who pool the money are supposed to know each other and know the risks of their own investments, as they freely choose their target companies. The target company also freely chooses its investors and both parties agree on a price. It is a free-market with no state intervention. Then if an investment goes wrong, as many will go wrong, nobody can blame anyone but themselves.

This is also why the state now encourages the establishment of PE funds.

While many bad PE funds and companies will certainly go to the wall, in just a few years the survivors will be extremely fit and free.

This will have deep political consequences, as the Chinese leaders, students of Marx, strongly believe in the link between the economy and politics.

It seems a pure coincidence that, parallel to this PE craze, President Hu Jintao on September 6 announced the need for further political reforms, calling for "bold experiments" in the special economic zones, which are often used as test-beds for economic or other changes, and for "democratic elections in accordance with the law, democratic policy decisions, democratic management, and democratic oversight".

"We must make courageous reforms ... as well as avoid rigidity and stagnation," Hu said on a visit to Shenzhen to mark the city's 30th anniversary as a "special economic zone", something that kick-started the Chinese economic reforms. Shenzhen's economy has grown at an average of 25.8% per year over the past three decades.

On Monday, Hu said the Communist Party would keep backing economic and political reforms in special economic zones such as Shenzhen. "We must not only maintain the special economic zones ... but make them better," said Hu.

Last month, Premier Wen Jiabao made a high-profile visit to Shenzhen and spoke of pursuing political reforms to safeguard China's economic health.

It is still very unclear what these political reforms will be and if the experiments will include some forms of universal suffrage. It is certain, however, that these will ride in parallel or on the back of a different financial environment, where in a few years free and healthy PE funds with a higher economic profile will have changed China's credit landscape. (2010-09-09 Asia Times)


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