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China's shaky equity story
December 29, 2003
China Life Insurance's recent $3 billion IPO has been the world's largest this year. Bankers reportedly received $80 billion in demand for the stock. We may be well in the middle of a new China stock market bubble.
But if public market investors are loading up on China equities, why are private equity investors growing more cautious on China? W K Funds, a well-respected Taiwan firm, has pulled out of China.
If Taiwanese venture capitalists, who speak the same language and know China better than most, leave, what can others, including public market investors, hope for? China used to represent more a third of regional private equity spend; now it's less than a quarter.
There are several problems with equity investment in China, be it public or private. The macro data is always exciting: constant growth at 8-plus per cent a year.
But the macro data may not be accurate. Thomas Rawski, a professor at the University of Pittsburgh, used energy consumption figures to suggest that China's GDP growth was closer to 4 per cent between 1998 and 2001 rather than the official 7-10 per cent.
While Rawski's research has been contested, the bigger problem is that China's macro data does not translate into a strong micro story.
The World Bank estimates that return on equity for non-listed domestic Chinese companies has been below 3 per cent every year since 1996.
Return on equity for listed companies has been higher, at around 8 per cent, but recall that companies are beautified, and loss-making portions excluded, prior to floating.
As one surveys China's corporate landscape, therefore, a paradox takes shape: China's growth has not been matched by profits.
Why this absence? The main reason is easy credit. For most Chinese enterprises, bank lending is available on tap.
Repayment is welcome but not mandatory. China has had 20 years of credit growth at an average rate of 22 per cent per annum.
Even this binge has left banks with excess deposits of $578 billion, or 43 per cent of GDP. India's excess deposits, in contrast, stand at only $133 billion or 26 per cent of GDP.
Credit in China has led to industrial overcapacity, partly offset by growing exports and ballooning trade surplus with the United States, which in turn fuels further credit growth in China through increased deposits.
At a micro level, Chinese enterprises devote few resources to product innovation; backed by bank credit, their approach to competition focuses on price.
China, therefore, has been a credit, not an equity, story. This is strange because equity better fits the higher-risk profile of a developing market.
In Taiwan, for example, China Development Bank (now China Development Industrial Bank or CDIB) played a vital role in the development of the private sector.
The International Finance Corporation is doing the same on the mainland, but to a lesser extent. For their part, domestic Chinese banks are not allowed by law to make equity investments.
The mainland equivalent of Taiwan's CDIB, China Development Bank, has a similar mandate to its counterpart across the strait but its only tool is credit, not equity.
Given the ample supply of cheap or zero-cost credit in China, private equity capital, which is expensive, holds little attraction.
There are exceptions. Private companies in China do have difficulty to access bank lending. As a result, they rely on internal cash flows.
This has constrained growth but, being generally well-run and profitable, private enterprises should be prime targets for private equity capital. Although such investments make sense for both sides, they have been relatively rare.
Why? There are two challenges for private equity investors in China's emerging private sector: corporate governance and control. The private sector in China has been fighting a guerrilla war against large state-owned behemoths.
In this, it has relied on street smarts. Government support and legal infrastructure have been limited. Private property does not enjoy constitutional protection, for example. You do not 'own' land in China; you simply have a right of usage valid for a limited period of time (a maximum of 70 years).
In order to overcome the lack of recognition and prosper, China's private sector has had to grow nimble in more ways than one.
The CEO of Euro-Asia, a leading private firm, was arrested last June for forging some $200 million in receipts and other instances of wrongdoing.
Multiple book-keeping is common. The response of many investors has been to seek control or at least meaningful influence over management.
This is tough. China's private companies are entrepreneurial, and these entrepreneurs cherish their freedom. The growth of their companies to national or international scale, which private equity capital could enable, is secondary, in their eyes, to continued control. Control is more important than becoming the next Dell or Wal-Mart.
Presented with a good offer, the entrepreneur may consider accepting a minority investment from a multinational that is strategic (but, ironically, most multinationals are not interested in taking small stakes), but financial investors -- what can they bring to the table?
There are benefits, of course, such as financial discipline, but conveying them to strong-willed entrepreneurs can be an uphill struggle.
Valuations are another challenge in China, not restricted to investments in the private sector. The same liquidity that creates credit pushes up valuations on China's domestic stock markets, creating unrealistic expectations in the minds of entrepreneurs.
Meanwhile, demand for good private equity deals is high, but the supply of healthy, profitable companies is low. Indeed, in this as well as many other respects, China is a seller's market. This pushes up valuations and makes returns harder to achieve.
Assuming you have found a good, attractive company, invested in it at a reasonable price, the final challenge, perhaps most important, is exit.
China does not encourage private companies to list, and only the listed shares can trade.
While domestic valuations are theoretically high, there is no liquidity for the stock held by a listed company's original investors.
The stock markets in Hong Kong, the US, Taiwan or Singapore all have their issues for Chinese companies seeking to list, though Hong Kong is emerging as the preferred choice for enterprises in traditional industries, while high-tech companies prefer Nasdaq.
Taiwan's capital markets would be extremely attractive if only they were open to Chinese companies. Taiwan's stock exchange is one of the deepest in the region.
Its capitalisation is some $400 billion, underpinned by a free float approaching 50 per cent. In other words, unlike in China, where free float is small and traded shares have a different legal status from untraded ones, Taiwan's market capitalisation figures are accurate.
Alas, this stock market is not open to Chinese companies -- not even to firms backed by Taiwanese entrepreneurs in the mainland. This is a result of political tensions between Taipei and Beijing, and not likely to change soon.
All things considered, the best course of action for private equity investors eyeing China is to invest in the growth of the country's private sector.
Investors in both private and public equities need to be mindful of corporate hanky-panky but good companies can be found.
Meng Niu, a leading private equity-backed Chinese dairy coming planning to list in Hong Kong, is one example.
The larger role of equity in China, and the systemic problems brought about by decades of easy credit and export-led growth, will be more difficult to untangle.
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