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PRIVATE CREDIT TEAM
WHITE PAPER
August 2015
Adamas’ view on Private Credit with respect to recent market movements –
light at the end of the tunnel?
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of
foolishness”. This opening paragraph of Charles Dickens’ A Tale of Two Cities aptly sums up the topic
of China as an investment theme in many boardroom discussions lately. Unlike most previous years,
the topic is not whether to double down on China, it has been whether to hold or reduce exposure to a
particular sector or even the country overall. China’s economy grew by 7% in the second quarter and
momentum has continued to slow into the second half of 2015. Growth in industrial production, fixed
asset investment, retail sales and exports have all fallen. Foreign-exchange reserves have fallen from $4
trillion to $3.65 trillion over five quarters. Around half of that $350 billion decline represented
hot-money outflows. These culminated in the forced surprise devaluation of the RMB on Aug 11. So
where are the opportunities in China? How should investors position themselves and what are the
consequences of the recent market movements?
Rising debt – but manageable:
China’s economic rise since the financial crisis has been fuelled by a massive stimulus campaign started
in 2008, which was largely supported by a rapid increase in debt as shown in Figure 1 below. China’s
debt as a share of its economy increased by 80 percentage points between 2008 and 2013 and currently
stands at around 240% of GDP. This headline debt level has led some investors to worry and fear an
imminent debt bubble burst.
However, diving into the numbers and the
Figure 1
background of the ‘so called’ debt binge, one
would see that the problem lies in the rate of debt
growth and not in the level per se. Even at 240% of
GDP, China’s total debt is not excessive when
compared to many large industrialized nations as
shown in Figure 2. China’s rapid increase in
leverage was driven by a combination of structural
and cyclical factors. Structurally, controls on bank
deposit and lending rates have historically reduced
borrowing costs in the economy. This has created
incentives for corporates to borrow and invest
excessively, at the expense of depositors. The bias
towards excessive borrowing worsened from 2009,
when the government implemented a massive
investment-driven stimulus, financed mostly by
debt. In subsequent years, a huge amount of credit was channelled into unproductive sectors of the
economy, fuelling substantial overcapacity in real-estate and industrial sectors. Inefficient usage of
credit, combined with considerable slippage, resulted in GDP growth failing to keep up with debt
growth, lifting the overall debt ratio in the economy.
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A strong balance sheet:
If one looks at total government debt, it is currently manageable at about 60% of GDP. This includes
central and local government debt and key government agencies' debt.
Figure 2
Source: BIS, CEIC, IMF, NAO and AXA IM Research
Source: BIS, CEIC, IMF, NAO and AXA IM Research
AXA Investment has recently done an interesting analysis whereby they constructed a scenario of
significant defaults in the risky parts of the financial system, with very low recovery rates of about 20%.
A complete official-sector bailout would see China’s total public debt rising to about 80% of GDP, of
which 60% would be central government debt. This would still be significantly below the levels of
other major economies (see Figure 3 below).
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August 2015
Figure 3
Source: BIS, CEIC, IMF and AXA IM Research
Growth and where will it come from?
The key then, is continued economic growth and the central government is focused on engineering that.
China will most probably need another stimulus package to keep economic growth at 5% to 7% and
allow time for the real estate sector to recover and for corporate spending and exports to pick up. In
fact, this has already begun with the central government re-starting investments in the country’s
high-speed rail project and other public transport infrastructure projects. For example, China has
announced an ambitious initiative to build an unblocked road and rail network linking China and
Europe. The intention is to develop an economic belt that includes countries on the original Silk Road
through Central Asia, West Asia, the Middle East and Europe. At 60% of GDP, the government's
balance sheet can certainly handle more stimulus at this stage.
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Despite a large infrastructure build-up in recent years, especially on roads and highways, additional
infrastructure investments in railways, urban public transport, urban utility networks, water and
environmental related projects are still needed for the economy to service the rapid urbanization that
continues to take place.
China's three policy banks, China Development Bank, the Agricultural Development Bank, and the
Exim Bank, had a combined balance sheet of RMB 15.8 trillion at end 2014 (CDB alone has a balance
sheet of RMB 10.3 trillion), or almost 10% of the banking system. China's recently approved policy bank
reform has been designed to increase and enhance the policy banks’ growth-supportive role in the
economy.
The eventual success of China’s debt deleveraging will hinge on the continuous efforts of the central
government to rebalance the economy, remove structural distortions and prudently manage monetary
policy. The Chinese government has several tools that it can use to achieve its objective. Unlike the US
and Europe, China still has room to cut its interest rates and its Required Reserve Ratio (RRR) to
achieve monetary loosening. As the RMB is a controlled currency and not freely convertible, Beijing can
manage the value of its currency to boost exports and encourage economic growth. We expect the
deleveraging and transition from an investment led to a consumer-led economy to be a gradual and
prolonged process but one in which the government has control over.
The Stock market:
China A shares have massively corrected with the Shanghai Composite Index having fallen by 43% (26
August 2015) since its peak of 5,166 on June 12. The Chinese government and regulators have been
intervening on multiple fronts to stabilize the market including: interest rate and RRR cuts, margin
financing loosening, reduction of IPOs, and state-directed share purchases by government funds and
institutions.
These have led to a lack of confidence amongst foreign investors who now begin to doubt Beijing’s
commitment to market reforms and the health of the Chinese economy. Is the Chinese stock market a
reflection of the economy?
We think not and for a good number of reasons. The main driver behind the market run up has been
increased speculators’ participation (both corporate and retail), which was in turn driven by: (i)
reduced returns on other investment assets (property, wealth management and trust products, bonds)
and (ii) a significant increase in margin financing, which was initiated by the central government’s
desire to promote the development of the equity market as part of the Third Plenary reform agenda.
Figure 4 below show that the A share run-up has been in tandem with the increase in new trading
account openings by retail investors and the rise in margin financing.
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Figure 4
Hence, the run-up and eventual correction in the A share market is not so much a reflection of the
Chinese economy but more of a withdrawal of liquidity by speculators as margin calls were made and
shares were forced sold into the market. This created panic, causing herd selling by both retail and
institutional investors.
In addition, the larger and more representative Shanghai Stock Exchange consists mainly of
State-owned Enterprises. Hence, the share price performance of these listed companies are arguably
more representative of Chinese government policy than on economic and industry-specific
fundamentals.
A consequence of the stock market turmoil is the Beijing government stepping in to limit the number of
onshore IPOs to a bare minimum so as to prevent a further fall in the overall share market. This has the
effect of driving private companies to the private lending market to fund expansion plans.
Currency movements:
The devaluation of the RMB is at the forefront of the minds of any investor invested in China today.
Critics view the devaluation of the RMB as a desperate measure by Beijing to boost export growth and
revive its sagging economy.
With slower economic growth, softer exports and increasing capital outflows, it is only natural for the
RMB to depreciate to reflect the true economic fundamentals. Devaluation also buys the Beijing
government a little more time as monetary policy gets genuinely loosened to counter the effect of a
significant slowdown in Fixed Asset Investment. It provides more room for China to cut interest rates
without triggering massive capital outflow to support the currency.
In addition, the weakening of the RMB has been in tandem with the overall flow out of emerging
market currencies and into the USD on expectation of a Fed rate hike. All emerging market Asian
currencies have taken a beating in the last 12 months (see Figure 5 below) with depreciation of some
currencies like the MYR in double digits decline.
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PRIVATE CREDIT TEAM
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August 2015
Figure 5
Spot Rate
8/22/2014
8/25/2015
DOLLAR
INDEX
SPOT
82.336
93.828
12M Currency
Depreciation
against USD
-12.25%
USD-CNY X- USD-HKD USD-INR X- USD-IDR X- USD-MYR USD-PHP X- USD-SGD X- USD-KRW
RATE
X-RATE
RATE
RATE
X-RATE
RATE
RATE
X-RATE
6.1528
7.7502
60.4725
11673
3.161
43.839
1.2491
1017.7
6.4104
7.7513
66.4388
14058
4.2385
46.68
1.4055
1193.13
-4.02%
-0.01%
-8.98%
-16.97%
-25.42%
-6.09%
-11.13%
-14.70%
USD-TWD
X-RATE
29.992
32.692
-8.26%
Source: Bloomberg
This, plus the flight of stock market “hot money”, had most probably caused Beijing to want to get
ahead of the curve by devaluing the RMB. If one considers China’s ambition of gradually making the
RMB a fully convertible currency and a global reserve currency, letting market forces guide the value of
the RMB is a necessity. Currency volatility will likely increase in the short term and a further
weakening cannot be ruled out. A rapid free fall is unlikely given that China still runs sizeable trade
and current account surpluses, its large FX reserve of $3.7 trillion would deter any speculators and it is
unlikely the Chinese government would tolerate a sudden fall in the currency.
A weaker RMB should have a positive impact on exports and macro growth, leading to lower credit
risks in the corporate sector. The negative impact on corporate debt servicing ability is not significant
given that only 8% of China’s corporate debt is denominated in a foreign currency, mostly in USD. The
most impacted sector would be the real estate industry given it has been one of the most active issuers
of USD denominated bonds in the past two years. On average, about 40% of a Chinese developer’s debt
liabilities are in non-RMB terms. However, the weaker RMB could be positive for the physical real
estate market as it could increase liquidity in the market due to increased participation by Hong Kong
and other USD earning individuals who would now find it cheaper to buy apartments in RMB terms.
Demographic and structural changes – where are the opportunities?
China’s demographic trend of a declining share of children and youth in the population versus a rising
elderly share will shift the mix of consumer spending. For example, demand for retirement homes will
increase and spending on financial services, particularly for retirement saving purposes should
increase.
Healthcare is a big sector with lots of opportunities as Chinese companies on the pharmaceutical side
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August 2015
innovate and as demand for healthcare facilities including old-age care centres increases with an ageing
population. Healthcare spending is expected to rise as a share of GDP.
Continuing urbanization and rising household wealth should continue to drive demand for private
housing and associated urban infrastructure. The real estate sector should recover albeit slowly,
beginning with the Tier 1 cities and moving across provincial capitals and Tier 2 and 3 cities.
The push to lower pollution, and now carbon emissions, will lead to even greater investment in
domestic solar and wind farms, boosting the global position of Chinese producers.
High-speed-rail construction will continue domestically and increasingly abroad, as Chinese
companies become the builder of choice for high-speed rail especially in emerging markets.
Chinese producers of heavy machinery and other industrial products will increasingly look to sell their
products overseas to utilize excess capacity back home. This has already happened with several of
these companies following Chinese policy banks into infrastructure and power projects in emerging
countries such as Indonesia and Africa.
We clearly see scope for certain sectors of the economy to continue growing quite substantially due to
these structural changes. Supporting these sectors and understanding the good companies and what
separates them from the competition will be in filtering the wheat from the chaff.
Opportunities in private debt – focus on SMEs:
Misallocation of debt has been a major perennial issue in China. The corporate sector is the largest
borrower, accounting for 63% of all borrowing or 148% of GDP. However, most of this debt goes to
SOEs, which are collectively less productive than private sector companies. Worse still, most of these
debts to SOEs ended up in the real estate sector or in increased industrial capacity. Also, the
state-owned banks tend to favour lending to state-owned enterprises rather than to privately owned
companies. With non-performing loans expected to rise, state-owned banks are expected to turn even
more cautious towards lending to privately owned small to medium sized enterprises (SMEs).
Currently, more than 90% of SME, cannot get bank financing.
The SMEs lending gap is currently estimated at around $3.5 trillion in 2014, of which $1.9 trillion is met
by non-bank financing channels (shadow banks). This would continue to provide room for further
expansion of China’s shadow banks. Growth of shadow banking assets is expected to be 14-19% p.a.
(2015 - 2017). Much of the growth in credit since the global financial crisis – about 30% over the past
five years – has come from the non-bank financing channel.
A weaker RMB would have ramifications for the corporate lending market in China, especially so for
the offshore bond and loan market. The immediate impact would be a move away from offshore
USD-based funding to the onshore loan and bond markets.
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Figure 6
Source: J.P. Morgan estimates, Bloomberg.
This creates opportunities for private debt providers like Adamas, which has the platform to offer
onshore RMB financing. Among Chinese companies, the most impacted sector would be Chinese
consumer and property sectors that are heavily geared with non-RMB denominated debt. Chinese
firms are also exposed operationally if a significant proportion of their costs comes from overseas. Top
beneficiaries are producers of commodities where China is not the price setter, such as copper and
aluminium, as a weaker RMB will enable commodity producers to be more export competitive. We
expect these sectors to present interesting financing opportunities in the private debt financing space.
Private debt providers like Adamas typically are more nimble, faster and able to be more creative in
delivering a customized financing solution to corporates. The state-owned banking system is not
well-equipped to seize these financing opportunities. Chinese banks typically only want to lend against
fixed assets, not cash flows or receivables.
Is the SMEs sector really a high risk area? Since the global financial crisis, there has been a much faster
increase in leverage among larger companies, while SMEs have decreased their leverage (please see
chart below). As many larger companies are also SOEs, this pattern implies the credit risk of SOEs,
from a pure leverage perspective, is actually higher than SMEs. Hence, investing in the SMEs sector in
China is actually a safer trade than investing in SOEs today.
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Figure 7
For private lenders, the opportunity in China remains within the private SMEs sector. SMEs sector is an
important part of the Chinese economy, accounting for about 60% of GDP and 80% of urban
employment. However, more than 90% of SMEs cannot get bank financing in China. Looking to the
equity markets, public equity market financing has not kept pace and given recent turbulences will
probably slow.
Figure 8
Source: iResearch and China Securities Regulatory Commission
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So – what is the case for investing in China?
Looking ahead and past the near term volatilities and headline news, there are still clear investable
trends in China. At the core is the question of how Chinese consumers will behave in a slowing
economy and ultimately the extent to which they will be the driver of economic growth over the next
few years. The key is a bottoms-up approach and picking the winners from the losers in terms of
sectors, companies and asset class.
Improving productivity and efficiency will remain the key to maintaining profitability for many
companies, given lower economic growth (overall and at a sector level) and the impact of producer
price deflation on multiple sectors. Companies which possess the technology and/or produces
equipment that enhances production productivity would be good investment targets.
The weaker RMB would benefit export –oriented companies and Chinese commodity producers as
their revenue would be mainly USD denominated while their cost base would be in RMB. Domestically
focused consumer-oriented companies with high import costs would stand to lose due to a high
percentage of costs being tied to international USD-denominated prices.
Developers are the biggest borrowers and issuers of foreign currency debt. They will likely shift their
funding needs onshore and rely more on the onshore bond and loan market. Smaller developers with
smaller balance sheets and earnings base would be more exposed as they would have a smaller buffer
for withstanding a weaker RMB.
A balanced investment portfolio should still include China, after all, it’s the second largest economy in
the world. As outlined above, the A-share market may not be the best way to gain exposure to the
country given its speculative nature and the interventionist inclination of the Beijing government. As
we have noted, China’s economic significance has been felt not just locally, but globally. In August, the US
suffered extreme volatility in its markets. Europe also suffered. Not to mention rest of Asia. China’s
economy will continue to expand at multiples of developed markets’ growth rates. The best way to avoid
volatility has to be via the private lending market.
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Conclusion
The recent headlines have caused concern for foreign investors, however we feel that following our
analysis we see even greater opportunities. Why is this?
The size of the country’s debt is manageable and can still be increased. This is supported by a strong
balance sheet. There are sectors that will be centrally supported and will continue to grow even if there
is an overall slowdown in the economy. The Chinese economy is indeed slowing down but the
government has policy tools available at its disposal such as further interest rate and RRR cuts,
managed devaluation of the RMB and policy bank lending to boost economic growth. There will still be
winners within the different sectors and industries. Growth will be slower but the pie is still growing.
The recent movements in the stock market are essentially speculator-driven and should have very little
impact on the wider economy. The temporary shutting down of the IPO market will lead to other
sources of financing such as private debt becoming more important. The latest currency fluctuations
are an evolution of the market as the currency and economy becomes more liberalized. A weaker RMB
by itself is not a negative for the private lending market as it would bring about special financing
opportunities in the different sectors. The key is a bottom-up approach to company and industry
selection. This is especially so in the SMEs sector, which is in general more efficient and nimble than the
state-owned enterprises and hence better able to weather the effects of a weaker RMB. Despite the
monetary loosening measures by the central government, we believe this will still flow to inefficient
SOEs and infrastructure projects and not to the SMEs sector. This will cause the SMEs sector to remain
underserved from a financing perspective, which creates interesting opportunities for private debt
investors. Demographic and structural changes will lead to changes in where growth is found and
where investment opportunities lie.
For investors willing to take a longer term view, China still presents a plethora of investment
opportunities especially in the private debt space. It depends on your interpretation of the outlook
and also what you invest in. Key is the selection of industry, companies and structuring the transaction
in the right way. Having an experienced team on the ground with a focus on the right sectors, is key in
delivering stable returns. For those who can see beyond the near term volatilities and look for the light
at the end of the tunnel, China can still be a spring of hope. We expect to find the ‘best of times’ again –
you just need to look for it!
Best regards,
Paul L. Heffner
Managing Partner & CEO
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Barry Lau
Managing Partner & CIO
PRIVATE CREDIT TEAM
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August 2015
Contact Details
Paul Heffner
Adamas Asset Management
Managing Partner & CEO
1801-03, 18/F, Tai Yau Building, 181 Johnston Road,
Direct: +852 3793-6288
Wan Chai, Hong Kong
Mobile: +852 9435-1257
Direct: +852 3793-6200
Email: [email protected]
Email: [email protected]
Disclaimer
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