PRIVATE CREDIT TEAM WHITE PAPER August 2015

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1 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 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 background of the so called debt binge, one Figure 1 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. Page 1 of 12

2 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). Page 2 of 12

3 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. Page 3 of 12

4 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 ) 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. Page 4 of 12

5 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. Page 5 of 12

6 Figure 5 DOLLAR INDEX USD-CNY X- USD-HKD USD-INR X- USD-IDR X- USD-MYR USD-PHP X- USD-SGD X- USD-KRW USD-TWD Spot Rate SPOT RATE X-RATE RATE RATE X-RATE RATE RATE X-RATE X-RATE 8/22/ /25/ M Currency Depreciation against USD % -4.02% -0.01% -8.98% % % -6.09% % % -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 Page 6 of 12

7 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. ( ). 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. Page 7 of 12

8 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. Page 8 of 12

9 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 Page 9 of 12

10 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. Page 10 of 12

11 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 Barry Lau Managing Partner & CIO Page 11 of 12

12 Contact Details Paul Heffner Adamas Asset Management Managing Partner & CEO , 18/F, Tai Yau Building, 181 Johnston Road, Direct: Wan Chai, Hong Kong Mobile: Direct: Disclaimer This publication has been prepared for the exclusive use of investors considering an investment in the fund managed by Adamas Global Alternative Investment Management Inc. or its affiliates ( Adamas Asset Management or Adamas ). Adamas is a Hong Kong Securities and Futures Commission (SFC) licensed company in Hong Kong and has no affiliated company in the United States. Adamas is not affiliated to Adamas Partners, LLC. The contents of this publication, including all figures, tables, and drawings, are the intellectual property of Adamas. Forwarding or reproduction of this publication or parts thereof, regardless of reason or form, is not permitted without the explicit written authorization of Adamas. This publication is for informational purposes only. The information contained herein is neither an offer to sell nor a solicitation of any offer to buy shares in any fund managed by Adamas. Any offering will be made only to qualified investors on the basis of the relevant information memorandum, together with the current financial statements of the relevant fund, if available, and the relevant subscription application, all of which must be read in their entirety. No offer to purchase shares will be made or accepted prior to receipt by the offeree of these documents and the completion of all appropriate documentation. The shares have not and will not be registered for sale, and there will be no public offering of the shares. No offer to sell (or solicitation of an offer to buy) will be made in any jurisdiction in which such offer or solicitation would be unlawful. All information contained in this publication may be changed without advance notice and is qualified in its entirety by the information memorandum of the relevant fund and its related subscription application. Nothing in this publication is intended to amount to investment advice. Adamas assumes no responsibility for errors or omissions in this publication. Adamas does not guarantee the accuracy or completeness of information, text, graphics, links, or other elements contained in this publication. This publication is provided without any warranty, whether explicit or implicit. This applies in part but not exclusively to a warranty of marketability and suitability for a particular purpose as well as a warranty of non-violation of applicable law. Adamas assumes no liability or guarantee whatsoever for damages of any type, including and without limitation for direct, special, indirect, or consequential damages associated with the use of this publication. Any information that may be referenced in this publication through provided links is not subject to the influence of Adamas and Adamas provides no warranty or approval whatsoever for third-party websites. Past performance of a fund is no guarantee as to its performance in the future. Investments in the funds managed by Adamas may not be suitable for all investors. The price of shares may fall as well as rise. This publication is not an advertisement and is not intended for public use or distribution. Page 12 of 12