An Underdeveloped Financial Market of China

China’s economy has seen extraordinary growth in the 21st century, driven by market-oriented reform, industrialization, and urbanization. On average, GDP has grown nearly 10% annually since 2000, making China the world’s second largest economy. However, the growth rate has slowed to approximately 6. 5% in recent years as the economy has matured. Despite these mind-blowing growth rates, there have been some constant hidden risks that haunt the economy from a financial regulation standpoint:

1. Excess reliability on real estate market
2. Credit Driven Model
3. Asset Bubble is growing bigger
4. Debt problem continues to be a big risk for the economy.

Chinese government is in dire need to get market-driven reforms, which facilitate more financing and innovation. Over the past two decades, the Chinese financial structure growth has outpaced the amendments/upgrade that the Chinese government could bring to the financial regulatory framework. With boom in Wealth Management Products that are tied to the asset pool (or the asset bubble), China is in that era in terms of its financial health where U. S was in 2007 (just before the crisis). And the government feels they need to introduce some ‘real reforms’.

For example: IPO registration-based reform to cut tax and make it more market driven. China Government needs to be ‘bold’, and ready to pay the cost for the reforms. Many Zombie companies in China that borrow debt but cannot pay them back. Government here agrees to kill the zombie companies but the government would incur some costs in order to do so, costs such as unemployment, bad loans or negative influence on GDP growth. To embrace these challenges would be very important as China government tries to improve their regulation framework.

Inefficiencies in public markets create an opportunity for shadow banking especially in Private Equity. The underdeveloped financial market, with its various inefficiencies, has been the major factor in the advancement of China’s Shadow Banking space. Despite more than two decades of progress in the capital markets, bank loans continue to act as the major source of financing for companies in China. The majority of Chinese banks are state-owned and, therefore, most loans are made to state-dominated sectors such as transportation, telecom and energy. As a result, small and medium-sized private companies — the key growth drivers of the country’s future economy – have suffered from a significant funding gap. As SME`s contribute to ~60% of GDP and about 80% of employment, the advent of shadow banking became an inevitable and integral part of the Chinese financial market in early 2000`s. Shadow Banking in the form of PE, became a real tool of governance that accumulated three main objectives viz. financing the SME’s, Internationalizing them and strengthening their business model.

No concrete policy to Shadow Banking till late 2015 with monetary policy in place and tightening, helped measure the impact on banks shadow banking activities not only on the balance sheet but also on the off balance sheet. However, Chinese state banks were still resilient and did not abide by the policy, as a result the effectiveness of the monetary policy on the total credit in the banking system was severely hampered and added only marginal benefit. However, recently, April 2017 China Banking Regulatory Commission (CBRC) issued a group of policies qualified as ‘regulatory windstorm’. The policy caters to the entire banking system with particular focus on the risks that shadow-banking represents. At the heart of the policy it targets the complex financial structures in which funds circulate between financial assets that offer high yields to investors and generate fee for lenders but do not add to the country’s economic activity.

For shadow banking the policy aims to eliminate the ‘regulatory arbitrage’ between banking, securities and insurance regulators. This was important as financial engineers have gained prowess in exploiting differences between the rules that govern similar investment products depending on which regulator supervises the institution that issues the product.

November 2017 – Rules tightened on asset managers to restrain from risky lending. Central banks suggesting new measures to limit the financial risk in the asset management industry. $15tn of asset-management products affected. The rules are to be applied in June 2017.

• Desired impact: prohibit asset managers from promising their investors a guaranteed rate of return + and to give up on the 10% management fees they collect for provisions.
• Financial consequences of the measures: the fear about implementation of these new rules resulted in a spike in Chinese sovereign bond yields +4%, pushing the Public Bank of China to invest $50Bn in the economy to calm the fears of investors.
• PE Industry in China: more stringent regulation but policy revisions promises more investment opportunities.

The volatility of China’s stock market over the past decade illustrates the fact that the country’s capital markets have been unbalanced and underdeveloped. As new rules around private equity and venture capital (PE/VC) investment appear to be tightening, so opportunities for expansion and reward are opening as China’s capital reform process takes shape.

In April 2018, People’s Bank of China, the China Banking and Insurance Regulatory Commission, the China Securities Regulatory Commission (CSRC) and the State Administration of Foreign Exchange (SAFE) issued the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions, commonly known as the new asset management rules in industry circles. This was a key initiative to safeguard against the systematic financial risk and encouraging capital “to forego the virtual and head for the real”. Financial experts believe this will blow the private finance business model in the short term, but over the long term it will be an effective medicine for promoting development of PE/VC funds.

Regulation regarding activity of the Chinese PE Funds that invest overseas (2018). Under this regulation, the government plans to intensify the scrutiny of PE funds set up abroad by domestic companies. The sole objective here is to mitigate the risks and monitor the off-shore fund raising activities. With this in place the regulators have implication abroad, and thus investors have incentive to circumvent this regulation to deploy capital abroad. A regulator such as NDRC – National Development and Reform Commission, state planner – in this specific context of PE fundraising activities might require to disclose the identity of Limited Partners. Banks and shadow-banking institutions would henceforth need approval from NDRC before engaging in overseas investment activities. An obvious consequence of this was the hinderance it caused to Chinese investors with offshore funds, as it was easy to raise millions (if nor billions) for projects abroad. Post implementation, this regulation sent out a bad signal, and served as a competitive advantage for other international funds as the funds could convince target companies that due to the change in the regulations, Chinese funds will share the information with the government.

Wave of closures among Chinese PE firms – as new regulations limit fundraising New regulations targeting excessive complexity in the design of wealth management products have also fallen heavily on private funds. The rules forbid opaque, derivative-like “nesting” structures in which the product sold to investors is comprised of other products, with underlying assets buried beneath layers of complexity. In the first six months of 2018, 163 private fund institutions were unable to renew their registration status with the Asset Management Association of China (Amac), government-controlled organism. An operation done every 3 months, as required. Among these 163, 70% + are PE funds or VCs Future of PE industry in China There is no denial that China has experienced rapid expansion since 2000, but despite that China-based private equity funds do not account for a higher proportion of the total fundraising market, infact even the prodigious growth of the PE fundraising market has only helped China keep pace with the expansion of the global industry.

The Chinese government intervened, and introduced variety of new controlling measures (2017-18) is to hedge them from the riskier nature of the PE in China compared to the rest of the world. This arises from the fact that funds in China only invest in one project and not many, making them completely undiversified. Moreover, the funds have a short time frame, usually 2 years, which mimics more a short-term loan as oppose to equity. The impact of the new regulations introduced saw fundraising plummeting significantly. The tight liquidity environment enforced by the financial regulation (windstorm policy), has led to more concentrated investments as GPs are more cautious in where to put capital.

The most promising impact that the new policies have on the PE industry is the consistent exit channel for PE investors, in addition to rational market valuations. Historically, Chinese IPO candidates have been infamous for their rigorous approval process, but under the proposed new system, the CSRC will be responsible only for determining whether applicants have provided full and accurate information prior to listing. The assessment of risks and valuations will be left to the market, similar to the IPO process in most developed markets, working in favour for PE industry. The new policies had the most promising impact on Chinese ooo candidates At an industry wide level, Chinese investors are getting braver and riskier, i. e. preferring to opt for tech startups as oppose to TMT in early 2000`s. As technology evolves and becomes increasingly sophisticated Chinese PE industry is getting more and more attracted to the following:

• Advent of Robotics: Given automation to the degree of 47% by 2034 in China, exciting advancements in the robot market, prompts eager investors to invest in this area, particularly in industrial and military robotics, that is $10 billion every year, only 7. 5% of the global robot market, 135 billion by 2019.
• Fintech & Blockchain: Growth and fall of P2P lending platforms in China, and other startups have disrupted the way fundraising, loans, and asset management landscape in China, giving plethora of opportunities to the PE firms.
• Mobile Internet: Increasing speeds and with endless possibilities, mobile internet and mobile technology PE/VC continues to attract and retain investors. For these reasons, PE has played a significant role in China by providing equity financing to companies unable to access traditional funding channels.

Most of the well-known, fast-growing companies in the private sector (e. g. , Mengniu, Focus Media, Alibaba, and Belle) have benefited from capital infusions from PE funds. The ability of PE to close the funding gap has generated outsized returns for investors in the country since the early 2000s As the PE industry in China adopts a new development model amid a slowing economy, the investors face both challenges and opportunities lie ahead for investors. Certainly, the low-hanging fruit is gone, and GPs cannot rely on the macroeconomic tailwinds that enabled them to invest and generate returns across the board in the past.

Conclusion

As the PE industry in China adopts a new development model amid a slowing economy, the investors face both challenges and opportunities lie ahead for investors. Certainly, the low-hanging fruit is gone, and GPs cannot rely on the macroeconomic tailwinds that enabled them to invest and generate returns across the board in the past. Nevertheless, we believe that GPs with adaptive investment strategies, strong operational skillsets, and sector focused resources will be able to achieve risk-adjusted returns in China’s transforming economy.

Likewise, it has never been more challenging for institutional LPs to allocate capital to PE opportunities. We believe that the key to success for LPs is to have historical perspective, in-depth knowledge of and experience within the local market, a deep-rooted local presence, and a fresh outlook when evaluating both established and emerging GPs. LPs who are able to successfully navigate the changing landscape will continue to be successful PE investors in China. Asia-Pacific has become the new contender Chinese companies are fascinated with fintech, keeping an eye out for cutting-edge solutions, such as blockchain technology. China is currently at the forefront of financial innovation, and with the country’s explosion of mobile internet activity, the field is set to become only more dynamic.