Soft Landings in Asia
by Mohan Kharbanda, Operating Partner
It is reasonable to expect that slowing economic growth rates in China and India will drive the refinement of Asia-related strategies in 2013 as private equity firms consider how best to leverage these countries for their portfolios. Those who were dazzled by the hypergrowth in these economies did expect some slowdown. However, the timing and curve of the slowdown have been quicker and sharper than most anticipated, due largely to the severity of the economic downturn in the United States and Europe.
To better understand where these Asian markets are likely headed in 2013, it is helpful to look back at the last decade.
Favorable Secular Trends
China’s exceptionally fast growth during 2003–2008 was fueled by economic reforms, a high savings rate to finance investments, improved macroeconomic management and a very favorable global environment that helped shift the weight of global manufacturing away from Europe and the United States. However, a heavy reliance on investment and exports for economic growth resulted in less focus on domestic consumption.<
China’s hyper growth, which peaked at just over 14% in 2007, has cooled to about 7.5% due largely to weakened demand for exports. This forced China to unveil a number of stimulus measures in 2012, including $150 billion in infrastructure investments and lending by state-owned banks. The result was a sharp increase in property prices, raising fears about potential asset bubbles. At the same time, there has been a slower than optimal shift of the economy toward consumption. The current savings rate of almost 30% remains stubborn because the Confucian society puts a heavy emphasis on providing for one’s family. The Chinese save to pay for education for their children and to cover health care and retirement costs because there is no equivalent of Medicare and Social Security.
Rebalancing the economy and encouraging domestic consumption are major challenges for the new generation of Chinese policy makers. The need for transition is more compelling in the era of increased minimum wages (20% to 30% in the last year) and declining population due to the one-child policy. China’s labor force between the ages of 15 and 65 is expected to peak in 2014.
In India, Gross Domestic Product (GDP) growth slowed to a nine year low of 6.5% for fiscal year 2011–12, and is expected to slow further to about 5% for 2012–13. Bureaucratic red tape, a rising current account deficit and depreciation of the local currency (the rupee) are contributing to this slowdown. And, unlike the rest of Asia, India is experiencing elevated inflation pressures, forcing the central bank to leave interest rates high.
The major ratings agencies have even begun to question India's investment grade status.
Political and Cultural Advantages
A return to faster growth in the Indian economy will likely take longer than in China, but there have been a number of positive developments. After two years of paralyzation amid corruption allegations, record low currency, one of the nation’s largest private air carriers teetering toward bankruptcy, and looming elections, the government began unveiling its biggest growth policy push in a decade. Provisions include allowing foreign airlines to invest up to 49% in local ventures and letting multi-brand retailers like Walmart invest up to 51% in local stores. A developing plan to allow banks to lend more money to real estate firms is expected to boost the employment-generating construction industry. And the government is expected to announce an increase in the cap on foreign investment in the insurance sector, opening the door for foreign players to buy up to 49% in local ventures as opposed to today's limit of 26%.
Already these policy efforts have reversed a trend of falling inflows of overseas money. With additional aggressive policy changes in the works, the prospect of resumed growth looks more promising.
In the long run, India has some inherent competitive advantages. The legacy of British colonial rule is a vigorous democracy and a parliamentary form of government. As in the United States, these kinds of institutions are very well-adapted to running a large, religiously diverse country where the central government is constrained by increasingly powerful states and weak coalition governments. And, of course, the British gave India the English language –a very useful tool in today’s business world and a unifying force in a country with hundreds of languages and dialects.
Private Equity Opportunities
During the rapid growth periods for China and India, Western private equity investors developed strong credibility in these markets. While short-term concerns persist over regulatory uncertainty and the lack of easy exit routes, local companies continue to turn to private equity funds for financing because other sources have dried up. The value of private equity investments in the Asia-Pacific region grew at an impressive 30% in 2011, largely due to increased investment volumes in India and China.
In India –the fastest-growing Asian private equity market in 2011 –entrepreneurs favor private equity funding due to the higher cost of
debt and the difficulty of raising funds through initial public offerings. The key opportunities for private equity remain:
- One of India’s biggest challenges, infrastructure is becoming one of the largest areas of private equity investment opportunity. Public infrastructure outlays are expected to double over the next five years to $1 trillion, with the private sector accounting for between 40–50% of that.
- The power sector is also attracting increased interest from investors, increasing to 45% of private equity funds’ total infrastructure investments between 2008 and 2010. Over the next five years, the construction industry alone will need an additional $150 billion to $200 billion to fund assets and working capital.
New dollar investment in Chinese financial assets was down in 2012 as the shine appeared to come off Chinese IPOs for U.S. and Hong Kong investors. Also, rule changes in China began to make private equity investing more difficult. It’s harder now to get permission to convert dollars into renminbi, and Chinese companies can no longer easily create offshore holding company structures to facilitate dollar investment and an eventual exit through offshore IPO. This decrease has not been due to a lack of opportunity in China, however. For example:
- Chinese companies have a huge appetite for growth capital and the potential to achieve high rates of return for investors. Many of China’s most successful entrepreneurial companies —including well-known firms like Alibaba and Baidu –were nurtured by dollar investors.
- There is a gap in China's financial system that private equity can fill. Most capital is channeled through state-controlled banks that offer low returns on deposits and cheap loans to state-controlled companies. Both savers, who want better returns on their investments, and entrepreneurs, who need capital, are keen on bypassing the state-bank system.
While growth rates in China and India aren’t expected to return to their historic highs any time soon, 5–7%+ growth rates are impressive given the current global headwinds.
At the end of the day, momentum is with China and India. Both economies will have continued growth in the long term and eventually, perhaps in our children’s lifetime, could have the top GDP in the world given their respective populations.
For private equity funds to succeed in these rapidly evolving markets, they must be aware of and able to adjust their approaches to the contours of the local economies and business cultures.