Tuesday, June 30, 2009

Is Lloyd Christmas Running California?

The Financial Times reported this morning that California's budget deficit has forced it to issue IOUs:
"California is preparing to issue IOUs to its creditors this week as it prepares to begin its new fiscal year deep in the red.

"Once the richest US state, California now has the dubious distinction of having the worst credit rating in the country.

"It faces a budget deficit of $24bn yet Arnold Schwarzenegger, its governor, and the state assembly cannot agree on a budget to address the shortfall."
The first thing that comes to mind is the scene at the end of the movie Dumb and Dumber (spoiler alert!), where Lloyd Christmas (Jim Carrey) tells the kidnapper that the suitcase once full of cash is now full of IOUs.

I'm sure there's a lesson somewhere about Lloyd and Harry's profligacy - among the things they buy with the cash is a Lamborghini Diablo - and California's inability either to raise taxes or cut expenditures.

If you think you've got what it takes to rectify California's shortfall, you can give it a whirl with the LA Times' State Budget Balancer.

Thursday, June 25, 2009

Private Equity and China's Move Away From Export-led Growth

Boss Hoyt raised some big questions in his comment on Zhou Xiaochuan and the Future of the International Monetary System. Interestingly, just yesterday one Mr. Hoyt posted an entry titled “China's Venture Capital Markets: Nascent, but growing” on the International Finance Corporation’s Private Sector Development Blog. Mr. Hoyt's post may hold the key to answering Boss Hoyt’s question about how East Asian economies - we will look at the case of China - will change shape as a weaker dollar reduces demand for Asian exports.

The core issue is the paucity of financing options available to Small and Medium Enterprises (SMEs). Through private sector (SME) development, China’s economy will reduce dependence on exports and increase domestic demand. An examination of the evolution and development of China’s financial sector reforms reveals that Venture Capital (VC) and Private Equity (PE) are the best conduits of finance for SMEs, and the best hope for China’s long-term economic growth and development.

This is a bit of a lengthy post, but if you're interested in private and financial sector development, private equity, graphs, and/or China, read on!

Examination of the Finance Gap

The Banking Sector: China’s financial system exhibits two overarching characteristics: it is dominated by the banking sector, which predominantly channels loans toward state-owned enterprises (SOEs), and it is highly inefficient (perhaps because it too is state-owned). Moreover, less than one percent of all loans go to private businesses.

Part of the problem is China’s turbulent history with non-performing loans (NPLs). Despite the government’s decision to remove NPLs from banks’ balance sheets, a large amount of NPLs remain, and this inhibits lending to the private sector because loans to entrepreneurs and private businesses require extensive due diligence.

The Corporate Bond Market: China’s debt capital markets grew from RMB 466bn in 2007 to RMB 5.6trn in Q3 2006, a growth rate of 12x (Goldman Sachs 2007, 187). Yet despite this astonishing growth, corporate bond issuances remain limited. The bond data for 2008 reveal that corporate bonds represented roughly 2% of total bonds outstanding. For SMEs seeking debt financing the problem lies in the extensive regulatory requirements.

The Equity Markets
: China’s principal mainland stock exchanges in Shanghai and Shenzhen have primarily served as conduits for the privatization of China’s state-owned enterprises. Recognizing the role equity markets can play in SME financing and development, the Chinese government began in 1998 an effort to open an exchange focused exclusively on SMEs. After a few false starts the government approved the creation of a Small and Medium Enterprise Board on the Shenzhen Stock Exchange in 2004. As shown in Figure I, the number of firms listed on the SME Board has grown rapidly, as has the Board’s market capitalization. Taking the last trading day’s data for each year - admittedly a rough sketch - the volume of shares traded has grown at a compound annual growth rate of 140%. Just yesterday the Financial Times reported that the new listing rules for the much-vaunted Growth Enterprise Board will take effect July 1st. Ostensibly the new GEB will take the place of the SME Board.

Figure I - The SME Board: Signs of a Growing Equity Market

Source: Shenzhen Stock Exchange (SME Board) - End of Year Data

Informal Financial Markets: Unable to obtain bank loans and largely locked out of the domestic debt and equity markets, Chinese businesses are compelled to rely on the informal (“curb”) markets for their financing. These markets are very expensive: one Chinese scholar has noted that while official lending rates were 6 percent, the curb market rates were three times higher at 18 percent (Fang 2001, 5). Yet despite these financing conditions, many small businesses remain profitable.

Entrepreneurs and SMEs: Engines of Chinese Economic Growth

China’s inefficient allocation of capital destroys opportunities for economic growth. Liu and Siu estimate that redirecting resources from less efficient SOEs toward the more productive SMEs would contribute 4.5 percent to annual GDP growth, and that the deadweight loss due to the mis-allocation of capital is upwards of 8 percent.

By almost every measure, the private sector serves as the engine of China’s economic growth. Tsai claims that private businesses account for two-thirds of China’s industrial output and employ more than 200 million people. Allen, Qian and Qian reveal that in 2004, the output of the “hybrid” (private) sector was roughly USD 1,500 billion, while the state and listed sectors produced 53% of that (USD 800 billion).

The Opportunities for Private Equity and Venture Capital

Given the size, performance, and robust appetite for financing among entrepreneurs and SMEs, PE and VC face rich market demand for their services. Moreover, the inefficiencies and the transitional nature of the Chinese economy create a large set of opportunities for the private equity investor.

Whether one discusses VC or PE in China, the trends are clear: private equity investments in China are increasing steadily.

Figure II - Venture Capital Investments and Deals in China

Source: Zero2IPO 2009.

A recent development is the growing importance and size of local currency private equity funds. For many years, foreign investors dominated the PE market. The Chinese government sought to ameliorate this situation by encouraging domestic innovation and investment, and through its creation of the RMB 6.1bn state-run Bohai Fund. The number of RMB funds grew 2.6x, from 41 in 2007 to 108 in 2008, and there has been increased interest among foreign PE firms in pursuing joint ventures with local counterparts (EMPEA, “Insight China” 2009).

China’s compelling macroeconomic story is leading to investments in a broad array of sectors: from IT and telecommunications to consumer goods to infrastructure. China’s growing middle class is a key driver of this diversification. To demonstrate, from 2002-2007, household consumption expenditures have grown at a compound annual growth rate of 10% (IMF, International Financial Statistics 2009), and GDP per capita between 2002-2006 grew at the same rate (ADB 2008, 139). As Figure III shows, China’s private consumption growth rate is outpacing GDP growth. This growth in prosperity and discretionary spending is increasing demand for a variety of goods and services.

Figure III - Private Consumption Growing Faster Than GDP

Source: Economist Intelligence Unit CountryData.

Challenges for Private Equity

Despite the promising macroeconomic trends and the government’s efforts to stimulate private sector development in China, several significant challenges remain. Private equity funds rely upon institutional investors for their capital, and often rely upon capital markets for exit opportunities. Both of these are underdeveloped in China.

In the United States, university endowments, pension funds, insurance companies, investment banks, and mutual funds all tend to allocate portions of their capital to private equity firms to diversify their portfolios and to seize the opportunity to achieve outsized returns. The sophistication of these institutional investors in the United States is vital to the sustenance of private equity, for not only do they serve as Limited Partners, but they also serve as vital contributors to the liquidity of equity and debt markets. This is critical both for the financing needs of the corporate sector, and for private equity funds looking to exit their investments through Initial Public Offerings (IPOs).

While China does have some institutional investors, they are still in an embryonic stage of development. A World Bank study notes that there are “few well-recognized and trusted non-bank financial institutions,” a fact that discourages the “vast pool of domestic household savings from being constructively mobilized to meet key national, strategic objectives, resulting in a highly polarized deployment of savings by the population.”

One promising development is the National Social Security Fund’s (NSSF) recent announcement that it hopes to attract three to five private equity funds to invest portions of the NSSF’s RMB 563bn (USD 82bn) portfolio. This is the wave of the future for private equity in China, and is a promising sign for the country’s future economic growth. If private equity funds are able to harness the capital held by the NSSF, the State Administration of Foreign Exchange (SAFE), or the state’s sovereign wealth fund - the China Investment Corporation - the opportunities for growth are immense.

The Roles for Private Equity

In addition to finance, Private Equity funds provide business expertise. Improved business practices and financial management and reporting standards can simplify credit risk analysis, thereby facilitating the ability to get follow-on financing through the domestic banking system. As noted earlier, China’s NPL problem leads to extensive due diligence and credit risk analyses for entrepreneurs and SMEs. Private equity can thus ease the NPL concerns of bank loan officers, and open up possibilities for private businesses to finance themselves through bank borrowing - alleviating reliance upon retained earnings and the curb market.

A vibrant and entrepreneurial private sector provides licit employment opportunities for those who have been released from privatized SOEs, allows China’s industries to move up the value chain, and stimulates domestic aggregate demand - the latter being an outcome that would lessen China’s reliance upon export-led growth, and would help to alleviate global imbalances. With its deep pool of human capital, China’s growing private sector can harness the innovative capacity of its highly educated citizens, and entice those who study abroad to return to China with new skills - and possibly with ideas on how to improve upon existing businesses or to create their own. As China pursues its economic reforms, private equity can play the critical role of closing the finance gap, thereby ensuring China’s continued economic growth and development.

Note to readers: if interested, the author would be happy to pass along a paper he wrote on the roles for Private Equity and Venture Capital in China’s Economic Development.

Monday, June 22, 2009

Zhou Xiaochuan and the Future of the International Monetary System

In March 2009, the Governor of the People’s Bank of China (China’s Central Bank), Zhou Xiaochuan, proposed an audacious reform for the international monetary system. Simply put, it was the most important development in international macroeconomics since Richard Nixon’s decision to abandon the Gold Standard in 1971.

As it happened, the story went relatively unreported in the U.S. mainstream media. That the proposal came from China is quite telling: as the largest foreign holder of U.S. debt, China publicly raised doubts about the solvency of the United States and the future value of the U.S. Dollar. In doing so, China called into question the prudence and sustainability of the international economic order.

Since the proposal, Russian President Dmitri Medvedev has joined the fray, calling into question the prudence of using the dollar as a reserve currency (see articles here and here), and the yield on U.S. Treasuries has increased - a sign that investors demand a higher return for higher risks. Reportedly, the leaders of the “BRIC” countries discussed the issue during their meeting in Yekaterinburg, Russia last week.

The Background for Zhou’s Proposal

Part of the background to Zhou’s proposal can be found in the Bretton Woods discussions following World War II. John Maynard Keynes feared that the reliance upon a reserve currency would lead to the “N-1 Problem,” wherein the world would become hostage to the international monetary policies of the United States. To avoid this, Keynes proposed an international currency - the Bancor - that would be linked to 30 internationally traded commodities. This was the fount of Governor Zhoul’s proposal.

Another part of the background to this proposal is China’s inordinate exposure to U.S. debt. As a result of the global financial crisis, the U.S. government has embarked upon expansive debt-financed stimulus programs to revive the U.S. and world economies. In addition, the Obama Administration’s budget proposal had the largest deficit in U.S. history, with forecasted deficits to increase throughout his term. For debt holders in Beijing, the U.S. government’s profligacy raises alarm bells, for not only does the likelihood of a U.S. default increase, but also the future value of the USD decreases with the prospects for future inflation. This ‘tough sell’ led Secretary of State Clinton to implore the Chinese to continue purchasing U.S. bonds during her trip to China in February. Indeed, in U.S. Treasury auctions, demand for the assets has softened, as evidenced by increased yields.

The Chinese are holding $1.35 Trillion of a sinking asset.

The final part of the background to Zhou’s proposal is the increasing internationalization of the Yuan-Renminbi (RMB). China has made overtures to ASEAN countries to invest in RMB-denominated government assets and to issue RMB-denominated debt. Additionally, the role of the RMB as a transaction currency is increasing. The Renminbi is now the settlement currency for Hong Kong-PRC trade, and the Bank of China has extended lines of credit to ASEAN countries to finance Chinese exports - an activity that used to rely upon the USD. Moreover, the Chinese government recently entered into currency swap agreements with Argentina.

What does this mean?

While the RMB’s likelihood of becoming a reserve currency in the near future is unlikely, the trend line is clear: the dominance of the USD is eroding. Certainly there are no substantive alternatives to the USD at present: the Euro area lacks a unified ministry of finance capable of issuing debt; China’s debt capital markets remain underdeveloped. Moreover, the United States has no incentive to forego the benefits of holding the reserve currency. It not only retains the benefits of seignorage, but it also benefits from lower borrowing costs.

Governor Zhou tapped into popular frustrations with the United States, and called into question the foundations of the international economic order. While it would be fanciful to think that a new version of the Bancor would supplant the USD as the world’s reserve currency in the near future, one must take Governor Zhou’s proposal seriously.

If something can’t continue forever, it won’t. The use of the USD as the world’s reserve currency will come to an end. Governor Zhou planted the seeds of what the future may hold in store. A world in which the USD is not the reserve currency will increase borrowing (and thus investment) costs for Americans, and it likely would increase the costs of certain commodities currently priced in U.S. Dollars, e.g. oil. Depending upon the monetary system that emerges, the ability of the United States to pursue an independent monetary policy could be constrained.

Granted, this outcome could help alleviate global macroeconomic imbalances, and a stable world currency could provide greater international financial stability. Yet a big question remains, whither U.S. influence when the dollar is no longer the currency of international commerce and finance?

Friday, June 19, 2009

The Goal of Global Trendlines

Global Trendlines seeks to identify and analyze global events and trends. As such, it takes stories of portent from U.S. and international media, provides a bit of historical context, and offers thoughts on where such events might lead.

Rather than posting incessantly with my latest feelings and unencumbered thoughts, I hope to post more rigorous analytical pieces roughly on a weekly basis.

I hope that Global Trendlines offers some respite from the vitriol and inanity often found in discussions of international politics and U.S. foreign policy. And most importantly, I hope the posts kick off thoughtful and enlightening discussions on the issues shaping the world in which we live.

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