China Recovery in ’09

Robert here. As promised, in this post we will provide some basic evidence of encouraging signs that China’s economy could recover in ’09.

As mentioned in previous AC posts and comments, we are, naturally, in frequent conversations with law firm partners and other business leaders in Asia, and the prevailing opinion, even from the most conservative and pessimistic, is that the major law firm deal flow in China could recover somewhat, if not yet to previous recent boom levels, by second half 2009 and that 2010 will likely be a good year. Keep in mind that the downturn hit China about one year after the US markets and it will likely recover well ahead of the US markets.

The Chairman of Morgan Stanley Asia Limited, Dr. Stephen Roach, has predicted recently that China’s economy will recover by the second half of 2009. In contrast, Roach predicts that the U.S. is only 20% through its deleveraging cycle and it will be a number of years before adjustments are complete. Merrill Lynch & Co., Hong Kong, economist Lu Ting: “China looks set to be the first major economy to recover from the current global meltdown.”

There is no question that Asia has suffered a major economic blow as a result of the current financial crisis. Asia’s export dependence renders it particularly vulnerable to the deteriorations of the Western economies. However, while hurting, Asia is comparatively in the best position to be the first economic region to recover from the sickness currently plaguing the world’s markets. GDP growth for Asia is predicted to be higher than any other region in the world in 2009. In early February 2009, the IMF predicted a GDP growth of 6.7%, 2.7%, 5.5% and 0.5% for China, Asia, Asia’s developing countries and the entire world, respectively, and has described China’s 8% GDP growth target as challenging, but possible (for example, Morgan Stanley’s Dr. Roach, predicted during the recent Davos World Economic Forum that China’s economy would see 8% growth again in 2010, while Bank of China (Hong Kong), Credit Suisse, Nomura International all predict 8% growth in 2009). IMF managing director Dominique Strauss-Kahn stated earlier this month, regarding China, “Once the economy regains its footing a rapid recovery is possible.”

The primary driver of Asia’s resilience in 2009 is China. As China’s economic fortunes go, so do those of the rest of the continent. With a stimulus package that both experts and investors believe is working, deep capital reserves, liberated policies on lending, and a low debt-to-GDP ratio compared to those of other countries, China is predicted to begin its recovery as early as mid-2009.

2009 may also be a surprisingly busy time for M&A. Everyone loves a bargain in a recession, from bored housewives taking advantage of the posh Soho boutiques unloading their designer wares at 70% off, to cash-rich Asian corporates looking to acquire interests in undervalued Western firms. While $100 million LBOs are a distant memory, mid-market deals look to be a potential new trend in the global recession.

Five reasons why:

Aggressive Bank Lending. China’s banking system is in much better shape than the U.S. and Western Europe. In fact, China is currently the only economy experiencing credit expansion, which some economists view as a major indicator that a mid-2009 recovery is possible. In January 2009 alone, Chinese banks lent almost a third of the amount that they lent in all of 2008, according to the People’s Bank of China. Unlike U.S. and European financial institutions, Chinese banks, which are not saddled with toxic assets, can more easily extend credit to individuals and corporations alike. Some economists claim that this aggressive loan expansion might signal a possible economic recovery as early as the second half of 2009. According to Merrill Lynch’s Lu, “China is the first economy to see real credit expansion at this point in time, during this trough of the global slowdown. That differentiates China from other economies.” While much of this lending is in the form of short-term loans and bill financing, which only boost the working capital of firms instead of providing long-term financing for investments, the crucial point is that money is flowing from banks to companies and households, according to Merril Lynch’s Ting.

Strong Balance Sheet, Strong Stimulus, High Investor Expectations and Stock Market Gains. Merrill Lynch’s Ting describes China as having “perhaps the deepest pockets in the world.” It was, therefore, no surprise to learn that just last week alone China went on quite a spending spree: $25 billion loan to Russia (to be repaid in oil for 25 years, locked in at today’s low prices); $10 billion loan to Brazil (again for oil); $4 Billion loan to Venezuela (again for oil); $19 billion bid by the mostly state-owned Aluminum Corp. of China for an 18% stake in Australian mining company, Rio Tinto. A growing number of countries and major global corporations are approaching the incredibly cash rich China with hat in hand hoping for a similar bail out. We expect this trend to continue. Cash rich private Chinese companies will likely get in the game too. For example, diesel engine giant Weichai Power is expected to soon buy a French plant of cash poor General Motors, which is desperate to sell off such assets.

China’s energy czar was quoted recently in People’s Daily: “The international financial crisis … is equally a challenge and an opportunity. The slowdown has reduced the price of international energy resources and assets and favors our search for overseas resources.” Erika Downs, a China energy specialist at the Brookings Institution in Washington, was quoted recently, regarding China banks lending in support of key government objectives: “What sets China apart is that Chinese banks have not been so badly hurt, and the policy banks still seem ready to lend.”

China has public debt of only 18.5% of GDP (compared with 75% in India), foreign currency reserves of $1.95 trillion, and a balanced budget. The strength of China’s balance sheet means that China has more public funds to earmark for expanding its 4-trillion yuan ($585 billion) stimulus package, which already includes projects such as the building of 3.5 billion yuan of public houses in Shaanxi province and Shanghai, and three new railway lines in Shandong province, construction on both of which commenced in December. Because China’s economy is production-oriented, as opposed to service-oriented, the Chinese economy can be easily aided by doing exactly what the Chinese stimulus plan is doing – spending cash on infrastructure and capital developments.

There are rumors that property could be another recipient of the huge stimulus packages already announced for several industrial sectors. Investors are optimistic about the success of the Chinese stimulus package, which is already starting to work. Keep in mind that China benefits in having a strong central government in this regard, as it can quickly push through efficient stimulus packages (where funds are not tied up so much in politics and are quickly dispersed to designated recipients / projects), whereas this is hardly possible in the West. This investor confidence has already translated to mid-February stock market gains on the Shanghai Composite Index, which has increased by 27% as of February 13. While worldwide benchmarks were reeling in response to the Dow’s sharp decline on February 20 on account of investor worries about U.S. bank nationalization, the Shanghai Composite Index actually gained 1.5 percent, after the Chinese government declared it would be adding light industry and petrochemical suppliers to its list of stimulus beneficiaries. There are also signs that a recovery in commodity prices might have begun, due in part to companies in China rebuilding industries. China’s imported iron ore has risen 28% since October. Hot-rolled steel is up 41% from November. The Baltic Dry Index, which measures shipping costs for commodities, has more than doubled since the end of January.

M&A Growth. Chinese M&A remained strong in 2008 despite the global economic slowdown. According to a Thompson Reuters report, 2008 M&A activity in China reached a record high of $159.6 billion in deals, up 44% from 2007, as compared to a year-on-year 11.1% fall in Asian deal volume (excluding Japan). Xie Tao, a PriceWaterhouse Coopers transactions partner based in Beijing, attributes this resilience to the fact that Chinese companies are not suffering from a dearth of cash, which is crucial for M&A activity. While M&A activity in China dropped in the second half of 2009, this was partly due to “a valuation gap arising from the unwillingness of domestic sellers to meet lower bids for buyers”, according to PWC’s Xie, who added that M&A growth should pick up in the second half of 2009 as pricing expectations align. China’s strong balance sheet may also drive 2009 M&A growth, as most recently seen in the $19.5 billion acquisition by state-owned aluminum group Chinalco for a stake in cash-strapped Rio Tinto. The stimulus package may beneficially affect M&A growth as well. “We expect domestic M&A activity to recover quicker than other regions of the world mainly due to the government’s 4 trillion yuan stimulus package, and regulators having room to lower interest rates. Private equity deals may be the first to recover,” said Christopher Chan, a PriceWaterhouse Coopers transactions partner.

As we reported in a previous post, China regulators are allowing bank loans for the purposes of M&A for the first time. This will help hasten the acquiring of Chinese firms that are ripe for acquiring in this market.

Not As Export-Dependent As the Rest of Asia. One concern about Asia’s economic future is its export dependence. Asia’s economies, which are largely export-driven, cannot be expected to fully recover until after the recovery of the consumer economies of the U.S. and Europe. The reasoning is simple: until the American and European economies – main export markets – recover, demand for Asian exports in consumer goods will remain depressed. While China is certainly dependent to a large extent on exports and recovery to recent boom time levels will depend on US recovery, China is in a better position than other Asia economies. Morgan Stanley (Asia) chairman, Dr. Roach has recently opined, with regards to Asia being dependent too much on exports: “Export-led regions are followers, not leaders. The only possibility (to recover earlier) is China, as it has large infrastructure spending in place that could provide support for economic growth.”

Regulators may Relax Rules On Domestic IPOs. Industry insiders are predicting that China’s securities regulator will allow IPOs to be launched on the “second board”, which would help stimulate an IPO market that has laid dormant for the past 5 months. A source close to the China Securities Regulatory Commission (CSRC) claims that the Commission has requested that companies who received their approval for IPOs in 2008 submit their annual reports to the Commission for possible issuances in 2009. If the Commission makes this allowance, some investment bankers predict that capital markets could see IPOs as early as the second quarter of 2009.

“Asian companies will be buying more mid-market companies in the U.S. as they become more attractive in terms of value” (Global Mid-Market M&A Outlook survey, Merrill Datasite).

While the global crisis has not spared Asia, there is some expectation that Asian companies, which are comparatively more cash-rich than their U.S. and European counterparts, will be seen on the buying end of 2009 M&A transactions. One only need look so far as Nomura’s acquisition of a number of Lehman Brothers’ divisions to recognize how certain Asian corporates are well-poised to exploit the current economic climate to purchase distressed assets at a discount. More recently, speculations that Australia-based ANZ Banking Group Ltd and Asia-focused Standard Chartered have shown an interest in purchasing the Royal Bank of Scotland’s Asian operations provide another such illustration. Partners at some Australian law firms are expecting a significant increase in Sino-Australian M&A for 2009, with the weak Aussie dollar and low P/E ratios of ASX-listed firms making Australian companies look like an attractive bargain.

Much of this M&A, however, is likely to be at the mid-market level. 68% of respondents to the Merrill Datasite report expect the attractiveness of mid-market targets to drive M&A in 2009. “Indeed, for Asian respondents in particular, the mid-market is expected to present significant opportunities,” the report added. Furthermore, more than half of Asia’s leading companies predict involvement in at least one M&A deal in 2009, more than any other region, according to a January global executive survey by the Economist Intelligence Unit. Investment bankers in Asia echo this sentiment, as they predict the activation of a long pipeline of M&A deals involving acquisitive, deep-pocketed Asian companies seeking to purchase struggling companies in the West. “Companies in financial distress, either because of fixed capital expenditure commitments or an inability to secure refinancing, will be a new source of opportunity for acquisitive Asian companies,” said Kalpana Desai, head of M&A Asia-Pacific for Merrill Lynch. According to the survey “Asia Pacific’s New Corporate Landscape: Asian Outbound M&A” published in January 2009 by KPMG, executives in Asia-Pacific regions believe that 2009 has the potential to see increased M&A activity in the region, with East Asian executives being the most bullish. Respondents to the survey believed that China companies would overwhelmingly be the most acquisitive in 2009 for Asian targets, and that Japan would be the region’s leader for acquiring businesses outside Asia.


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