China: 2016, the year of the ‘Fire Monkey’ and structural reform

2016 is the year of the “Fire Monkey” in China, which signifies volatility and change, an appropriate starting point in the process of rebalancing the Chinese economy from investment-led to consumption-led. At the closing of the National People’s Congress in March, 2016, the ‘13th Five Year Plan’ was approved, identifying supply-side reform as a key policy pillar in the short to medium term to rebalance the economy, revive growth and reduce excess capacity in traditional industrial sectors.

Some of the key policy initiatives from the plan included GDP growth targeted at 6.5% to 7%, driven by measures to encourage Innovation in the form of mass entrepreneurship; Fiscal and tax reform: to reduce the overall tax burden on corporations; Modernisation, particularly through the “Made in China 2025” plan to support domestic champions in strategic emerging industries; investment in the Information economy; investment in Infrastructure; and continued support for Urbanisation.

So starting with the growth outlook, while the days of double digit GDP growth may be over and 7% may be the “new normal”, it is important to remember that 7% would equate to RMB5 trillion in incremental GDP in 2016, which is the same as the entire Chinese economy 20 years ago, or the size of the entire Indonesian economy in 2014. So the Chinese “slowdown” needs to be kept in perspective. That said, corporate performance in this environment has been, and will continue to be impacted by over-capacity and the resultant intense competition, and in traditional industry it will be some time before demand catches up with supply. Good news then that the Government has confirmed its support for reducing excess capacity in traditional heavy industries (where state owned enterprises tend to dominate) such as steel and coal mining, and to close down “zombie” firms.

There was also bad news for investors in the form of revisions to proposed capital markets regulation, and the removal of the planned launch of a “strategic emerging industries” board on the Shanghai Stock Exchange. The board’s creation was once widely regarded as an important new listing venue for China’s SMEs, and for more than 30 overseas-listed Chinese TMT companies seeking to delist from abroad and re-list at home. It was also expected to become a testing ground for the planned new registration-based IPO approval process. Domestic capital markets have reacted positively to the news, fearing an inflood of new entrants would divert investment capital from existing trading venues, but by some estimates, as many as 380 companies had already met the listing requirements and were planning to publicly list and raise capital. Such companies will now have to seek alternative routes to access capital.

On FX, China adopts a “Managed Float” policy that is market demand-based with reference to a basket of currencies, dominated by the USD. However maintaining a stable exchange rate alongside monetary easing could be challenging; policymakers are likely to prioritise the goal of a stable exchange rate using FX reserves and de facto capital controls over aggressive monetary easing. In February 2016, China’s FX reserves showed a much narrower decline (US$29bn vs. c.US$100bn in the previous month), consistent with a visible drop in onshore USD/CNY spot trading volume and a more stable RMB exchange rate, indicating relief for China’s capital outflows pressure. Market consensus points to a modest RMB depreciation of c.5% vs. USD with an exchange rate target of 6.80 by the end of 2016.

This is in line with what we see on the ground in China. While we saw tightening de facto capital control measures in late 2015 and extending to the start of 2016, we are now seeing these measures relaxed as pressure on net capital outflow eases. This is especially true when it comes to transactions that support industry consolidation, for example, the acquisition of technology and brands, and is evident in Actis’ recent exit from Plateno Group, a transaction that required the Chinese buyer to pay USD1.35 billion in total.

In common with many of our markets globally, while industrial growth may be constrained and corporate profitability under pressure due to excess capacity and rising labour costs, consumption growth should exceed China’s headline GDP growth by a significant margin. That’s why the recent news that industrial profits for the first two months of 2016 grew at 5% year on year, the fastest growth rate in 18 months, should give the policy makers some breathing space in implementing structural reforms.

While the year-long anti-corruption drive has arguably resulted in a leaner and more efficient bureaucracy, historically the Chinese government is at its effective best when it is under pressure and sees no better alternative. All the signs are pointing to a rapid implementation of overdue structural reforms, benefiting sectors that Actis is focusing on in China: consumption related industries, demographically driven health care, deregulation and technology influenced financial services and an upgraded industrial sector.

And in our existing China portfolio companies, we continue to see signs of consumption growth exceeding GDP. At Bellagio, our casual dining restaurant chain, customer numbers grew by 15% in 2015. Our branded biscuit business Jiashili sold 10% more biscuits in 2015; China Micro-Tech, the largest manufacturer of endoscopic consumables in China sold 15% more sets of medical consumables, and our leading Chinese In Vitro Diagnostics company Chemclin sold over 40 million CLIA tests in 2015, an increase of about 20% over the previous year.