[Ride the Tide] PE Institutions: Which Course to Take amid the “L-Shape” Economy?


[Ride the Tide] Focusing on major macro-economic development trends at home and abroad, sharing JD Capital’s insights from its participation in China’s economy.

[Sharer] Research Institute of JD Capital: Focusing on studies of corporate strategies and macro strategies, and continuously following the development trends of macro-economic policies and the capital market.

This is first report of Chinese Economy and JD Capital’s Strategy in the New Normal: Overview

One third of the year of 2016 has passed. The market has been affected by the economic and financial data published recently and the opinions from senior officials regarding economic development trends. Judgment from senior officials indicates that the unexpectedly strong economic recovery in Q1 was far from being normal, and the decline of high frequency economics and credit data in April further proved that the economy remained in the period of adjustment. On May 9, an interview with an authority published on People’s Daily explicitly pointed out that China’s economic development trend shall resemble an “L-shape” rather than a “U-shape” or “V-shape”, which reaffirmed the fundamental judgment of senior officials that before 2020, the economic growth rate may demonstrate a “horizontal price movement” between 6% and 7%, with little possibility of exceeding 7% again. Amid the period of economic adjustment, which course should China’s PE institutions take?

The Story of China’s Growth is Far from Ending

Looking back into China’s economic development trend since 2015, the process of de-capacity, de-stocking and de-leveraging continued under the “new normal”, multiple macroeconomic indicators significantly declined under the joint impact of tendency and periodic factors, and China’s economy formally shifted from the “era of 7%+ growth” to the “era of 6%+ growth”. Nonetheless, from a broader time and dimension, the growth speed between 6% to 7% is still relatively high globally, meaning that the story of China’s growth is still far from an end.

In 2015, China’s GDP per capita reached RMB 49,351 yuan (approx. USD 7,880). A review of the development process of major economies around China shows that most of them were still in high-speed growth when their GDP per capita reached the threshold of USD 7,800.

Thanks to the stock market boom in the first half of 2015 and the overall credit expansion throughout the year, the added value of China’s financial sector grew by 15.9%, which generally propelled the economic growth. According to calculations, the growth of China’s economy was 6.2% with the factor of financial sector adjusted., which was roughly equal to that of Korea when their per capita GDP reached USD 7,800, and marginally higher than that of Japan and Taiwan. Hong Kong and Singapore, both as municipal economies, enjoyed relatively higher growth when their per capital GDP exceeded USD 7,800. As a matter of fact, the economic performance of major Chinese cities at such time point was just similar with that in Hong Kong and Singapore: the real economic growth of the year when per capital GDP in Beijing, Shanghai, Guangzhou and Shenzhen exceeded USD 7,800 was 9%, 9.7%, 14.5% and 15.0% respectively. In other words, for mainland China as a whole, its economic growth when its per capital GDP exceeded USD 7,800 was no lower than Japan, South Korea and Taiwan in East Asia, and the same applied to major cities in mainland China as compared with Hong Kong and Singapore at this critical point. It is thus reasonable to estimate that the inertia of economic growth in mainland China shall remain relatively strong in the years to follow.

As a major economy, China enjoys a huge growth potential, though some regions are fundamentally weaker. Compared with economies like Japan based on relatively pessimistic estimations, China is still probable to ensure that its per capita GDP exceeds USD 15,000 within the next 20 years and remains stable between USD 10,000 to 12,000 in 10 years. This round of residents’ income growth shall bring about continuous consumption upgrading, with household savings continuing to serve as a pillar for investment growth. While the physical production capacity of many heavy industry products in China reached its limit around 2011 and has been on a decline recently, taking into comprehensive consideration of heavy industry, light industry and service industry, the rapid growth of individual consumption, especially service consumption, is still to come in the next 10 years. The period from China’s entrance into the WTO in 2001 to the double dip in 2012 truly deserves to be entitled the “Golden Decade” of China’s economy; while after 2013, China’s economy shifted from high-speed growth (apparently over 7% per year) to medium-high speed growth (5%-7% per year). Despite clearly divergent anticipations about the growth speed, we may argue that it is completely realistic for China’s economy to maintain an average annual growth of over 5%. In this sense, even if the era we are living in is not paved with gold, it still deserves to be called a “Silver Age”.

Consumption Upgrading Leads to Economic Transition

China’s economy is undergoing profound changes. In 2015, the contribution rate of final consumption expenditure to the growth of GDP increased from 51.6% to 66.4%, 15.4% higher than that of 2014. The growth of total retail sales volume of consumer goods maintained relatively stable, increasing by 10.6% in 2015, roughly at the same level with previous years. Meanwhile, the actual GDP growth showed a steep decline.

Changes are taking place in the previous “high-saving and high-investment” model driving China’s economic growth. The “post-80s” and “post-90s” generations, more reluctant to save than previous generation who has been through times of material deprivation, gradually became main consumers. With the transition of consumption mentality in the whole society, the structure of China’s consumption market turned from an emphasis on physical goods to both physical goods and services. New growth areas emerged in every aspect of basic necessities of life, with consumption in tourism, movie & television, entertainment and leisure growing rapidly, and the weight of medium and high-end consumption increasing in all sub-fields. These trends bring PE institutions with new investment opportunities. And the sub-field leading companies are expected to attain leapfrog development. JD Capital also plans to act to this trend and work, boost the development of leading enterprises and share in their growth benefits.

Corresponding with the consumption upgrading led by the young and middle-aged, population aging also has promoted the sound development of certain industries. Consumption needs in medical care and elderly care witnessed a steady growth, and the demand structure also evolved towards the higher end. An increasing number of people are no longer satisfied with basic needs, and start to pursue more comfortable and improved services, which creates broad development prospects for relevant markets.

Together with the population structure adjustment comes the consumption upgrading of medium-term education and baby products. Faced with a relatively low overall fertility rate, parents are investing an increasingly amount of capital on child education, which contributes to a broad space for the development of diversified and differentiated private education programs. Besides, as the Central Party Committee has formally decided at the fifth plenary session of the 18th Central Committee to give universal permit to second child bearing, the fertility rate may rebound accordingly and thus stimulate the market demand of baby products in the years to come.

On this account, new consumption needs and growth areas are being fostered by all people, including the young and middle-aged, the elderly, school-age adolescents and preschool children. This shall become the key stand for the overall stability of China’s economy in an expected period in the future.

Systematic and Institutional Reform Brings About New Vitality

The period before 2020 is expected to be the crucial stage for comprehensive reform deepening. The core of the new-round reform is to effectively transform government functions and substantialize market’s decisive role in resource allocation.

In this round of reform, crucial opportunities for PE institutions shall emerge in at least the following aspects:

First, governments’ self-renovation focusing on streamlining administration and delegating powers provides a favorable business environment for enterprises and significantly vitalizes innovation and entrepreneurship in the whole society, which also creates a sound social environment for equity investment, especially VC investment.

Second, the reform and development of the capital market itself brings about crucial opportunities for PE institutions. The general trend of an increasing proportion of direct financing will stay unchanged; the trend of lowering thresholds for enterprises listed on the main board or NEEQ will continue; and the withdrawal channels for PE institutions shall be more diversified and convenient. Progress in the M&A market reform shall provide convenience for M&A of public companies by PE institutions, and PE institutions may be more deeply involved in the M&A of leading enterprises as countries with mature market economies.

Third, the progress of mixed ownership economy reform enables private capital to join in the mass state-owned assets. The improvement of management structure and administrative efficiency of state-owned enterprises shall benefit all parties involved. PE institutions, however, may become a major force of this progress.

Fourth, the transition of local government financing methods and industrial guidance models provides new room for social capital. The previous high-liability and high-leverage operational mode of local governments has accumulated relatively high risks, and government-enterprise cooperation models such as PPP are becoming maturer and gaining momentum. The investment incentive mode simply reliant on fiscal and tax incentives is also changing in that local governments are increasingly active in setting up various kinds of industrial investment funds, taking the initiative in guiding industrial structures and sharing the potential benefits of high-growth enterprises. PE institutions deeply involved in these industrial funds may gain support from local governments in areas of both funds and projects.

The period of economic adjustment is both a challenge and an opportunity for PE institutions. Nevertheless, generally speaking, opportunities outweigh challenges. The strategic deployment in the current period of China’s economic adjustment shall generate considerable profit towards the completion of economic transition and institutional reform.