[Note: below is Chapter 5 from Great Wall of Numbers]
Since Deng Xiaoping’s “Southern tour” in 1992, China has consistently been one of the top recipients of foreign direct investment (FDI), totaling $85 billion in 2010 and $574 billion overall. In contrast, up until recently the US still led in both annually received FDI ($194 billion in 2010) and $2.58 trillion overall. Even though its full year FDI received fell from the year before – a decline that continued through February 2013 – in the first half of 2012 China actually overtook the US for received FDI ($59.1 billion versus $57.4 billion).
And while US firms and institutions currently invest more FDI within China than Chinese firms invest in the US (in 2011, Chinese companies invested $6.3 billion in the US representing 0.15% of total foreign investment in the US) this will probably change – despite a closed capital account (discussed in Chapter 10). For example, among other deals, a Chinese firm was recently granted approval in December 2012 to purchase bankrupt Massachusetts-based battery maker A123 Systems for $256.6 million. As a consequence Chinese outbound investment in 2012 such as mergers and acquisitions reached $8 billion for the first time in the US, globally increased to $93.09 billion (compared to $13.58 billion in 2007) and its outbound direct investment (ODI) is expected to reach $150 billion by 2015 due to deals such as A123 Systems. One example of continued investment is from ENN Group, one of the largest private companies in China. Through a joint venture with CH4, a Utah-based energy company, ENN plans to open a network of 50 natural gas stations across the US this year. Each station costs about $1 million to build and the joint venture has a goal of building 500 stations altogether. For comparison, the EU collectively receives twice as much FDI from China than the US currently does (due in part to political trepidation).
Where are the potential investments that Chinese firms have looked at in the US? For example, during the build-out of the enormous Haynesville natural gas fields in the Texarkana region, one of the investors courted by local energy companies was CNOOC (the 3rd largest oil company in China), which at the time reportedly wanted to invest $750 billion into the North American energy business. It is unclear as to how much they did end up investing (or if they returned a profit) but several Chinese energy companies have now moved up to Canada and invested $3 billion in a new pipeline project in the tar sands as well as put together a “$15.1 billion deal to acquire Nexen.” In February 2013 the deal closed marking the completion of the largest overseas acquisition by a Chinese company. And depending on regulatory conditions North American energy firms may or may not continue to do business with Chinese firms, yet there is one area that foreign experts can provide inside of China right now.
So what opportunities are there for foreign financial professionals?
While it has become almost cliché to say, finance is one of the industries that is undergoing “reform and opening up.” This involves building institutions, physical infrastructure and a legal structure – all of which is thoroughly discussed in both Mark DeWeaver’s new book as well as a Brookings Institute report in June 2012. Yet reforms in general are always just around the corner.
For example, because of pent up savings due to relatively few investment vehicle choices on the mainland, once larger liberalizations begin, there will be opportunities that can come from not just asset management and private equity (PE) markets but through the large expertise requirements in the relevant fields that currently do not exist (e.g., debt structuring). As part of the once-in-a-decade leadership transition that began in November 2012, one expectation was and is that there will be a “big bang” of reforms in the coming months. One immediate, visible reform was the creation of super-ministries referred throughout this book (e.g., Ministry of Health dissolving to become National Health and Family Planning Commission). Another case in point, on November 19, 2012 the State Administration of Foreign Exchange (SAFE) announced that it “ended 35 foreign-exchange approval rules and simplified others.” By reducing paperwork and shortening approval processes, such liberalizations are done with the intention of attracting FDI. On December 12, 2012 the Shanghai stock index surged to its highest daily gains since October 2009 due to policy changes in the Qualified Foreign Institutional Investor program (QFII合格境外機構投资者). As a consequence sovereign wealth funds such as Qatar Holdings and central banks are now allowed to raise more than the $1 billion previously permitted for investing in the securities market.
Another instance is on December 17, 2012, where a number of new liberalizations were implemented such as reducing regulatory approval and remittance of profits for foreign-owned companies. Continuing this trend, on February 28, 2013, the government expanded its short-selling program which will now enable select brokerages to borrow shares from preapproved publicly traded companies. And on March 15, the China Securities Regulator Commission announced that effective immediately, brokerages could convert loans and other assets into securities, paving the way for securitized business. On a provincial level, financier Harry Ding (see below) explained to me, that pilot regions throughout China are also enacting reforms to make it easier for entrepreneurs to begin operating. Shenzhen and Zhuhai in Guangdong announced that effective March 1st they have streamlined 18 different business licenses, created a new version of business licenses which no longer requires lengthy documentation procedures and removed some of the registered capital restrictions.
Another specific area you and your firm may be able to literally capitalize on shortly is building a local bond market in structured debt. Over the past several years there have been attempts to roll out local government bond markets on the mainland. In November 2011, Shanghai issued China’s first local bond issuance yet eight months later, all of the programs were scrapped. Yet a year later, in November 2012, the China Securities Regulatory Commission (CSRC) approved a plan from ICBC (the largest commercial bank in China and in the world) to start a pilot program of selling bonds known as asset-backed securities (ASB) beginning in 6 months. The local market of this local debt, based on several estimates of over 10,000 local-government financing vehicles (entities that were set up to bypass these kinds of bans) is between $1.7 trillion and perhaps up to $5.4 trillion, which I discuss later in Chapter 17.
Foreign firms specializing in managing distressed loans have already capitalized on opportunities on the mainland (with mixed results), including Shoreline Capital Management who raised $300 million for a new fund last year specifically to invest in distressed Chinese debt. DAC Capital is also in the process of raising $300 million for a new Chinese-focused fund. The gamble is while investors in such debt may receive returns if and when a borrower repays portions of the loan, local government policies and a nebulous court system can make returns lower than they would have otherwise would have been (e.g., transaction costs and opportunity costs).
In October 2012 I spoke with Shawn Mesaros, CEO of Pamria an asset management firm located in the financial district in downtown Shanghai. Despite these setbacks above, in his view SOE banks will “eventually become facilitators, that they will offload debt which can then be restructured. As a consequence there will then be a bigger market for sovereign debt.” In addition, even though public capital (through SOEs) is currently cheaper than private capital Mesaros thinks that private equity (PE) is still a relatively good business, “it is not as easy as you think because domestic companies typically would rather not share equity in exchange for your capital.” For perspective, according to the consultancy Bain, “the total value of mainland private equity investments jumped from US$3.7 billion in 2005 to US$15.2 billion in 2011.” And nearly $230 billion worth of deals were collectively completed between 2001 and 2012.
Yet to give you an idea of the soft PE market today in China, according to a recent report from the Wall Street Journal, both foreign and domestic PE firms have been struggling over the past two years. The value of PE deals in 2012 declined 27% to $21.9 billion in part because of the domestic stock market performance. Between 2010 and 2012 the Shanghai Stock market declined roughly 37%. Fortunes however, may continue to fluctuate in the future as the main benchmark index regained about 9% in the first six weeks of 2013 then lost 7% over the following month through mid-March. However because many investors cash-out of their positions through the securities exchange, fewer firms have wanted to go public.
Subsequently, private-equity firms which provide this junction have been affected as well. In fact, in 2012 there was a 70% drop in initial public offerings (IPOs) – in the first half of 2012 alone there was a 37% drop in IPOs, from 218 during the same time last year to 138. PE deals as a whole “fell an unprecedented” 43% last year. Furthermore, of the 10,000 PE deals conducted between 2001 and 2012, 7,500 remain “unexited” as the firms cannot go public on Chinese exchanges. And whereas PE firms in China raised 75 yuan-denominated funds in 2011 and raised another 52 yuan-denominated funds last year, only 2 new funds have been raised in 2013 (both focused on real-estate investment). This is in part because there has been an across the board red light from Chinese regulators since last summer (as of January 31, 2013, a record 873 companies have filed for IPOs in China yet have to wait) and Chinese firms trying to list on American credit markets are essentially persona non grata due to regulatory oversight from the SEC and disagreements with Chinese auditing regulators.
However despite these drops, there is still an active set of foreign and domestic PE activity, including Jiuding (the top domestic PE firm) who has averaged an internal rate of return of 30% since 2010 (an IRR is one gauge of how profitable investments are). Furthermore, this “softness” in the PE market may have a silver lining as well. For example, according to Peter Plakidis of Deutsche Bank, “[a] softer equities capital market has meant that private equity is not competing as much with public money, and depressed public valuations have improved the returns for private-equity firms. Hence, private-equity firms now have more companies on their radars as attractive investment opportunities.”
In addition to PE, according to Mesaros, one large SOE bank on the mainland is already filling an office floor just for fixed-equity investments. And if they are doing it, then perhaps other SOEs are close behind. What this means to Mesaros is that eventually the big spreads “that can roll over price takers will become smaller.” This also means that there is potential for foreign experts in this field to also train and get involved at a variety of levels within the periphery of this investment field.
And in both the long and short-term, irrespective of growth trends on the macro side (which I discuss in later chapters), expertise in these two areas is in short supply. At the same time, as noted above one challenge in this type of training is retention. I was told by an another American source that a very large US bank (top 3) has trained numerous local financial experts in some of these sub fields (like forfaiting and futures) yet was unable to retain them due to an insatiable demand for such experts at mainland institutions. Or in short, since talented human capital in certain areas is scarce, training may be a risky endeavor.
Natalia Shuman, the new COO of Kelly Services’ in China recently explained the labor supply issues of financial experts in this region,
[…] the lack of supply and high demand is reflected in compensation. If you look at Shanghai’s market today it’s not only financial analysts. There are multiple positions and multiple functions where salaries are very competitive compared with global. People are getting the same salary, maybe even higher, particularly in Shanghai and Beijing, compared to New York or London nowadays.
And recruiting local talent for financial positions is also a seller’s market in Shuman’s view “Chinese with Western experience who are coming back here; they could easily get more money here than they would get in New York or London.” Further human resource constraints including retention issues are discussed later in Chapter 15.
For perspective in December 2012 I spoke with a Chinese financial manager at Fosun International (复星国际有限公司) in its Hong Kong corporate subsidiary. Fosun is the largest privately held company in China, generating 25.73 billion RMB ($4.12 billion) in the first half of 2012. According to him, “I have colleagues who have a lot of career experience in the financial industry on the mainland but they currently do not have a competitive edge over their international counterparts when applying for finance positions in Hong Kong or elsewhere. Yet simultaneously, if they want to further their career they would prefer working outside the mainland because both the experience gained and the compensation in the international marketplace is significantly higher than anywhere on the mainland. And since the financial infrastructure and investment instruments in Shanghai still have not reached ‘critical mass’ it is basically more of a regional financial center compared with Hong Kong, which itself is filled with experienced staff in dozens of specialties that do not exist yet on the mainland. Concurrently, because there are more and more banks in China and more and more people that have financial backgrounds and overseas educations they also want to pursue careers in this industry making it very competitive in certain specialties compared with previous years.”
On the other hand, he still sees opportunities as “the mainland industry needs experts to train local people how to work in all areas in this growing market because there are relatively few providers doing it today. Not just in debt markets, M&A, private equity or IPOs, but also in all forms of international trade such as letter of credit, trade finance, arbitrage and export finance. Since there is a lot of overseas businesses that want to do business in China these banks will continually need to hire people capable of not just fulfilling relatively basic financial services today, but also the more advanced investment instruments and complex transactions in the future. And since nearly all of corporate finance on the mainland still depends on bank loans for credit, banks typically provide most finance and capital for nearly all companies. Thus foreign service providers can potentially bring their knowledge to our young industry for a mutually beneficial exchange.”
What are these salaries like? A recent Bloomberg report similarly noted the demand for qualified financial professionals and experts for China, yet also found that managing directors now earn less than they would in the US and roughly “on par with those in Europe and the U.K.” For example, managing directors in Beijing and Hong Kong earned between $900,000 and $1.3 million in salary, bonus and stock options last year – while their counterparts in the US earned $1.2 – 2.01 million and their peers in the UK and Europe earned $850,000 – $1.77 million.
In November 2012 I spoke with Richard Johnsson who was the President & CEO of Soderberg & Partners in Beijing. Soderberg & Partners is an independent financial advisory targeting high-net worth Chinese citizens since 2007. According to Johnsson, “one of the challenges early-on was to establish a business in a field that didn’t exist in China, and few could see the benefits of independent advice. The competition was all about returns, as opposed to for example tax planning; and the commissions were very low. But lately, the industry has expanded very fast. And one of the opportunities is of course that it is highly likely that the tax system and regulatory setup will look more and more like in the West. This will mean complicated tax systems and tax deductions will make planning hard for people, thus driving sales. On the other hand, other parts of government will try to control the industry, driving extensive compliance. But the former will likely come before the latter.” All of the Big Four auditing firms and Big Three management consulting firms have long ago established mainland offices; can your firm provide similar services?
In January 2013 I also spoke with Harry Ding, a native of Guangdong who has worked as a manager in the finance industry on the mainland for the past five years. According to him, “one of the opportunities for activities like day-trading and forex trading is that you do not need to have a PhD in finance to understand and be successful or even profitable in these segments. As a consequence, the companies I have worked with over the past several years usually involves training new college graduates with finance backgrounds how to use econometric models and computing technology to conduct their trades. While there are licensing and training fees as well as a learning curve, in the long-run their relatively lower labor costs usually acts as a profitable form of arbitrage. That is to say, that because they can effectively trade on exchanges like the Toronto Stock Exchange, they are usually several times cheaper to hire and manage than local talent in Canada.” Forex means ‘foreign exchange’ and typically involves the buying, selling and trading of foreign currencies (e.g., JPY, USD, GBP).
Ding also sees a few challenges in that, “because of the numerous restrictions on the financial industry and because of its overall developmental status, there are not as many investment tools and instruments available and those that exist can be difficult to trade profitably at large volumes. As a result, many individuals and institutions have turned to overseas investment. And by virtue of the fact that much of a firm’s activities are conducted overseas, it normally requires investors to transfer money out of China which oftentimes makes domestic clients feel uncertain as their assets are not physically close by, creating a psychological insecure feeling (e.g., uncertainty) especially in recent years as Western countries have had numerous financial scandals that have shaken investor trust and confidence. In addition, China has a capital transfer restriction that strictly prevents citizens from transferring assets to a broker or investment firm outside the mainland over an annual limit of $50,000 USD. Thus any amount beyond that requires other legal ways to process and transact it.” These capital restrictions are discussed in Chapter 11. Furthermore, can you or your company utilize local talent like Ding’s firms have?
Ding’s point regarding a dearth of investment instruments was recently echoed by Nick Yim head of Goldman Sachs China Market. According to Boston Consulting Group, the total value of private investible assets in China reached $12 trillion in 2012 (a 14% increase year over year). Where are these assets? According to Yim, most of his high-network clients only have “have 20% to 30% of the funds parked offshore, the rest remains onshore.” And because of the global financial crisis and relatively slower domestic growth, these clients “have become more conservative and now behave more like U.S. clients.” This means they are looking for safe, conservative lower yield products. While there are a limited number of investment products and a scarcity for seasoned bankers, which he considers to be the two biggest challenges, Yim sees a lot of growth potential due to improving legal and regulatory frameworks. And ultimately, because China also has a single culture, currency, language and regulator, he thinks that there are a lot of opportunities for Western private banks to provide diversification, risk management and retirement planning services in what may become the world’s largest economy in the next decade.
Takeaway: With more than 57 million inbound tourists that spent $48 billion last year, the domestic Chinese tourism industries is one of the largest in the world. Training staff and putting together a brand positioning campaign are just two areas of many that foreign expertise can bring to the growing industry (which may grow from 2 million hotels today, to 5 million in the next four years). In addition, financial service companies may be able to find opportunities to not only to train local financial firms on bond technicalities but also provide ancillary services to fixed-equity investment programs. And in addition to conducting your due diligence it is also recommended that you read through Chapter 10 regarding legal and regulatory risks and uncertainties.