New Twists in External and Internal Developments as Downward Pressure Further Develops

1The Macro Economy and Finance

Overall, July has not seen the same improvements in economic data as June did. Housing measures were tightened while external volatilities increased. Supply and demand sides both weakened again, putting more severe pressure on the real economy.

Industrial output did not continue the upward trend from June. As manufacturing growth slowed down to a crawl, companies actively reduced inventory and only passively replenished stock, with no proactive motivation to build up inventory. 

Fixed assets investments did not continue June’s upward trend either. Instead, they fell off a cliff. Among those, real estate investments dropped significantly, while infrastructure investment growth slowed again. Investments in the manufacturing sector, however, benefited from reduced taxes and fees, favorable industrial policies, as well as the results of import substitution strategy on certain high-tech manufacturing sectors, and kept its rebound from a low point. Although this is a stage that structural reform of the economy must go through, manufacturing is a relatively small sector while the decrease in real estate investment puts considerable pressure on fixed asset investments as a whole. We are closely watching changes in real estate financing situation and in particular, the risk of capital chain rupture among mid-sized and small real estate enterprises in this process.

Internally, consumer demand growth in July also slowed down. As a matter of fact, auto sales supported the consumer demand in the two previous months. As favorable policies ended, downward sales pressure resumed. Considering the worsening employment situation and the disappearing effect on wealth from real estate and stock markets, second half consumer demand is facing enormous pressure, and policy adjustments have not had visible effect on consumption. 

As China seems actively altering its trade destinations to EU and elsewhere, China's export achieved an obvious improvement. Nevertheless at the same time, import growth was still muted and lagged behind export growth from the same period. As a result, the recessionary trade surplus further expanded. We believe the depreciation of the Renminbi and the overseas interest rates cut could provide certain growth room for export moving forward. However, trade disputes will bring uncertainty and new volatility. Based on our estimates, if the US continues increasing its tariff, second half export could slip further by 3 percentage points, with limited impact on GDP. 

On the financing side, targeted local government debt issuance and SSE Star Market boosted the direct financings in July, but the lendings on bank’s Balance Sheets plummeted, causing a significant drop in overall social financing. As a result, credit growth decreased from 10.9% in June to 10.7% in July. Although still at a high level in 2019, the trend is concerning. As the US-China trade talks go through twists and turns, volatility increase and sentiments shift toward the risk-averse side. Demand for financing is slowing down with similar consequence for actual lending growth. Meanwhile, private and small enterprises face increased difficulties in financing and credit.

The Renminbi went through a rough patch, with its exchange rate breaking through 7 as the trade war went on in August. However, as the US recession risk increased and the US-China interest spread at 130 basis points, the RMB exchange rate remains resilient. On the other hand, if the situation further worsens, under a pessimistic scenario, the exchange rate could be pressured again.

2Private Equity Investments

In the first half of 2019, private equity investments extended the downward trend from last year. Institutions including China Venture and Zero2IPO Group issued H1 reports with different figures because of their individual angles, but the significantly downward trend was clear. In July, equity fund raising decreased again, with the monthly figure hitting a new low for the year. Wind data shows 127.3 billion raised from January to July, a 86% drop compared to the same period last year. The overall market is still chilling. SSE Start Market has seen active trading and the addition of an exit option, but it has not been as an immediate boost as expected at the beginning of the year.

On the investment side, there were 49.36 billion new investments, a 4.22 billion increase from last month but a 140.1 billion decrease from the same period last year. As a result, January-July investments dropped 57% compared to same period last year. The difference between the amount raised and invested dropped to a new low point of less than 10%. Dry powder is further drying up. Direction-wise, investments in July further focused on information technology, which took up 64% of the total. Finance, medtech, and industrials followed.

On the exit side, private equity sector saw 1.78 billion funds exiting in July, a 2.73 billion decrease from last month and 10.55 billion decrease from same period last year. Total exits from January to July totaled 157.87 billion, a 164% increase from same period last year. In fact, IPO approval rates in Shenzhen and Shanghai markets have seen a decrease from their high points for two months in a row, and the market cap to net asset ratio in smaller and tech boards hovered around the mid-point of 2018. It is obvious that the climate for private equity exits was not all favorable. As a result, pressure to exit is driving sector integration, generating M&A demands as a path for exit. 60% of exits in July were through M&A while January-July data shows M&A has been the mainstream method for this year.

An additional note is that the new developments in US-China relations is going to have a long term effect on the private equity market. Even if further trade talks produces positive results, the overall conflict between the two countries cannot be reversed. In the worst scenario, the possibility of a parallel system, led by US and China, cannot be ruled out. We expect the conflict to be a seesaw one that goes back and forth, with unfavorable effect on the private equity market. However, every crisis brings new opportunities. In particular, 

On the fund raising side, it might 1) increase market volatility and erode confidence; 2) affect USD fund raising as the willingness of US firms to invest in China is weakened; 3) the loosened restrictions on foreign investments will make overseas fund raising easier.

On the investment side, the short term effects are: 1) fundamentals will be broadly under pressure. Intrinsic profit generating capability of the companies will be lagging, leading to a decrease in quality investment targets; 2) regulations on key technological sector investments are tightened, making cross-border investment more difficult; 3) ODI investments face more approval uncertainty with pressure from the shrinking foreign reserve; 4) investors become more risk-averse and slow down their pace. On the long term, 1) demand for outbound investment will continue to increase; 2) the trade war will force import substitutions, creating investment opportunities. 3) foreign investors still value China as an investment destination and competition could intensify as China opens up more; 4) the Belt and Road Initiative can bring new development opportunities.

Finally, from the exit end, investment targets might be facing slipping results, weakened capability for debt repayments, fluctuations in valuation, worse financing expectations, extended IPO schedule, as well as other uncertainties in the short term, over the long term, the need for US and China for each other will still exist and the upgrading of Chinese industrial structure cannot be stopped. Domestic innovation will be supported by government policies, paving a smoother way for companies to go public and investors to exit.