Five years out from the global financial crisis, the developed world seems to be recovering, albeit precariously, while bears have now turned their focus to emerging markets and particularly to China, the second largest economy in the world. The financial system in most parts of Asia pulled through the crisis intact, but there has been deterioration in asset quality. Many Asian banks have undertaken a large increase in lending, driven by quantitative easing, which has caused money to flood the system. It is the Chinese financial system that is probably the most in need of reform and, clearly, the implications there carry the most relevance for the global economy. As these structural changes get underway, we anticipate a myriad of opportunities for hedge funds.
Current State of “Big Four”
The balance sheets of the “big four” Chinese state owned banks [Industrial and Commercial Bank of China, Bank of China, China Construction Bank and Agricultural Bank of China] have expanded significantly in part because of the quantitative easing-induced, post-crisis lending splurge. To date, a very low level of non-performing loans has been reported, though markets have turned a skeptical eye on these reports. As the private sector has developed and with the big four banks’ focus on State Owned Enterprises (SOE), an increasing amount of lending has taken place in the shadow banking system. In particular, there has been a significant increase in Wealth Management Products (WMP), which are largely non-guaranteed, backed by loans of differing tenor and sold by financial intermediaries as well as banks. The shadow banking system also includes trust products of similar provenance and local government financing vehicles, which have funded much of the real estate development across China. The depth and breadth of the shadow banking system is emblematic, in our view, of signs of both excess in lending across the system and the frustration that the present system is causing both for borrowers and depositors.
The Way Forward for Chinese Banks?
The new Chinese government, under Premier Li Keqiang, seems to have grasped the need to address challenges in the financial system. Interest rates are already being somewhat deregulated and securities markets are being developed (e.g., short selling in stocks is being expanded while government bond futures are being reintroduced after nearly two decades). Two of the asset management companies (AMCs) that were formed as part of the banking system bail-out in the 1990s – Cinda and Huarong – are now preparing to be listed in Hong Kong. Some market participants view this as a signal that the AMCs are raising capital to address a potentially large rise in the number of non-performing loans. Additional AMCs are being founded on a regional basis. In addition, a free trade zone is being set up in Shanghai that may potentially circumvent the current regime of capital controls. Additional reforms are expected to emerge slowly from the recent plenary session of the Communist Party’s central committee in Beijing.
We expect the Chinese financial system to undergo a fundamental structural change in the next few years. Interest rates will likely be further deregulated, banks will become somewhat disintermediated, a corporate debt market will grow in China, and, eventually, the capital account will open. While many bulls point to the strength of the government coffers, there is no doubt these changes have to happen to help solve the wasteful resource misallocations occurring in China today. The transition period offers many opportunities for hedge funds looking at the region. With so many economies across the region dependent on Chinese demand (or supply), it is likely that many regional financial systems will be impacted by the Chinese transition, both by changes in rates and stress to their systems. Interestingly, if the transition in the Chinese financial system is forced by a crisis (as many US commentators believe) rather than doled out in measured steps by the Chinese government, the environment may be even more conducive to hedge fund strategies.
Opportunities for Hedge Funds
While the timing of the Chinese structural changes is uncertain we see interesting opportunities for hedge funds both in the near and medium term.
Near-term opportunities, particularly for periods of stress:
- Long/Short Equity: Dispersion in the Chinese market lends itself to bottom-up security selection and liberalization of access to capital should bolster the performance of Chinese firms and force the SOE’s to reassess their business models. Other firms in the region, including customers, suppliers, and competitors, will likely be impacted as well. The opening up of Chinese equity markets and more participation in the Qualified Foreign Institutional Investor quota, as well as a more open capital account should also create more discipline around valuations.
- Event-Driven Investments: Whether the changes in the system are forced on by a crisis or otherwise directed, there will undoubtedly be an increase in corporate events – particularly IPOs and placements, and potentially even more M&A.
On a longer-term view the hedge fund opportunities should further expand:
- Long/Short Credit: The exponential growth that has taken place in Asian credit markets over the past decade should continue as banks are increasingly disintermediated. With the growth of the Asian institutional investor base and the lessening of dependence on overseas players, as well as the increasing ability to short through repos and CDS, credit markets are developing. Dispersion should increase given the changes expected in the financial system. Opportunities should exist not just offshore but onshore too as the domestic corporate and muni bond market develop further and foreign capital is allowed access.
- Distressed: Asian distressed debt has traditionally revolved around opaque deals. The expected changes to the financial system in China will likely require a more robust workout framework if developed market capital is to be attracted to the region. The listing of the AMCs in Hong Kong could help trigger this.
- Rates and currencies: While it is unlikely that the capital account will open in the short term, the growth of the overseas RMB markets and the creation of free trade zones is likely to contribute to increased speculation on the currency. Similarly, there are likely to be great opportunities as interest rate markets are deregulated. Given that many of the regional currencies are referenced to baskets including the RMB and many of the economies are dependent on Chinese trade, opportunities should arise.
The opportunities in Asia in both the short and medium terms will undoubtedly be driven by the changes in China and its financial and economic model. In some ways the slowing of the Chinese economy and the effects of changes in developed market quantitative easing policies should accelerate these changes and lead to an ideal environment for hedge funds set up to capture these opportunities, which at an alpha level should be largely uncorrelated with markets.
David Walter is a Director in PAAMCO’s Portfolio Management Group based in the firm’s Singapore office. He is responsible for Asian-focused hedge fund investments and acts as Head of Research for Asia and Sector Specialist for the Pan Asia Portfolio Solutions funds. Prior to joining PAAMCO, David performed a similar role for KBC Alpha Asset Management. Before KBC, he co-founded Arbiter Fund Managers, where he established and managed a dedicated Japanese long/short equity fund. Previously, David worked in London at Oxford Capital Markets, establishing and running a Japan-focused multi-strategy fund. Prior to that, he was Head of Japanese Equity Product at Sanwa International Securities. David began his professional career in 1986 at Barings Far East Securities, where he was employed as a Japanese convertible and warrant trader. He has twenty-seven years of investment experience. David is currently a member of the AIMA Singapore Executive Committee. David graduated from Christ Church, Oxford, with an MA (Honours) in Modern History.
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