China's rainy-day cash

Last month, this column highlighted the exploding of the decoupling myth. On one level, the theory of decoupling implied that the increasing volume of trade between emerging markets, together with the growth of domestic consumption within their borders, would enable them to be insulated from the worst effects of a global downturn. For private equity practitioners in the emerging markets of Asia, for example, this would be good news and enable them to carry on business largely as normal by continuing to exploit their countries' burgeoning consumer demand and economic growth rates.

Things haven't quite panned out that way, and the reasons for this were explored by a number of speakers at the recent Emerging Markets Private Equity Forum in London, hosted by PEI and the Emerging Markets Private Equity Association (EMPEA). They noted a number of ways in which the recession that had its roots in the US subprime collapse has ended up having a nasty impact on the developing world. Most obviously, perhaps, it caused stock markets to fall steeply and, in the process, cease to be a viable exit route for private equity firms. This is crucial in some emerging markets where IPOs are at least as likely an event as a trade sale, if not more so.

There have been other troubling knock-on effects for emerging markets private equity firms. For example, new deal activity has been affected by company owners' unwillingness to recognise that new valuation paradigms now apply. Infrastructure projects, a major source of deal flow in many emerging markets, continue to be hamstrung by lack of access to debt. Meanwhile emerging markets fundraising has been damaged not just by the denominator effect but also by a “flight to safety” on the part ofWestern limited partner groups concerned that the risk of emerging markets is simply too high in an environment like today's (spot the irony).

These are all factors already becoming apparent, even before consideration is given to future problems that may be lurking around the corner. Economic volatility has in the past had an unfortunate tendency to occasionally segue into political instability in emerging markets. “Who's the next Suharto?” was a rhetorical question posed from the Forum's stage by keynote speaker Bill Emmott, former editor of the Economist. In addition, concern was raised about the level of experience in emerging markets. Severe downturns are not a new phenomenon but in emerging markets many fresh-faced GP team members may be seeing such conditions for the first time. Will they be up to the task of safely steering portfolio companies through choppy waters?

And yet, for all this, the mood at the Forum was relatively upbeat. Indeed, the word “relatively”was often heard. Yes, testing times for emerging markets private equity lie ahead but these markets' performance relative to developed markets should in theory be impressive. As one speaker suggested: “If we get it right over the next two or three years and achieve out performance, hesitant LPs will finally accept that they need to make emerging markets a key part of their portfolios.”

Furthermore, there is one development which at least partially vindicates the notion of decoupling. Some emerging markets, most notably China, have accumulated current account surpluses and vast foreign reserves which they have not enjoyed during previous downturns and which can now be deployed to bolster their economies with various fiscal stimuli.

This is the reason why, as many developed countries around the world contemplate the prospect of sliding into recession while some indebted developing countries seek IMF bailouts, China is still confident of achieving a healthy GDP growth rate of at least eight percent next year.

And it's also part of the reason why China's private equity market appears to be in a particularly strong position for the years ahead. Consider, for example, the swift action taken by the Chinese government to ease lending restrictions and also the recent announcement to boost state spending on infrastructure projects by an additional $293 billion over the next three to five years (source: South China Morning Post) – such measures are bound to produce benefits for private equity firms operating in the country in the period ahead.

If not decoupled exactly, China's economy at least has some highly favourable and distinctive characteristics. In the eyes of private equity firms, the global financial crisis is unlikely to change their perception of China as a country rich with opportunity.