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Don't underestimate China's economy

The steady drumbeat of news of China’s macro-economic slowdown has continued, taking Chinese equity markets down seemingly with each headline.  Meanwhile, the US stock markets have been hit hard in sympathy, with investors clearly worried about the impact a slowdown in China may have on the global economy.  With this tumult, we’ve seen a chorus of negative sentiment from leading Silicon Valley voices regarding China.

Clearly all is not perfectly well in China right now, but its important to keep China’s economic growth in perspective.  China’s 2015 GDP is estimated at over $11 trillion (in US dollars), over twice as much as both Japan and Germany and closing in on the US, with over 7% annual growth.  The world has never witnessed this rate of growth for an economy so large.  At GGV Capital, we remain excited by the prospects for China’s new economy, both shorter and longer term, and we believe investors will be rewarded for staying patient and doubling down as the less committed capital fleas the market.  Consider the following:

New economy versus old economy

Outsiders find it difficult to fathom how quickly China has emerged as a modern, economic powerhouse.  The immense Chinese economy we know today has grown out of trends and local reforms that are barely 30 years old.  The past 150 years of development in the US have essentially occurred 5x faster in China.  And, because China’s economic development has occurred more recently, its growth has been infused with much more modern technology than is the case in the US.

As my GGV Capital partner Hans Tung recently mentioned on CNBC, one consequence of the rapid, technology-heavy development cycle in China is a bifurcation between traditional, “old economy” companies, many of which are SOEs (state-owned enterprises) that trade publicly on China’s local exchanges, and “new economy” mobile and internet companies.  As a result, the dichotomy we see in the US between slow growing, declining industries such as durables manufacturing or brick & mortar retail, and rapidly growing, tech-enabled segments such as sharing economy and mobile, on-demand companies is even more pronounced in China.  While old economy industries in China are slowing, the growth in new economy industries remains vibrant.  As we see in many of our own Chinese portfolio companies, new economy models are flourishing in industries such as retail, exports, travel, real estate, food and auto.  Apple is flourishing in China.  Software is eating China, as it is in the US.

Much of the growing middle and upper class in China is employed by new economy companies and increasing consumption of new economy goods and services is driven by this group as well.  Macro-economic factors are certainly important, but the micro-economic dynamics of the new economy in China are profound.  As I’ve written earlier, because public stocks are not widely held in China, the recent declines in local stock indices is hurting a relatively small percent of the Chinese population.  As long as the Chinese consumer stays in the game, the new economy in China will continue to flourish.

There’s no denying that investor sentiment is broadly negative regarding China.  Most of those with whom I’ve spoken in the tech hedge fund business are bearish on China and have sold out of their positions in the ADRs of Chinese companies.  As a result, prices have plummeted.  For example, the BNY China Select ADR Index is down a full 16% year-to-date.

While Warren Buffett preaches to be fearful when others are greedy, he’s also famous for the other side of this saying: “be greedy when others are fearful.”  When looking at the largest Chinese ADRs, this strategy has paid off handsomely in the past. Over the past decade, investors in a basket of Baidu, Tencent and Ctrip are up about 14x, but have had to endure three steep drops during this time period of 88%, 49% and the recent 32%.  Re-loading on these dips has only served to improve IRR in the past.

Of course, its possible that this time will be different, that these ADRs will not recover and continue to underperform.  However one might handicap this scenario, an intriguing element of this chart is that there doesn’t seem to be much correlation between the state of these Chinese ADRs and the timing of the founding of China’s recent spate of leading tech companies.

Whether now is the right time to jump back in with China ADR investments or not, the next breed of leading new economy companies in China may be born at any time.  Anyone pulling out of the China market now risks missing seeing the next Alibaba, Baidu or Tencent.

Growing convergence

The Chinese and US economies are the two largest in the world.  GGV was founded in 2000 on the premise that these two juggernauts would experience increasing convergence.  We’ve seen convergence gain momentum over the past several years in areas such as mobile, on demand services and connected devices, to name a few.

The largest Chinese tech companies such as Tencent and Alibaba have been busy investing in and acquiring startups in the US and beyond.  Their aspirations clearly extend beyond China.  The US is a prime target for Chinese companies, but not the only market of interest.  In fact, Xiaomi has been aggressively pursuing growth in India and Brazil, promoting its Chinese born products and brand in these key emerging markets.

Similarly, China represents Apple’s largest market, and Tim Cook recently famously re-asserted to CNBC’s Jim Cramer in a note that Apple’s China business has “continued to experience strong growth…through July and August.”  Meanwhile, Uber has asserted that China is their fastest growing market and just raised $1.2 billion for its China effort.  AirBnB has recently announced its intention to increase its presence in China, hiring local leadership, and, per The Information, Google is also reportedly planning to re-enter China after a five year hiatus, launching a Chinese version of the Play Store soon.

As Chinese companies extend beyond its borders and its society becomes increasingly intertwined with global tech players, the idea that the Chinese market is an island becomes less and less relevant.  China is part of the global economy and its fortunes are likely to rise and fall with global economic factors.

Chinese government is all in

Beijing has been a target of naysayers lately.  Onlookers see the moves that the CSRC (China’s SEC) and other government agencies have been making to stabilize its stock market with a measure of suspicion and an indication of desperation.

This is a mistake.  The Chinese government has created the environment for an incredible 30+ years of economic growth, helping lift several hundred million people out of poverty, creating a thriving and growing Chinese middle class.  Its this middle class that represent the new economy.  The Chinese government understands this and will continue to implement growth oriented policies to drive urbanization and a growing middle class.  The government’s resources are substantial, and I’d expect success from these efforts.


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