One of the most interesting macroeconomic activities for the year which has kept the investors on edge would be the divergence in monetary policies of the world’s largest economies.
We all know the extreme swings of 2020 and 2021, where interest rates were close to zero, and the ‘Fed Put’ was in effect due to the continuous supply of free money to the economy. Life was good.
That all has changed and how.
This year has been a very different story. The Fed, since March 2022, has raised the interest rates by 225 basis points to tame runaway inflation that’s hovering around a multi-decade high.
Typically, inflationary cycles in countries around the world are linked to the world’s largest economies – similar actions across markets soon follow rate hikes by the Fed. For instance, India’s RBI has also revised Repo rates thrice this year to curb rising inflation.
However, not all central banks move in tandem.
In contrast, the People’s Bank of China has maintained an accommodative stance and has taken several rate cuts, which marks one of the first-ever policy rate cuts amid the Fed’s rate hike cycles.
These rate cuts have surprised many participants and beg the question: Why has PBOC chosen to cut rates when the Fed is in its most aggressive rate hike cycle in decades?
To hike or not to hike?
Theory and practice have shown the Fed’s rate hikes can tighten global liquidity and pile the pressures of capital outflow and currency depreciation on emerging markets. China’s accommodative stance is an attempt to improve liquidity in the system and revive credit demand.
Why is it critical to increase liquidity in China’s economy?
China has been badly hit by widespread coronavirus lockdowns that have affected businesses and consumers. Gross domestic product (GDP) fell by 2.6% in the three months to the end of June from the previous quarter.
During this period, major cities across China, including the significant financial and manufacturing hub Shanghai, were put into full or partial lockdowns.
As depicted in the chart below, China’s economic growth has slowed significantly and has grown at a meagre 0.4% in Q2 2022.
Also making matters worse for the Chinese economy is the unravelling of the housing market, with July being the 11th consecutive month in which home prices fell on a month-on-month basis.
This is again attributable to zero-COVID policies, due to which many real estate developers could not deliver the projects.
And, as a protest to this, citizens have now taken matters into their own hands by refusing to repay home loans for houses yet to be completed. According to the South China Morning Post, the ‘mortgage boycott movement’ is now active in 320 real-estate projects across 100 cities.
Now, the sector, which contributes to ~29% of total gross domestic product and ~35-40% of bank loans, is facing severe challenges and is looking at multiple bankruptcies. Evergrande is one of the most prominent players with an outstanding debt of US $300 Bn and has defaulted on a crucial repayment deadline.
Now, in this situation, there is a significant liquidity crunch in China’s banking system. To overcome this, PBOC has relaxed the regulatory norms to increase cash supply in the channel and sold US $ reserves to generate liquidity.
What cues does this provide for Southeast Asia?
Rate hikes by the Fed have a disproportionate impact on the pricing of Tech stocks in the public market. As the rate of borrowing increases, investors move away from high-growth tech stocks to safer bets like energy and utilities.
For instance, the tech-heavy NASDAQ composite has fallen 18 percent year to date, compared to a 11% fall in the S&P 500.
This disproportionate negative impact on the valuation of new tech companies is because their cashflows are far into the future, which therefore gets discounted more heavily at higher interest rates.
The crown jewels of Singapore’s tech industry, Sea and Grab, have also not been spared from this rout. Both these companies have seen their share price drop by nearly 75% from their peaks in November last year.
Following the drop in share prices, the management at both these companies have worked swiftly to bring about a shift in the collective mindset – away from growth at all costs to focus on prudence, cost reduction and consolidation. While profitability remains a distant dream, these companies are looking to maximise their runway as liquidity dries up for the foreseeable future.
Private valuations have also fallen in tandem with the public market’s share prices.
However, the outlook for SEA start-ups seems relatively better, thanks to balancing tailwinds from China’s slowing growth.
Last year’s spike in liquidity saw a lot of Asia-focused PE and VC firms raise large commitments from limited partners, with most registering a 10-15% growth in fund size.
While valuations have dropped, most firms still have sizable surplus funds that are yet to be deployed. According to a report by Bain & Company, total unspent PE capital at Asia-Pacific-focused funds rose 22% to a record $477 billion, representing 3.2 years of future investment, up from 2.7 years in 2019.
Till date, nearly 50% of all funds earmarked for investment in this region have gone to China.
However, future investment ratios may look different – the country’s slowing growth has prompted investors to rethink their fund allocation. Moreover, increasing regulatory hurdles are adding to China’s start-up woes – exits for PE/VCs firms have become challenging, as China-based companies are forced to find alternative channels to the US IPO market.
China’s dramatic policy changes have also exacerbated investor concerns. For instance, Beijing’s ban on for-profit tutoring last year crippled the business model for many online education companies, prompting valuation write-downs for several ed-techs in the country.
A blip in an otherwise bright future
As investment in China slows down, start-ups in SEA may benefit as funds get diverted to start-ups in emerging markets in the region.
If we look at funds raised, we’re already seeing this playout. VCs focused on SEA and India have raised USD 3.1 billion in 2022, nearing the USD 3.5 billion raised in all of last year, according to data from Preqin. In comparison, fundraising by China-focused VCs fell sharply from USD 27.2 billion in 2021 to just 2.1 billion in 2022.
It is important to note that SEA has been a laggard to China and India, with several countries just going through their wave of digitisation. One can argue that it is underfunded compared to its peers and, hence, less impacted in dry powder allocation.
There is no doubt that SEA as a region is not immune to macroeconomic conditions. Its listed crown jewels face significant pressure in public markets, and several unicorns have paused plans to list.
However, in a broader view, VCs in the region has never had more dry powder. More importantly, in most cases, business fundamentals and long-term theses for tech businesses remain intact.
Interest rate hikes do not change long-term tailwinds, and Southeast Asia only stands to benefit in this regard.