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China's growing might is creating global risks, but the country is plugged into the world economy and this will act as a break on strident nationalism says Fred Hu, founder of Primavera Capital.
Hu is one of Asia’s most well known economists and private equity bankers.
As chief economist for Greater China at Goldman Sachs from 1997, he was right in the thick of banking sector reform: a position, which enabled him to persuade the bank’s reluctant board to sign off on one of the most lucrative investments it would ever make - a strategic stake in ICBC.
Below he explains why he correctly thought it was the opportunity of a lifetime.
After leaving Goldman, Hu went on to establish private equity firm Primavera Capital in 2010.
FinanceAsia interviewed him as part of the magazine’s 20th anniversary celebrations. Below, he also discusses the radical transformation China has made over the past two decades and the challenges it faces over the next 20 if it is to grow rich before it grows old.
Would you agree the market has generally underestimated the pace of change in China over the past 20 years?
Yes definitely. I first joined Goldman Sachs as chief economist in 1997 in the early days of the emerging markets hype. A lot of global banks were setting up desks in Hong Kong then with an eye towards opportunities in Mainland China.
I was always one of the most bullish on China, but even I underestimated the sheer speed and magnitude of the transformation. Back then, everyone was very focused on Eastern Europe and the difficulties countries were facing shifting from centrally planned to market-oriented economies. It felt like it was going to be a very bumpy road for China too, fraught with risks.
When do you think China reached the tipping point in its own transition?
I’d say 1999 was probably the dawn of the market economy. At that point the telecoms sector had been overhauled and the energy sector was undergoing the same process.
But the Asian Financial Crisis had also demonstrated how the Chinese banking system needed a major overhaul too. That’s when I started working with the government and central bank to provide technical advice on how to tackle legacy NPL’s and capital shortfalls.
Bank of China Hong Kong was the first to get listed on the Hong Kong Stock Exchange in the summer of 2002, raising $2.66 billion. It was based in Hong Kong, but it was state-owned so its IPO was a very big landmark for China.
Once it was listed, all eyes turned towards Bank of Communications [BoCom] based in Shanghai. I introduced HSBC as a strategic investor and they became the first ever foreign strategic investor in China’s banking sector, providing capital and the know how to help BoCom improve risk management and internal controls.
BoCom’s $2.1 billion IPO in 2005 was the first time a Mainland Chinese bank had ever listed overseas.
The bank you’re most personally associated with is ICBC though. There’s a very famous story about how you “sexed up” a letter from Goldman, which facilitated the bank’s eventual investment in the bank. How did that happen?
Well up until Goldman’s investment, international investment banks had played their natural role as advisors and thought leaders. And let’s not forget, the Chinese banks were facing overwhelming problems, particularly ICBC because of its sheer size and scale.
I’d got to know Hank Paulson [Goldman’s CEO] quite well as he made frequent trips to China. I could see he was very interested in doing the advisory work for ICBC, but far less keen on Goldman providing its own capital.
When he met ICBC’s president, Jiang Jianqing, for the first time he was asked very directly whether Goldman would make an investment in the bank itself. Goldman drafted a letter in which it assured ICBC it would work very hard to find the right kind of high-level strategic investors in its role as advisor.
It also mentioned that it would discuss the matter of a direct investment internally. I had the job of translating this letter into Chinese and then delivering to ICBC. Let’s just say I made it sound like the investment was much more of a given than it actually was at that point.
Of course I then had the far more difficult job of persuading Goldman that ICBC was a good investment.
Did you yourself realise just how big an opportunity it was? After all, the bank made over $7 billion in profit I believe.
Yes I did. I think you’ll find economists generally have a much better understanding than anyone else including private equity investors!!
Joking aside, I was just very lucky to be involved with the restructuring of the Chinese banking sector at a very early stage. Therefore, I could see what a big opportunity there was.
I really wanted to work alongside the government to design a viable roadmap for far-reaching banking reform.
At the same time I also wanted Goldman to work with ICBC since it was China’s biggest bank. The numbers are just mind-boggling: 100 million retail customers and 30 million corporate clients. I thought that if we could help turn ICBC round then the whole Chinese banking system would be placed on a solid footing.
Goldman ended up investing $2.58 billion in ICBC. That’s a big number even by today’s standards. Back then it was the single biggest foreign direct investment China had ever received.
The bank took a very, very big bet on China and I had to convince a lot of people: not just Hank Paulson, but also the whole Goldman Sachs board, the risk committee etc.
I prepared a 100-page investor memorandum, but really there were two key points.
The first related to the macro-economic backdrop. I argued that the Chinese economy was entering a sweet spot for the next five to 10 years and would benefit from very fast economic growth. I said that if the global macro economy did well then ICBC would too because of its size and scale.
Secondly, I highlighted the strength of ICBC’s management and particularly Jiang who’s an exceptional leader. I got to know him really well over the years.
I really believed in him and his team’s ability to execute right from the beginning. He’s an extremely decisive man. From the outset, he was committed to positive change and cleaning up the bank’s legacy problems.
If you look at ICBC now it’s come a very long way in terms of operational performance and efficiency. It’s much more professional, it’s better capitalized and has better risk controls.
And a lot of that is down to him. He served 16 years at the top of ICBC. That made him the longest serving CEO of any major global bank and he created so much value in that time.
What’s your view on the Chinese banking system now? How worried should we be about rising NPL’s?
No matter how positive I’ve just sounded, banks are always vulnerable to the macro-economic cycle and slow downs. Domestic banks are under a lot of pressure right now.
China has a very big debt overhang. Far too much credit has been extended over the past six or seven years. There’s also too much capacity and returns are low.
But I don’t agree with the China bears because most of the country’s debt is domestic in nature. The economy is slowing down, but it’s not in recession.
There's still time to de-leverage in an orderly fashion and restructure surplus capital.
How long will this take?
We’re just the beginning. It’s a multi-year process, if not longer.
The start has been a bit slower than expected but we are making incremental progress.
This requires the top leaders to have a clear vision and maintain their determination to really implement fundamental reform. I’m positive capital allocation will become more efficient over time.
We shouldn’t forget how difficult this is. In the West, the restructuring has been ongoing for more than eight years now since the global financial crisis in 2008.
One of the key issues for China is the fact that many banks are still controlled by the government.
But I’m still optimistic. There’s a very strong venture capital dynamic in China and this country has a long tradition of entrepreneurship.
It’s a very exciting time right now with all the reforms and the innovation we’re seeing coming out of the private sector.
Are you not worried about the level of competition in the private equity sector? There seems to be an awful lot of funds chasing the same hot companies like Ant Financial, which can result in overvaluation?
Competition is good. China is so big that if you think through your strategy and have a competitive edge then you can find plenty of deals.
I also don’t agree about valuations. Thanks to last year’s stock market crash, valuations now lower in China than they are in Europe and the US. China is no longer very expensive.
We’ve been talking about the last 20 years for our anniversary at FinanceAsia. What will China look like after the next 20 years?
If we assume that reforms keep moving ahead and we should, then China will be the largest economy on the planet and per capita income will be on a par with the West. China’s equity market will definitely be second largest behind the US, or perhaps on a par with it.
China will have a majority of the most valuable companies in the world. By 2020, state-owned enterprise will account for less than 5% of GDP.
What about those who say China might get old before it gets rich because of the legacy of the one-child policy?
I think these risks have been over-exaggerated. We shouldn’t just think in terms of headcount but the quality of education and our human capital.
What about automation? How will China keep providing jobs as more people come off the land?
Well you can’t have it both ways and argue that automation and slowing population growth are bad.
I do think there’ll be more robots than bodies in 20 years time and that will be an important factor helping China overcome slowing population growth.
But I don’t think we should be worried about this. Humans will still be doing the skilled jobs.
Robots will do the jobs that can be automated and humans will find new opportunities as they always have. I believe in the potential for robots, but I believe in the even greater potential of humans.
What risks does China face in achieving all this?
There are two. Domestically, the biggest risk is the government forgets that reform needs to continue and remain comprehensive.
If we lose sight of this then the country could squander some of the opportunities it currently enjoys.
Overseas there is potential for many misunderstandings with the US, which could lead to some kind of hate collision between the two countries.
The world is also trying to grapple with radical ideologies. This is also a risk.
But China’s rise is a peaceful one. China today is completely plugged into the world economy and there is an extraordinarily high degree of mutual dependency with the rest of the world and this will act as a powerful constraint on hyperbolic nationalism.
My base case is that China’s growing economic supremacy is a net blessing for the world. China is now the largest trading partner and a major source of capital for most Asian neighbours and many emerging countries in the world. As shown by President Xi [Jinping]’s One Belt One Road initiative, China seeks to use trade and investment to create a win-win outcome for many nations.
My other positive is China’s attempts to reduce its dependence on fossil fuels and rely on renewables. If it’s successful this will be the first time a major economy has made such a shift and within a very short time span. It could provide a dramatic role model for countries like India and Indonesia.
This year also marks the 50th anniversary of the Cultural Revolution. What do you think Chairman Mao would have made of the changes that have happened in China since he died?
I think it’s fair to say he would have had mixed feelings. Mao was a revolutionary and he wanted China to be a wealthy and powerful nation commanding global respect.
The irony is that Mao’s vision for China is not turning into a reality through his radical policy ideas and social engineering but through market oriented reforms, which have turned China from a country of poor peasants into a prosperous nation of entrepreneurs and middle-class consumers.
