The bear in China

Last week, the PRC raised rates for the second time in just over a month, playing a dangerous game of catch up in an effort to stem inflation. While the government had hoped to keep inflation growth at 3.5%, it reached a staggering 5% at the end of December, affecting food prices and negatively impacting the buying power of the poorest.

Gayle Berry, an analyst with Barclays Capital said, "It is a clear concern of the markets that a tightening in policy in China will have a dampening effect on demand growth, but probably what more you're seeing here is a kneejerk reaction to the initial news. It was broadly expected. A lot of people were anticipating some sort of big news over the holiday period, so I wouldn't say it's come entirely as a surprise to everyone on in the market."

Berry further notes that economists do not see it affecting the larger GDP picture. "What you're seeing is the government responding to what has been very strong economic growth and very strong activity indicators."

But while growth numbers remain high - pegged at over 9% for 2011 - in the context of private equity, investors should not confuse GDP growth with corporate growth and revenue generation, something that Weijan Shan, Chairman of PAG, warned the audience at last November's AVCJ Forum in Hong Kong.

There are still question marks around the timing of a fallout stemming from the unfettered lending to local governments, corporates and individuals alike at the end of 2008 as part of China's stimulus package, which has seen more than one "development project" with little or no prospects for success in the real world. In fact much of this money went into real estate speculation, another issue the PRC government is trying to tackle.

And then there is of course the question about RMB convertibility. Economist Andy Xie believes that the idea that the RMB will suddenly become freely convertible is perhaps a bridge too far. "In China the system is not based on the rule of law; it's based on administrative power. So it's a system that cannot live with a freely convertible currency." He further explains, "There's never anything that's open-ended. Only when political reforms happen, when a really competitive political system is put in place, will you have a convertible currency." It is not a coincidence that the country's name in Chinese translates into ‘the kingdom of the great middle.'

The above are all hot topics, but that is not to say that 2011 will not see the same private equity wave of activity - fundraising up 28% year-on-year, 40% of all capital deployed in Asia invested in China, and a 135% increase in PE-backed IPOs - but it is a warning to would-be China bulls that economic fundamentals.

Note: The 2011 AVCJ China Report is a comprehensive guide to private equity activity and the investment landscape over the past 12 months. For more information or to order your copy, contact Helen Lee at: AVCJResearch@incisivemedia.com.

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• Greater China