Inflation is probably the largest, and most rational, challenge facing the Chinese economy today.

We anticipated inflationary pressures while constructing the portfolio for our previous fund, LCP-2, and LCP-3’s initial investments in Pineapple and Jaw reflect, and are arguably benefitting, from this environment.

As we embark on building the remainder of LCP-3’s portfolio, our stance is that inflationary pressures are manageable but real, and that the opportunity to find attractive businesses at reasonable prices should rise considerably from current levels.

Inflationary Risks

Inflation remains a challenge and concern for the Chinese economy. Price pressures are being driven by rising food, labor, and land costs. Of note:

• Hog prices rose 6.5% MoM in February to RMB 15.04/kg;
• Wages in Wenzhou, a business hub in Zhejiang province, rose 17% YoY in February; and
• Leases on farmland in Shandong province have increased 56% over the past 5 years

The government has responded with efforts to curb lending and control liquidity. Over the past month, the People’s Bank of China (PBOC) has raised interest rates by 25 bps for the third time since October and has increased the Required Reserve Ratio (RRR) by 50 bps to 19.5%. We expect further tightening in the coming months.

Publicly, policymakers have appeared on both sides of the fence. Premier Wen Jiabao has repeatedly stressed inflation as a concern in recent addresses and has indicated that reform of the yuan’s exchange-rate regime may be on the cards to strengthen the currency and curb price pressures, but noted that any RMB appreciation will be gradual. Other policymakers appear noticeably more upbeat. At this past month’s National People’s Congress, Zhang Ping, head of China’s National Development and Reform Commission (NDRC), said the government would have little difficulty maintaining inflation at 4% YoY.

While we do not welcome inflation, rising labor and land costs on China’s seaboard are driving manufacturers to China's less developed, and less expensive, inland areas. A collection of leading indicators, including fixed asset investment, industry value-added, and export growth, show that industrial activity in China’s central and western regions is outpacing that on the eastern seaboard.

Tightening measures have also intensified the shortage of bank loans available to small private enterprises in China. While small-and-medium sized enterprises account for 98% of total enterprises in China and 65% of total GDP, they received just 39% of bank financing in 2009. Private equity funding has historically filled this liquidity gap.

Further, a comparison of the BRIC economies suggests that inflationary fears are perhaps being exaggerated.


While many of Lunar’s investments have benefitted from inflationary pressures (notably, Jaw and Pineapple), inflation remains a long term concern for China and a limited number of investments in our pipeline.

In response, we have redoubled efforts at existing portfolio companies to protect against inflationary pressures, although this is currently of limited concern in the case of LCP-3. More importantly, we have focused our due diligence efforts on understanding how target new investee companies will perform as interest rates rise, liquidity contracts and businesses adjust to an economic environment likely characterized by a strengthened RMB, rising input costs and higher funding rates.

As these pressures are digested in the coming 6-18 months, we believe the opportunity to find attractive businesses at reasonable prices will rise considerably from current levels.