Citi China Equity Strategy/macro

CITI CHINA EQUITY STRATEGY/MACRO –

China Equity Strategy - Trip Note: SMEs and Informal Lending Reach a Crossroads n The macro/micro mismatch — While China's macro-level indicators remain solid, micro-level variables have deteriorated since 3Q. In the cities we visited (Dongguan, Wenzhou and Suzhou), the general business and financing environment for SMEs is already worse than in late 2008 when macros led the cycle down.

n Getting worse before getting better — Firms and local government officials that we spoke with agreed that SMEs will likely suffer more in the next 3-6 months. Rising costs, slowing demand (relative to fast expansion under the stimulus), and tightening credit have contributed to the crunch. A proportion of those SMEs that are structurally wrong-positioned or that misallocated resources could be wiped out. Only then would the market share and pricing power of surviving firms improve.

n Surging funding costs are one trigger, the transition is another — Lending rates in the informal credit market have risen to historical highs due to thin margins in manufacturing and speculation in thick margin sectors. The panic among SMEs is likely only the beginning of the structural transition.

n Informal lending frenzy varies across regions — Among the three key cities we visited, Wenzhou is most active in informal lending, while firms in Dongguan (more non-local firms) and Suzhou (more medium-sized firms) are less involved. In Wenzhou, about 45% of informal lending was to manufacturers.

n Facilitating the SME transition — Many export-oriented SMEs are unable to redirect their business towards domestic markets as they will lose tax benefits they enjoy as exporters and branding provided by foreign counterparts. Tax cuts are thus more critical than credit easing for medium-sized firms.

n Policy easing expected in 1H12 — Firms and local