Cost of Capital in China

I received the following article from Macquarie Securities. This article originally appeared in Chinese in China Times daily. It has been translated. Worth reading in full. 

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Wenzhou’s Case of the Runaway Boss: Numerous Banks Involved

by Wang Xiaohui

http://www.chinatimes.cc/yaowen/hongguan/2011-04-22/23188.shtml

As monetary policy has gradually tightened, entrepreneurs in Wenzhou feel like autumn leaves shivering in the wind of tight funding supplies.

Zhou Dewen, the head of Wenzhou’s SME Development and Promotion Association, on April 22nd told our journalists, “Recently, I’ve heard of cases where SME owners disappeared to escape repayments to loan sharks.” Mr. Zhou also said that banks have long since stopped lending to SMEs, forcing the companies to turn to loan sharks.

Our journalists have learned that as commercial banks have restrained loan issuance, private lending rates have risen significantly; with 8% a common monthly rate charged for private loans. There are numerous funding organizations in Wenzhou – loan sharks, commercial banks, SMEs, guarantee firms, pawn shops, investment companies, and even underground casinos – and their interwoven relationships have created unpredictable risks.

The runaway borrower

On April 21st, the gates of Jiangnan Leather Company were firmly closed, and only a few security guards remained. There was a notice on the gate saying that the owner of the company, Huang He, had absconded and the government would establish a liquidation team to handle remaining business.

Our investigation reveals that Huang He, together with his wife and two children, fled the country on April 6th. Before leaving, he had gone to casinos in Macao with a few second-generation-rich types. “He lost too much, and couldn’t get out of the casino. The others rescued him by drumming up the money.”

Our journalists learned from the liquidation team that, by noon on April 22nd, 95 vendors and individuals had submitted a total bill of Rmb132.89mn to Jiangnan Leather, with private loans accounting for Rmb50mn and the remaining debt in payables.

Jiangnan Leather was founded in 2002 as a subsidiary of Jiangnan Holding Company, who’s registered capital is Rmb15.8mn.

Zou Jianqiang, the deputy head of Wenzhou Industrial Park Management Committee, disclosed that 10 banks are involved; including China Everbright Bank, Guangdong Development Bank, Bank of China, Longwan Rural Credit Cooperative Bank, and Shenzhen Development Bank. Bank loans to Jiangnan Leather and related companies stand at Rmb142-145mn. Few banks lent directly to Jiangnan Leather – an accounting firm is currently conducting an audit of the company. “It’s very complicated. Some have guaranteed Jiangnan Leather, and some others have guaranteed the guarantors,” said Zou Jianqiang.

Huang He’s disappearance has caused trouble for some listed companies. Jiangnan Leather owes payables of Rmb8.53mn to Fujian Nanfang [SHA: 600483], and the latter has already written loss payable provisions of Rmb0.15mn.

Our investigation suggests that Huang He may have borrowed heavily from many guarantee firms, but no guarantee firm has registered with the liquidation team.

According to Mr. Zou, some guarantee firms are actually underground lenders financed with private money, and they are worried about a potential “bank run” once their creditors learn of the event.

Surging interest rates

The cause of this undesirable event is the People’s Bank of China’s (PBC) recent tightening, which has left the already vulnerable private lending market in Wenzhou even more exposed.

“A monthly rate of 2% is too low. I’ll take however much you have to lend out.” Wang Hongzhong joked with our journalists. Wang Hongzhong, a gnarled old man, is now an influential lender in the local market.

“2% monthly rates are usually charged on loans between relatives and friends, and the money is used for business purposes,” said Mr. Wang. Loan sharks gather money by buying at a 2% monthly rate and lending at 10%, 20%, or even 50% per month. The craziest loan sharks, who are generally large lenders or gamblers, now lend in the morning and receive the repayment in the evening. These loans are extremely risky.

All this is because of the PBC’s tightening policies. On April 21st, the PBC raised the reserve requirement ratio (RRR) for the fourth time this year. On top of three previous rate hikes, bank lending has suddenly tightened.

“Now, even regionally important companies like us can only secure previously promised credit lines. It’s unimaginable to get more,” Chen Shisheng, CEO of Xingji Corporation, told our journalists.

SMEs’ lives are even harder. More and more SMEs are now turning to private lenders, gradually pushing up curb market rates.

“Currently, monthly private lending rates are generally 6%, 7% or 8%. In other words, if you have borrowed Rmb100, you must pay back Rmb196 by end of a year.” Said Zhou Dewen.

The chains of lending

The chains of private lending, on which each of the institutions mentioned above are a link, binds the fate of all. SMEs are borrowers, but are simultaneously potential lenders as well.

Commercial banks’ main method of dealing with the difficulties of loan issuance is enlisting a guarantor (or an investment firm) to raise funds. The money is then deposited in banks and lent to borrowers. For example, on a loan of Rmb1mn, borrowers must pay both the 5% monthly rate to private lenders and loan rate charged by the bank.

The funding sources for private lenders are miscellaneous. Some attract money from the countryside or other cities at monthly rates or 2-3% and then lend at 5-6%. These intermediaries typically earn a monthly return of 3%.

A small business entrepreneur told our journalists that private businessmen often connect via industrial associations. Through introductions by friends, private lenders establish relationships with SME owners.

Consequently, lending relationships have been established between private lenders and entrepreneurs within these small social circles. When an SME looks for financing, lenders (including banks) require other SMEs to guarantee the borrower. This produces mutual guarantees or guarantee chains (A is the guarantor of B, B offers guarantee to C, etc.). When one firm gets into financial trouble, other companies lend their support.

Stoppering the regulatory loopholes

This financing model sows considerable risk: when one link in the chain breaks, the financial fallout quickly traverses the chain.

When only loan sharks’ money is at stake, the risks can be limited; but if banks are part of the lending chain, the risks may spread to the larger financial system.

Fang Peilin, the president of Fangxing Guarantee Company, told our journalists that interest rates in Wenzhou are dual-track; one track for commercial bank lending, and another for private lending. There is a large gap between the two tracks.

Zhou Dewen describes one channel connecting these tracks: “Some guarantee companies, or investment firms, collaborate with bank employees to create profit by borrowing from banks to make private loans.” This said, he doesn’t think this is a prevalent phenomenon.

Chen Shisheng says that banks monitor the lending flow, but the “length” of their monitoring is limited. Transferring money through various accounts, loan borrowers can escape the banks’ supervision. Although bank supervision has significantly strengthened, this loophole is yet to be fully stoppered.

Mr. Zhou told our journalists that private lending is an effective complement to the formal financial sector and plays a positive role in promoting the development of SMEs and the rural sector, but requires further regulatory supervision.


This post originally appeared at The Gold Standard and is reproduced here with permission.