Here’s an on-the-ground update of a Chinese practice with some Japanese origins.
It’s what China expert Michael Pettis compared to the zaiteku undertaken by Japanese companies in the 1980s. Put simply, it involved the firms going on speculative corporate investment binges. Today in China, it’s more to do with intercompany lending — firms stepping in, where the banks cannot.
In any case, the update comes from Standard Chartered, where analysts went on a tour of ‘City X’ last week. The city is apparently nothing special. Just your average Tier 2 town in China, with local officials busy trying to get a grip on home prices and bank lending.
Which is where non-bank credit comes into play. Things like loan guarantee companies [GCs], which are, strictly speaking, not supposed to lend their own money to customers — but do so anyway.
Here’s Standard Chartered’s Lan Shen and Stephen Green:
In City X, something slightly different is happening, which we suspect is being repeated in cities across the country. We found that a couple of large local state-owned firms whose main business was not finance are now expanding into operating guarantee companies, pawnshops, trusts, etc. We surmise that they are doing so with the support of large surplus cash earned by the group’s (often monopoly) activities, or with funds easily borrowed by the parent group from friendly banks. It appeared that at least some of their business was based on their ability to borrow funds at 7-8%, and then on-lend at rates of 20-30%, arbitraging the dual-interest rate environment. They would also in theory be free to funnel funds borrowed for one purpose into, say, real estate.
We find this disturbing for a number of reasons:
- • The state already dominates much of the financial sector, but areas like GCs and small loan companies open a window to private-sector activity. Local SOEs now look set to dominate these new parts of the financial sector too.
- • Such platforms combine industrial and financial functions within the same group. This introduces new risks, since it facilitates fund flows that fall outside of regulators’ monitoring. It also adds a new transmission mechanism for bad credit problems to spread through the economy.
- • These platforms also broaden the scope for corruption at firms with low levels of government oversight.
Guarantee companies don’t fall under the regulation of the central bank or the China Banking Regulatory Commission (nor are their activities included in things like China’s society-wide measures of financing). Instead, they are overseen by the local government, which, you could argue (as StanChart does) might have more of an interest in promoting quick economic growth than in ensuring longer-term quality supervision.
And on that note, here’s some recent news from the GC-front:
Informal loans are going bad for the first time in years, but the scale is difficult to judge. GCs appear to be on the front line, as a number of cases of bad loans are now being reported. Xiamen in Fujian province has been hit by a couple of big cases where loans have gone bad, or where funds have disappeared. There are reports that a number of local GC owners have disappeared in Wenzhou, Zhejiang province, as guaranteed borrowers default, leaving lenders exposed to the loss. A manager of a group involved in both loan guarantees and informal lending in City X said that some 40% of his informal loan book (five loans in total) was currently problematic – and that legal action had been started. He was not that worried, though, saying that although this was a new phenomenon, he expected to recover at least half the funds. Two friends have told us that informal loan companies in other cities of which they have direct knowledge have faced their first non-performing loan cases, and are now being very much more conservative about extending new loans.
Now the guarantee companies do have some safeguards built in.
They take collateral in return for their loans (though we imagine actually assuming control of that collateral in the event of a loan going bad could be tricky). And they also have a certain level of capital (though how much of that is itself borrowed is open to speculation).
Nevertheless, StanChart’s conclusion might not surprise…
Some form of central government regulation may be coming for the GCs, particularly if (as we think is likely) we see a lot more distress from the sector.
China moves to curb off-balance sheet lending – FT