The Informal China Banking Sector is Growing

After Wednesday’s stock market excitement, the government “quashed” rumors Thursday that they were going to relax prices on refined oil products. According to China Daily, “the National Development and Reform Commission [NDRC], China's economic planning agency, said rumors that the authorities plan to relax domestic oil and gas price controls are baseless.” The Shanghai Securities News, the official paper of the stock exchange, quoted an unidentified government official as saying that relaxing the pricing regime would hinder earthquake relief and reconstruction.

What may have started the rumors Wednesday were indications that the government may instead help oil companies by reviewing the windfall profit tax imposed on all upstream oil producers. Apparently PetroChina lat week appealed to the government for just such a review. It is worth noting that the government is likely to be – and for good reason – very secretive about any plans to change oil prices since this is only likely to encourage hoarding in the short term. Shortages continue to be a problem and low domestic oil prices – at roughly one-third the world price – have done nothing to stimulate energy conservation. I think the problems of hoarding, shortages and smuggling are only going to get worse over the next few months, especially as the serious reconstruction in Sichuan kicks in, and we will see a resurgence of these rumors about relaxing price freezes from time to time. It cannot be easy for the government to cope with the consequences of maintaining low domestic oil prices, and it certainly isn’t cheap.

The stock market reacted very strangely Thursday to all of this. The SSE Composite opened down and lost 2.1% from yesterday’s close within the first thirty minutes of trading, before bouncing around for much of the morning within a 1-1/2% trading band. It suddenly shot up in the early afternoon to a few points above yesterday’s close, before collapsing in the last 90 minutes to 3586, down 1.65% for the day. Neither I nor my student Shang Ning was able to get much of an explanation for the sharp ups and downs today. This has the feel of a very uncertain market chasing its own tail.

Meanwhile there was an interesting article in today’s South China Morning Post about the increased cost of converting HK dollars into RMB. Bank of China, the city's RMB clearing bank, widened the spread between the buy and sell rates for the RMB early this month from 10 basis points to 75 basis points. This was reportedly done because the PBoC was worried that increasing demand for RMB in Hong Kong could affect its exchange management and its domestic monetary policy.

Sure enough, the exchange volume dropped significantly since the move, but the newspaper report quotes Joseph Yam Chi-Wong, the chief executive of the Hong Kong Monetary Authority, as saying that “some transactions may shift to money exchangers or even through underground channels if people are very sensitive to the buy-sell spread.” They may shift? I think it is a dead certainty that money is shifting to informal channels. After all there is plenty of evidence that hot money inflows are high and increasing, and if there is a slowdown in the formal channels for RMB purchases, what else can one assume?

Along that line I missed a very interesting article in the April 23 edition of a local magazine, The Economic Observer. The article, titled “Chinese Firms Tapping Informal Loan Networks,” discusses one of the things I have been wondering about a lot on this blog. I have always assumed that one of the consequences of the stricter lending caps imposed this year would simply be to move borrowing out of the formal banking system and into less formal borrowing channels, and I had heard anecdotal evidence that this was indeed happening. Apparently some economists at the All-China Federation of Industry and Commerce have been doing their own work on the subject.

Research by the Federation estimated that Chinese companies raised some 800 billion yuan through informal channels last year, among which researcher Chen Yongjie said over 20 billion yuan likely came from Wenzhou. Businesses that raised money in this fashion would likely be charged a 5% monthly interest rate, amounting to around 60% in one year.

According to Chen, over five million private businesses made up 70% of China's total, making up 65% of China's GDP. But despite the importance of this segment to Chinese industry, Chen's data indicated that the proportion of loans from banks to them decreased over the past three years. The proportion of short-term loans to private business was about 11% in 2005, but only 9% in 2006. China Society of Private Economic Research chairman Bao Yujun had spent two weeks investigating in Shaoxing, Wenzhou and nearby regions, and discovered that underground fundraising was indeed gaining momentum in Wenzhou.

Despite the fact that underground fundraising goes against regulations made by financial supervisory bodies in the Chinese central government, the local governments were turning a blind eye. Bao spoke with a prominent politician of one city in Zhejiang who stressed that there was no way they could clamp down because businesses had to survive and that locals had to remain employed.

Wenzhou, for those who don’t know, is a city in the south famous both for the ferocious entrepreneurialism of its citizens and for its extensive informal banking sector – with the second characteristic probably not unrelated to the first. The point the researchers are making is that as small businesses in China grow, they are getting less and less help from the large commercial bank, who prefer to concentrate their now-limited lending power to loans to the large SOEs – yet another way in which China’s financial system fails miserably in delivering capital to its most efficient users.

Not surprisingly, these private companies are turning to the informal banks for funding, in spite of borrowing costs as high, according to the article, as 5% a month, which they describe as 60% a year but which I would qualify as 80% a year if correctly compounded (which at least gives some idea of the profitability both of the private companies and of the informal banking sector).

The worrier in me would make two points about this – besides the obvious one about how the banking system misallocates capital. First, such high borrowing rates can spell catastrophe if the economy were to suffer a sharp slowdown since borrowing at this rate must require optimal economic and profit conditions to be justified. Second, any attempt to measure real loan expansion in China is likely to be overly conservative if we ignore the impact of these informal lending institutions. Credit growth is almost certainly higher in China than what the numbers from the commercial banks suggest.

Comments

[rlirph]

5% a month or 80% compounded annual interest rate sounds like borrowing from loan sharks which also come with deaths/broken legs if loans are not repaid on time. This kind of loan arrangement has always existed in Asia in recent times. That's why Household Finance opened finance shops in Japan.

Does any one know anything about PetroChina borrow money on this basis? The story was that last year PetroChina has money but cannot get them converted through official channels. The company was forced to borrow at ursury rates. I remembered reading the newspaper to that effect. When management was asked about it they gave a typical answer "I'll look into it and let you know" answer which raised more eyebrows.

[M. pettis]

I would be surprised if PetroChina didn't have access to bank loans, but remember that until the earthquake (and the January storms before that) there were attempts to cap lending growth, and a lot of companies have been screaming for capital.

[sharpe_mind]

China's reserves grew by nearly 75 Billion USD in April. Not a month you can attribute much to mark to market on FX or bond positions. This was three times the trade surplus plus FDI.

The yuan barely moved in April as authorities capped the exchange rate around 7 in order to "stabilize expectations of further yuan appreciation"; clearly noone was convinced by this gesture.

[Billz]

For typical private business loan (underground lending as the author calls it), the interest is quoted by the month and need to be paid each month. So the interest does not compound and the total annual interest payments equals monthly payment x 12.

Many Chinese private companies are having cash flow problem. One such example is Wan Song Real Estate company in ZheJiang province. Their total debt is over 5 Billion RMB and total equity is less than 100 million RMB. The company has over 3000 lenders, mostly local residents who try to get high income on savings. Initially the company offered interest rate of 2% per month, when the going got tough, the company tried to raise fund by offering monthly interest rate of 5% or 6%. In March, when the company failed to pay the monthly interest, lenders demanded principal back but there is no money to return. Unless the real estate market pick up significantly in the near term, the lenders will probably lose most of their money loaned to the company.

I think this event will have chain effect of reduce liquidity in the undergound lending system, thereby drive up interest rates, increase the cost of doing business and drive more business into failure. China had good economic time for 30 years, it can not last for ever.