SHADOW MARKET
With whole swathes of China’s private sector locked out of the state-owned banking system, many companies are turning to unofficial, unregulated, and often illegal means to raise money.
By Zhou Xiaojie and Yang Jian

As Liu Cong Hui sees it, her company is powering the Chinese economy in more ways than one. In a literal sense, Tianwei Yingli New Energy makes and sells solar panels used by factories to meet part of their energy needs. Just as important, says Liu, the company’s finance manager, entrepreneurial companies like hers are fuelling the lion’s share of China’s breakneck economic progress.

And yet, complains Liu, trying to find the financing necessary to fund her RMB110m-a-year business is proving to be a nightmare. The Baoding-based company – in China’s north Hebei province – is notching up respectable growth rates and has impressive expansion plans. Nonetheless, sighs Liu: “For every step of our growth we face a financing bottleneck.’

In desperation, says Liu, the company’s founder has twice sold a portion of his shares to a state-owned enterprise (SOE) in order to raise the necessary capital to continue growing – handing over a controlling stake in his company in the process. “Banks have stringent requirements for loans,” Liu says. “They place huge emphasis on whether you can provide enough collateral or have a guarantor, but they pay precious little attention to your fundamentals, such as your company’s prospects and growth.”

Sadly, the plight of Tianwei Yingli is far from unique. Despite being the most dynamic and promising sector of the economy, private businesses in China are often locked out of the state-owned banking system. Trying to arrange a simple bank loan, finance managers are finding, is about as easy as pushing string. It’s for that reason that many companies have abandoned the banking system altogether, and now rely on a raft of alternative, unofficial – and often shady – techniques to borrow money and raise capital. Needless to say, such “shadow markets” are expensive and inefficient at best, and often illegal at worst.

Cash crisis

Statistics show how tough the situation is for many private firms. In a recent survey of private enterprise by the All China Federation of Industry and Commerce, 58% of respondents believe “financing sources” are the biggest constraint facing non-SOEs. In another study, research from the National Association of Industry and Commerce shows that 35% of private enterprises have never borrowed money from a bank. In contrast, the debt-ridden SOE sector, which contributes just 40% of GDP, accounts for 70% of all domestic bank loans.

Xu Dianqing, a professor of economics from Ontario University of Canada, believes the reasons are obvious. In particular, he points to the structure of the Chinese banking system. With privately-owned banks still forbidden, the market is dominated by China’s big four state-owned banks, with a handful of tier-two commercial banks and countryside credit unions featuring in the background. Historically, these institutions have played little more than a cashier role for the country’s giant SOEs, with almost no accountability required from bank managers as to the health of their lending.

“It doesn’t matter if a state-owned bank lends money to a state-owned enterprise. It’s state money after all. Bad loans will be covered by the state,” explains Xu. But, he adds: “If a bank lends to a private enterprise, it has to bear the responsibility when suffering a loss.”

What’s more, the fact that the People’s Bank of China (PBoC), the nation’s central bank, dictates lending rates leaves little leeway for banks to price their loans correctly.

Inevitably, bank managers have avoided taking risks on private businesses and have concentrated almost entirely on the SOE sector. But, with many government-owned companies badly run and in poor condition, loan performance has been terrible, a fact that further compounds the banks’ reluctance to take risks in the private sector. It’s little surprise that, despite a staggering RMB24.5trn of savings in China’s financial system at the end of 2004, private companies are unable to access much of it.

Instead, they turn to the shadow markets which operate outside official channels. A study from the Central University of Finance & Economics estimates that, nationwide, as much as RMB820bn was borrowed unofficially in 2003, a figure equivalent to approximately 30% of all official loans that year.

Even the PBoC has acknowledged the issue. In a rare expos´e of the situation, the bank acknowledged in May this year that underground private financing has a complementary role to play alongside official bank lending. “Because the direct financing channels are limited,” said the report, “small and medium enterprises in more developed regions have tried hard to seek alternative financing channels.”

Under the table

Nowhere are the shadow markets more apparent than in Wenzhou, a vibrant manufacturing hub in East China’s Zhejiang province. The city first saw the emergence of local private finance networks in the early 1980s. Since then, they’ve grown dramatically, as a report from the Wenzhou City branch of the PBoC shows. The report estimates that, by the end of 2004, loans in the city’s shadow market had reached as much as RMB42bn.

Zhang Chongchao, a 36-year-old entrepreneur from Wenzhou and owner of three leather factories generating annual sales of over RMB100m, is an experienced user of underground finance. A high-school dropout, he started his first business at the age of 17 with a loan of RMB200,000 from his fellow villagers. In the years since, Zhang has returned to the shadow markets, accessing pools of funds supplied by rich entrepreneurs, well-off peasants, and smart merchants who have already made their fortunes from China’s phenomenal economic growth over the past two decades.

“I wouldn’t be where I am today without the support of private loans,” Zhang readily admits. Typically, he says, a loan of less than RMB10m requires just a phone call and an IOU letter to proceed. “You know I have money but I need a RMB5m short-term loan. I come over and sign an IOU and take the money. It’s as simple as that,” says Zhang.

However, the convenience of private financing comes at a price. The uniform lending rates for short- and medium-term loans set by the Central Bank are all less than 6%. But try to borrow on the shadow markets – where private loans are unprotected by law – and companies can expect to pay at least double that.

Results from the PBoC report show that private loans in Jiangsu and Zhejiang – including Wenzhou – come with interest rates ranging from 12% to 30% per year depending on the strength and credibility of the borrower. Usually, the report adds, these loans are for less than a year.

Zhang’s experience matches such findings. In the past he says he has paid annual interest rates of around 13% a year. “And I also had to pledge a property ownership certificate for one of my businesses to secure the loan,” he notes.

In other regions, especially the northeast and northwest, the interest rates on private loans are significantly higher, with annual rates of between 100% to 200%, says Li Jianjun, assistant professor at the Central University of Finance & Economics. Unsurprisingly, he says, “Many enterprises go bankrupt, causing widespread poverty among local residents.”

Gaming guarantees

Another common technique used by China’s small businesses to raise funds centers on trying to tap the state-owned banking system via the use of credit guarantees. Often these arrangements are above-board and clearly defined, but equally often they rely on murky relationships, and occasionally outright law-breaking.

The experience of Tianwei Yingli and its solar panel business is an example of a respectable – if somewhat desperate – transaction. Back in 2002, Miao Liansheng, the company’s founder, was desperately hunting around for funds to expand his business. With no access to banking lines, Miao’s solution was a brutal one: to sell 49% of his firm to Tianwei Baobian, a bigger, listed company, for RMB45m. But just two years later, with the company performing well, Miao realized that he would need a further RMB400m to invest in new capacity – a figure that dwarfed his company’s RMB8.5m of annual net profit.

The solution this time was to go down the guarantee route. Selling a further 2% of his company to Tianwei Baodian – and ceding control of his company in the process – Miao received in return credit guarantees that enabled him to borrow RMB280m, still some RMB120m short of what he wanted.

“We’ve graduated from our start-up phase, but still we can’t get enough financing,” sighs Liu, the company’s finance manager. And, she adds, finding a company willing to provide loan guarantees is almost as hard as borrowing from the banks unassisted.

Zhang, the leather merchant from Wenzhou, sympathizes with Liu’s predicament, but also understands why guarantees are hard to come by. “I would only provide guarantees for family or friends,” he stresses. “There have to be favors, relations, or interests involving relatives and business partners for me to think about providing a guarantee, otherwise it would be foolish to get involved.”

Given Zhang’s reliance on guanxi in the past, his devotion to close contacts is understandable. Nonetheless, the notion of providing a guarantee based on family connections rather than sound financial reasons might seem less than wise to some observers. Indeed, Zhang reveals that he has lost money this way in the past, when a company he guaranteed went bankrupt.

Still, there are businesses that specialize in providing credit guarantees. China Investment Trust Guaranty in Beijing is a good example. Jiang Xiru, the company’s CFO, says his company currently provides guarantees to 4,000 private businesses, so helping them to scale the walls of the banking system which would simply be too high otherwise.

Jiang recognizes that his is a risky field to work in, and reckons it takes a good deal of intelligence and effort to eke out any sort of decent return. “We really try to get to the bottom of companies’ businesses and their management teams,” he explains. “On this basis, we offer consulting services to help companies improve themselves, and only then will the risks in the guarantee be fundamentally lowered.”

Of course, many companies will fail to meet the requirements of loan guarantors such as Jiang and his colleagues. In such situations, some companies turn, in desperation, to more shady practices by trying to dupe the loan officers at banks with guarantees of dubious merit. The recent scandals at Lantian, Yinguangxia, Nongkai, D’Long, and a host of other companies shows the scale of the problem.

One favorite technique involves related-party transactions. In particular, a company sets up a subsidiary with a decent amount of capital and then uses the subsidiary as the guarantor for its own loans without disclosing the relationship to the bank. According to Tan Weimin, deputy general manager of Shanghai Xinqi Investment, such schemes are widespread and in many cases can be structured to be legally sound. Nonetheless, he adds, arrangements like these create nothing but trouble for the banks involved.

A new twist on invoice discounting

Yet another technique to provide short-term liquidity is invoice discounting or receivables financing. Methods such as these have a long and respectable history, whereby companies borrow money from banks or other parties against the strength of their accounts receivable ledger, with the lender charging a fee for the loan. In China, however, the unique nature of the banking system means that such venerable financing ideas are practiced in unusual and sometimes questionable ways.

In one frequently used situation, a company looking to borrow money will arrange a fake transaction with a company it knows well – often an associate firm or related party. The aspiring borrower will then take its fake invoice to a cash-rich SOE and use it as collateral to borrow needed funds for a period of time just shorter than the due date on the invoice, often six months in the future. The incentive for the cash-rich SOE – which remains oblivious to the shenanigans behind this scheme – is the opportunity to lend money at a better rate of interest than it would earn on deposit in the bank. Sometimes the SOE will also demand a pledge of fixed assets such as land as additional security.

As Tan of Shanghai Xinqi Investment observes, the deal is essentially a formal contract grafted onto a pseudo trading contract. Needless to say, he adds, “Invoice discounting [of this sort] touches grey area in the law, and there are huge risks for participants.” If the borrower goes bankrupt, not only does the SOE risk losing its capital, but the debtor named in the fake invoice could face charges of financial fraud.

Look West

Another twist on the invoice discounting model arose last year thanks to the government’s moves to tighten China’s monetary policy in a bid to rein in certain runaway sectors of the economy. With overheating worries most prominent in China’s eastern coastal cities, banks in this region have come under the most pressure to cool the pace of invoice discounting. But that has only served to create an opportunity for banks from China’s slower-moving western provinces to step into the breach. Not only do they face laxer regulation in the west, they also prefer to do business in the east, where companies are more dynamic, faster growing, and less likely to go bankrupt.

Just look at Shan’xi province in the west. In 2004, its banking system lent RMB115bn in invoice discounting deals, an increase of 13% over the previous year. And that’s against a backdrop of falling borrowing in Shan’xi province itself. The trick lies in the fact that, while cross-province loans – such as from a bank in one province to an enterprise in another – are highly restricted, cross-province invoice discounting is allowed.

“More and more private firms in Zhejiang and Jiangsu provinces in the east are turning to banks in western regions to discount their receivables,” says Zhou Moquan, general manager of Shanghai Pingwen Investment Management.

To attract more business, banks in the west also offer lower interest rates, with monthly discount rates of 0.27%, about 0.02 of a percentage point lower than in Shanghai or Zhejiang. What’s more, notes Zhou, banks in the west are more lax in their lending requirements, and are even setting up offices in the east to drum up business.

Need for reform

Of course, what all this shadow market activity shows is that China’s financial system is riddled with flaws and badly needs attention. Quite apart from stifling the private sector, the current arrangements add huge amounts of unrecognized risk to an already shaky banking infrastructure. As if record levels of non-performing loans weren’t a big enough problem, the various shadow market schemes employed by private enterprise mean that broad chunks of the finance market are unregulated, and risk is being built up in unknown ways and places.

For their part, the authorities recognize this, and are working away at various solutions. In a speech given in February, Wu Xiaoling, the vice-governor of the PBoC, acknowledged frankly that the Chinese financial system is seriously lagging behind economic development. In answer to the problems faced by private enterprise looking for finance, she believes China needs both regulation and training. Regulations, she says, are needed to govern the private loan markets in order to protect both creditors and borrowers. And in the state-owned banking system, she calls for efforts to improve education about credit and risk management. There’s also a need, she adds, to set up special agencies designed to promote the development of a small-loan market.

However, important questions remain. In particular, whether the PBoC will relax control of interest rates so that commercial banks can start to price risks more accurately for small- and medium-sized companies.

Xu at Ontario University calls for even more aggressive action. For many years now, he has called on Beijing to allow the establishment of private banks. He likes to distil the lessons of China’s economic reforms over the past 20 years into two key points: first, business ownership must be completely transparent, and second, free and fair market competition is the only way to allocate resources efficiently. To this end, he concludes, “Private banks are the only solution.”

For Liu at Tianwei Yingli New Energy, such thinking makes complete sense. But will she see a decent solution any time soon? She’s not banking on it.