China shadow banking: dancing in the dark

By Guest Contributor
February 8, 2012

By Helen H. Chan

HONG KONG/NEW YORK, Feb. 8 (Business Law Currents) – Uncertainty over the exact size of China’s underground private financing activities, also known as the shadow banking industry, is causing concerns among international investors as well as the Chinese government.

Restrictions on bank lending to China’s small-to-medium enterprises and to the real estate sector over the past few years have driven many of these businesses to seek alternative methods of financing from larger cash-rich entities. This demand for funding has in turn prompted the development of non-bank financiers such as trust companies and private short-term financing service providers.

Commonly, private lenders charge substantially higher interest rates for short-term loans and may even source or borrow funds from non-conventional sources to lend out. One such lender, Credit China Holdings, offers loans collateralized by real estate but also accepts jewelry and watches as collateral.

While the underground lending market in the PRC has provided financing options to struggling companies in the absence of bank lending, these options are fraught with risk. The lack of capital requirements, standardized record keeping, and other regulations for private lending have in many situations created ticking time bombs.

Consider the private financing crisis in the city of Wenzhou. In 2011, more than 40 business owners in the city defaulted on loans from private lenders, as disclosed by the Wenzhou Public Security Bureau. While some of the loans had come from private corporate lenders, a substantial amount of capital had come from the savings of local households, further exacerbating the economic damage caused by the defaults.

The dubiousness of the underground loan market in China is causing some investors to pause for thought. In its semi-annual review, mutual fund manager International Value Advisers noted that it was “difficult to buy attractively priced businesses” in China. The firm cited uncharted credit growth in China driven by the shadow banking system as one of its major reasons for hesitation.

Similarly, investment banks such as Goldman Sachs have noted that uncertainty over the shadow banking system has resulted in increased volatility in China’s equity markets for much of last year. In a shareholder report issued to clients of the Goldman Sachs Trust last December, the bank observed that private lending activities were gaining increasing attention from PRC lawmakers.

Striving to maintain market stability, financial watchdogs have begun to tackle shadow lending. Following the private financing crisis in Wenzhou, government officials implemented legal thresholds for interest rates on private loans. Rates that exceed fourfold of China’s benchmark interest rate are no longer entitled to legal protection and the borrower may refuse to pay the excess interest owed.

More recently, China’s banking regulator, the CBRC, has turned its gaze to the country’s trust investment firms to stem grey market lending. In mid-January the CBRC imposed a nation-wide ban on the sale of trust products that invest in commercial paper, which had become a popular way for China’s SMEs to secure funding. According to Reuters news sources, the market for such products is worth an estimated 200-300 billion yuan (US$32-48 billion).

Despite valiant efforts to clamp down on non-bank lending activities, government tightening policies that cut off lending to SMEs may not bring about market stability. Restricting the ability of Chinese banks to grant loans to SMEs compelled many companies to seek funding from the shadow banking industry in the first place. Closing off alternative financing may force companies to go deeper into the ground one way or another.

 

(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at http://currents.westlawbusiness.com. )

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