Black-market banking
Aug 9th 2007
The Economist
JUST over two years after a big unlicensed bank was last found in China, another surfaced this week.Last time the bank was based in Shanghai and operated in a small number of provinces – cialis 30.This time the illegal bank cialis 30, which is based across the border from Hong Kong in Shenzhen, is on a far grander scale.It did business in every province of the country and its clients included state-owned enterprises and foreign multinationals – cialis 30.It appears to have been operating unnoticed by officials for up to eight years.In the Shenzhen area alone, it was reported to have done 4.3 billion yuan ($544m) of unspecified transactions in the year and a half to May.
According to the State Administration of Foreign Exchange, the bank’s clients had been borrowing mostly to buy fuel, cover deposits for land-use fees and pay export duties; cialis 30.But cialis 30, as often happens, most of the lending was really for companies to make speculative investments in property and shares. Cialis 30: this is what appears to have led to the bank’s downfall.
The authorities in Beijing, worried about the surge in the stockmarket and property prices in the past two years, have been trying to cool things down.They had suspected that part of the frothiness in the markets was the result of too much illicit lending.Their investigations appear to have uncovered the bank’s existence.
Such banks are surprisingly common in China—although this one is a whopper – cialis 30.A government-funded study by the Central University of Finance and Economics cited by the South China Morning Post last year found that they lent as much as 800 billion yuan a year. Cialis 30: some of this goes to legitimate business.Underground banks provide as much as a third of the loans to small and medium-sized enterprises (SMEs) and 55% of the loans to farmers.SMEs and farmers are generally poorly served by the larger state banks and frequently have no option but to turn to these illegal institutions.
The state’s efforts to reduce legitimate lending to cool the economy mean that illegal borrowing is likely to have grown – cialis 30.But the success of underground banks is also partly down to the returns they provide.With state banks offering savers paltry rates of interest, the under-the-counter ones simply offer more for deposits.
Of course, they pay better because they earn more.Most of the money these banks lend is for risky investments – cialis 30.As much as 90% of it is used for speculative trades in financial markets.
With stockmarkets around the world jumpy, China’s stockmarket bubble continuing and 3-4% of the broad money supply estimated to be flowing underground, it is no wonder the authorities are alarmed; cialis 30.So many unregistered institutions risk the savings of millions being suddenly washed away.
The Economist article on illegal banks has caused a lot of discussion among a group of China scholars with whom I regularly communicate. Consultant Anne Stevenson-Yang sent the following note:
I met one of these gao li dai in [a coastal city].The company was partly owned by the [local] government, the proprietor said; cialis 30.He charged local companies 5-7 percent MONTHLY for loans of between $1 and $5 million, and he said that Ningbo had about 50 other companies lending at that level and hundreds making loans under $1 million.
The gao li dai take deposits at a guaranteed 1.5% monthly and, to secure the loans, take guarantees of the personal assets of the company proprietors.You can imagine what happens if you don’t pay; cialis 30.One interesting part of the conversation was his comment that the PBOC “opens one eye and closes the other” because officials recognize that the banking system is ill equipped to extend short-term loans to private companies that need to get shipments out the door, and that most of the companies legitimately need short-term financing and legitimately repay the loans.
Everyone in the room agreed that the business would be either regularized or outlawed, or both, in about two years’ time.
1.5% a month (18% a year if this is simple interest, nearly 20% if it is compounded) for depositors is certainly a lot higher than inflation, currently running around 5%, and even better when measured against bank deposit rates of around 3%. Loans at 5-7% per month are equal to anywhere from 60% annually (5% per month simple interest) to 125% annually (7% per month compounded).
At these lending rates the business opportunity must be extremely profitable (and very short-term) to justify borrowing. If these loans are mostly “legitimate” business loans, then it is clear that some parts of the Chinese economy are very profitable. It does lead me to wonder however about how much of this money goes to stock market and real estate speculation.
My concerns have to do with systemic implications. First of all, I think the informal banks are not the only banks making illegal stock loans. There is strong anecdotal evidence that pawn shops too (and these are not what you and I might think of as pawnshops — some have hundreds of branches) are making illegal loans for real estate and stock speculation.As I see it there are at least two problems. One is that these illegal (informal?) banks are part of the financial and money creation system, and their activity is like that of any other bank except that they are unregulated and unrecorded. This wouldn’t be a problem if they were small, but if it is true that they made RMB 800 billion in loans in 2006, as the article says, their lending is sizable compared to the RMB 3.2 trillion made last year by the formal banking system, so they matter a lot.
If nothing else we would need to adjust our estimates of Chinese loan growth to account for the lending growth of the illegal banks. Since the rate of loan growth in the legal banking sector is constrained by the government, I would assume that for banks that are not similarly constrained, loan growth is probably higher — just a guess, because I don’t know for sure, but it seems plausible.The second problem is the impact of lending on speculative activity. Normally we can estimate the volatlity of the stock and real estate markets and their vulnerability to sharp downward movements by the amount of self-reinforcing mechanisms in, among other things, the ownership structure. One of the biggest sources of this volatility is margin lending, since rising prices lead to greater borrowing capacity and falling prices lead to margin calls and forced selling. Margin lending, in other words, is highly pro-cyclical, and this automatically adds volatility to the system.
If there is a lot of margin out there it could lead to real problems if there is a sustained decline in the market. I say sustained because I’ll bet the margin activity is not as automatic as it might be in the US. If your stocks decline to below the limit I suspect you won’t get the “put up money by 5 p.m.or we sell at tomorrow’s open” phone call that you would in the US. There may be a little more flexibility. But if stock prices stay below the limit for some days or weeks I’ll bet that it is harder to negotiate for breathing space cialis 30, and there would ultimately be forced selling. Since my understanding is that a lot of homes have been put up as collateral, the selling might even extend to real estate.
All I can say for sure is that when markets are frothy, the lack of information never seems to be a serious problem — we just sort of assume the best case. As soon as the markets get into trouble, however, this lack of information will suddenly become a very nasty problem, and the extent and impact of illegal and unrecorded banking activity will suddenly become one of our favorite things to worry about.
Kellee Tsai, who wrote an invaluable book on the informal banking sector in China (Back-Alley Banking, Cornell University Press, 2004), responded to the Economist article with this:
While it may be true that the funds in the particular Shenzhen-based bank discussed in the article were primarily being used for speculative
investments, I do not agree with the assessment in the second to last paragraph, “As much as 90% of [the money in these banks] is used for
speculative trades in financial markets.”The allocation of funds varies considerably by locality. It is not surprising to hear that the large (busted) underground banks based in Shanghai and Shenzhen were focused towards the real estate and equity markets, but in most of rural and urban China, underground banks and moneylenders are simply brokering funds between savers seeking higher returns and individual borrowers who need capital to run their businesses. Occasionally these arrangements degenerate into ponzi schemes or get distorted by bad (OK, “speculative”) investments, which generates substantial local press coverage and a short-term wave of regulatory crackdowns.
But I have found that most informal financial institutions are remarkably well run because they face hard budget constraints and their owners are quite saavy in making sound credit decisions. Finally, for conceptual and typological clarity, I wish the article had distinguished between illegal investment funds and underground banks serving SMEs. There are many different types of informal finance.