Tuesday, November 1, 2011

Inside the SME Credit Crisis and Private Shark Loans

Recently the SMEs (Small-and-Medium-sized Enterprises) credit crisis in China Wenzhou city has brought concerns to the financial markets. This article shall outline the whole picture of the problem and what measures have been taken to rectify this private market credit crisis.

(1) How can this credit crisis occur for SMEs?

As we already mentioned in our earlier article: Why PBoC Prefers Reserve Requirement Ratio (RRR) Hikes, excessive RRR hikes can only invite banks to lend most of their money to SOEs (State-owned Enterprises) with more political sway, organizations with political connections or enterprises supported by the government. In addition, the current negative real deposit rate policy also encourage the wealthy in China to lend their savings to SMEs at annual rates starting at least 36% rather than just putting their money into banks that can only generate negative returns. These policies generate a simple demand and supply rule in the credit market that makes borrowing money from normal Chinese banks difficult and forces SMEs to get urgent loans from private lenders instead.

As the private lending market develops, a phenomenon called "Everybody Lending" (in Chinese: 人人貸) occurs throughout China, particularly in Wenzhou city where people commonly name it as the "Birthplace of China entrepreneurship". Wenzhou in Zhejiang province is in fact one of the richest cities in China (being ranked number 3 in disposable income per capita), is usually the "weathercock" of Chinese economy and now becomes the centre of private lending crisis. A lot of so-called private investment companies have then been established there which are actually shark loan business operators (or back door lending facilities). Around 89% of individuals or families, and 59% of firms in Wenzhou have participated in such "private loan" schemes offering annual interest rate over 36% or even up to tripple digits to SMEs. This civil usury phenomenon, however, is not unique in Wenzhou. Similar crisis also exists in Xiamen, Shenzhen, Zhejiang, Jiangsu, Fujian, Henan and Inner Mongolia etc. We can say these Chinese people have just got lured into Ponzi schemes and eventually become loan sharks, although they are mostly illegal. It is also reported that even government officials have involved in lending money to private loan sharks. These illegal loan shark businesses are funded or supported by government officials, and some of them may even be operated as a kind of bribery.

As the illegal underground lending market continues to develop, property market in China has also been heavily funded by shark loans, again because the whole property sector has difficulty in borrowing money from normal Chinese banks (reference: No More Loose Monetary Policy in China. Some SMEs even stopped their original export business and became loan sharks for the higher return in property market, thus creating a larger speculative bubble.

Given the relatively large percentage of private lending participation in Wenzhou, any sizeable default on private loans can possibly trigger a negative chain effect to the whole underground lending system. The collapse of this underground banking system can be the worst consequence for both the private money borrowers and lenders in Wenzhou if the troubles in cash-flow are not solved and the lending chain is broken.

At the end of the day, bubble burst for this kind of private lending is unavoidable, because there is virtually no SME business can earn such a high profit margin to cover the ultra-high shark loan interest rate. It is just like a subprime market crash, or some people may call it "Wenzhou Loan Shark Crunch", once credit liquidity has started to dry up. It has been reported that owners of over 90 Wenzhou-based SMEs have fled since April 2011. These Chinese private business owners in Wenzhou disappeared or even committed suicide for the reason that they failed to pay off the expensive black market shark loans. Such news or spreading crisis rumors have also brought damage to the Chinese stock markets, on fears that real estate developers are losing ability to funding and may be forced to cut property prices sharply or to offer sizeable discounts.

(2) What measures have been taken to rectify this private market credit crisis?

In fact, earlier in May, the China Banking Regulatory Commission (CBRC) already issued a guideline to instruct Chinese banks to boost their credits to small business operators, and to tolerate a higher ratio of bad loans relating to SMEs (small-and-medium-sized enterprises).

On 28 September 2011, Wenzhou city government imposed an upper limit on the interest rates that private non-bank lenders can charge borrowers. Under this special administrative measure, private non-bank institutions can only offer loans at an interest rate not exceeding four times the PBoC benchmark lending rate. The Wenzhou city government also requested banking institutions to increase their financing supports to SMEs (small and medium-sized enterprises) by imposing a ceiling on interest rates for loans to the related businesses. Interest rate ceiling is now capped at 1.3 times the PBoC benchmark rate. (Remark: PBoC one-year lending rate is currently at 6.56%). Although the interest rate cap may rectify the crisis in the long run, this may also create a shortage of credits in the short term as it cannot compensate lenders for the true market risks taken, thus may eventually exacerbate the crisis by accelerating the process of loans going bad.

While SME bankruptcies and suicides have drawn attention to central government, China premier Wen Jiabao did visit Wenzhou during the National Days Holiday in early October and urged Chinese banks to provide preferential financial credits to support SMEs by reducing lending costs and eliminating unnecessary fees etc.

As long as the normal banking system is relatively isolated from the collapse of these private loansharking activities, we believe the risks to the whole Chinese economy can still be contained. We, however, do agree that the SME credit crisis has to be carefully managed or it may negatively impact the domestic employment market.

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