Treating the Cancer of High Interest Rates in China — Caijing Magazine commentary
The cost of borrowing money is a huge and growing burden for most companies and municipal governments in China. But, it is also the most attractive untapped large investment opportunity in China for foreign institutional investors. This is the broad outline of the Chinese-language essay published in this week’s Caijing Magazine, among Chinaâ€™s most well-read business publications. The authors are me and Dr. Yansong Wang, China First Capitalâ€™s Chief Operating Officer.
Foreign investors and asset managers have mainly been kept out of China’s lucrative lending market, one reason why interest rates are so high here. But, the foreign capital is now trying to find ways to lend directly to Chinese companies and municipalities, offering Chinese borrowers lower interest rates, longer-terms and less onerous collateral than in the Rmb15 trillion (USD $2.5 trillion) shadow banking market. Foreign debt investment should be welcomed rather than shunned, our commentary argues.
If Chinese rules are one day liberalized, a waterfall of foreign capital will likely pour into China, attracted by the fact that interest rates on securitized loans here are often 2-3 times higher than on loans to similar-size and credit-worthy companies and municipalities in US, Europe, Japan, Korea and other major economies. The likely long-term result: lower interest rates for company and municipal borrowers in China and more profitable fixed-income returns for investors worldwide.
Iâ€™ve written in English on the problem of stubbornly high borrowing costs in China, including here and here. But, this is the first time I tried to evaluate the problem for a Chinese audience — in this case, for one of the more influential readerships (political and business leaders) in the country.
The Chinese article can be downloaded by clicking here.
For those who prefer English, hereâ€™s a summary: high lending rates exist in China in large part because the country is closed to the free flow of international capital. The two pillars are a non-exchangeable currency and a case-by-case government approval system, managed by the State Administration of Foreign Exchange (SAFE) to let financial investment enter, convert to Renminbi and then leave again. This makes it all but impossible to arbitrage the 1,000 basis point interest rate differential between China domestic corporate borrowers and similar Chinese companies borrowing in Hong Kong.
Foreign financial investment in China is 180-degrees different than in other major economies. In China, almost all foreign investment is in equities, either through buying quoted shares or through giving money to any of the hundreds of private equity and venture capital firms active in China. Outside China, most of the world’s institutional investment â€“ the capital invested by pension funds, sovereign wealth funds, insurance companies, charities, university endowments — is invested in fixed-income debt.
The total size of institutional investment assets outside China is estimated to be about $50 trillion. There is a simple reason why institutional investors prefer to invest more in debt rather than equity. Debt offers a fixed annual return and equities do not. Institutional investors, especially the two largest types, insurance companies and pension funds, need to match their future liabilities by owning assets with a known future income stream. Debt is also higher up the capital structure, providing more risk protection.
Direct loans — where an asset manager lends money directly to a company rather than buying bonds on the secondary market — is a large business outside China, but still a small business here. Direct lending is among the fastest-growing areas for institutional and PE investors now worldwide. Get it right, and there’s no better place in the world to do direct corporate lending than in China.
For now, direct lending to Chinese companies is being done mainly by a few large US hedge funds. They operate in a gray area legally in China, and have so far mainly kept the deals secret. The hedge fund lending deals I’ve seen have mainly been short-term lending to Chinese property developers, at monthly interest rates of 2%-3%.
I see no benefit to China from such deals, nor would I risk a dollar of my own money. A good rule in all debt investing is whenever interest rates go above 20% a year, the lender is effectively taking on “equity risk”. In other words, there are no borrowers anywhere that can easily afford to pay such high interest rates. Anyone who will take money at that price is probably unfit to hold it. At 20% and above, the investor is basically gambling that the desperate borrower will not run out of cash while the loan is still outstanding.
Interest rates are only one component of the total cost of borrowing for companies and municipalities in China’s shadow banking system. Fees paid to lawyers, accountants, credit-rating agencies, brokerage firms can easily add another 2% to the cost of borrowing. But, the biggest hidden cost, as well as inefficiency of China’s shadow banking loan market is that most loans from this channel are one-year term, without an automatic rollover.
Though they pay interest for 12 months, borrowers only have use of the money for eight or nine months. The rest of the time, they need to accumulate capital to pay back principal at the end of one year. China is the only major economy in the world where such a small percentage of company borrowing is of over one-year maturity. China’s economy is guided by a Five Year Plan, but it’s domestic lenders operate on the shortest of all time-frames.
If more global institutional capital were allowed into China for lending, I would expect these investors to want to do their own deals here in China, negotiate directly with the borrower, rather than buying existing securitized shadow banking debt. These investors would want to do more of their own due diligence, and also tailor each deal, in a way that Chinaâ€™s domestic shadow banking system cannot, so that the maturity, terms, covenants, collateral are all set in ways that correspond to each borrowers’ cash flow and assets.
China does not need one more dollar of “hot money” in its economy. It does need more stable long-term investment capital as direct lending to companies, priced more closely to levels outside China. Foreign institutional capital and large global investment funds could perform a useful role. They are knocking on the door.