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China’s loan shark economy — Nikkei Asian Review

Leave a Comment / June 25, 2016

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China loan sharking

China’s loan shark economy

PF

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What’s ailing China? Explanations aren’t hard to come by: slowing growth, bloated and inefficient state-owned enterprises, and a ferocious anti-corruption campaign that seems to take precedence over needed economic reforms.

Yet for all that, there is probably no bigger, more detrimental, disruptive or overlooked problem in China’s economy than the high cost of borrowing money. Real interest rates on collateralized loans for most companies, especially in the private sector where most of the best Chinese companies can be found, are rarely below 10%. They are usually at least 15% and are not uncommonly over 20%. Nowhere else are so many good companies diced up for chum and fed to the loan sharks.

Logic would suggest that the high rates price in some of the world’s highest loan default rates. This is not the case. The official percentage of bad loans in the Chinese banking sector is 1%, less than half the rate in the U.S., Japan or Germany, all countries incidentally where companies can borrow money for 2-4% a year.

You could be forgiven for thinking that China is a place where lenders are drowning in a sea of bad credit. After all, major English-language business publications are replete with articles suggesting that the banking system in China is in the early days of a bad-loan crisis of earth-shattering proportions. A few Chinese companies borrowing money overseas, including Hong Kong-listed property developer Kaisa Group, have come near default or restructured their debts. But overall, Chinese borrowers pay back loans in full and on time.

Combine sky-high real interest rates with near-zero defaults and what you get in China is now probably the single most profitable place on a risk-adjusted basis to lend money in the world. Also one of the most exclusive: the lending and the sometimes obscene profits earned from it all pretty much stay on the mainland. Foreign investors are effectively shut out.

The big-time pools of investment capital — American university endowments, insurance companies, and pension and sovereign wealth funds — must salivate at the interest rates being paid in China by credit-worthy borrowers. They would consider it a triumph to put some of their billions to work lending to earn a 7% return. They are kept out of China’s lucrative lending market through a web of regulations, including controls on exchanging dollars for yuan, as well as licensing procedures.

This is starting to change. But it takes clever structuring to get around a thicket of regulations originally put in place to protect the interests of China’s state-owned banking system. As an investment banker in China with a niche in this area, I spend more of my time on debt deals than just about anything else. The aim is to give Chinese borrowers lower rates and better terms while giving lenders outside China access to the high yields best found there.

China’s high-yield debt market is enormous. The country’s big banks, trust companies and securities houses have packaged over $2.5 trillion in corporate and municipal debt, securitized it, and sold it to institutional and retail investors in China. These so-called shadow-banking loans have become the favorite low-risk and high fixed-return investment in China.

Overpriced loans waste capital in epic proportions. Total loans outstanding in China, both from banks and the so-called shadow-banking sector, are now in excess of 100 trillion yuan ($15.9 trillion) or about double total outstanding commercial loans in the U.S. The high price of much of that lending amounts to a colossal tax on Chinese business, reducing profitability and distorting investment and rational long-term planning.

A Chinese company with its assets in China but a parent company based in Hong Kong or the Cayman Islands can borrow for 5% or less, as Alibaba Group Holding recently has done. The same company with the same assets, but without that offshore shell at the top, may pay triple that rate. So why don’t all Chinese companies set up an offshore parent? Because this was made illegal by Chinese regulators in 2008.

Chinese loans are not only expensive, they are just about all short-term in duration — one year or less in the overwhelming majority of cases. Banks and the shadow-lending system won’t lend for longer.

The loans get called every year, meaning borrowers really only have the use of the money for eight to nine months. The remainder is spent hoarding money to pay back principal. The remarkable thing is that China still has such a dynamic, fast-growing economy, shackled as it is to one of the world’s most overpriced and rigid credit systems.

It is now taking longer and longer to renew the one-year loans. It used to take a few days to process the paperwork. Now, two months or more is not uncommon. As a result, many Chinese companies have nowhere else to turn except illegal money-lenders to tide them over after repaying last year’s loan while waiting for this year’s to be dispersed. The cost for this so-called “bridge lending” in China? Anywhere from 3% a month and up.

Again, we’re talking here not only about small, poorly capitalized and struggling borrowers, but also some of the titans of Chinese business, private-sector companies with revenues well in excess of 1 billion yuan, with solid cash flows and net income. Chinese policymakers are now beginning to wake up to the problem that you can’t build long-term prosperity where long-term lending is unavailable.

Same goes for a banking system that wants to lend only against fixed assets, not cash flow or receivables. China says it wants to build a sleek new economy based on services, but nobody seems to have told the banks. They won’t go near services companies, unless of course, they own and can pledge as collateral a large tract of land and a few thousand square feet of factory space.

Chinese companies used to find it easier to absorb the cost of their high-yield debt. No longer. Companies, along with the overall Chinese economy, are no longer growing at such a furious pace. Margins are squeezed. Interest costs are now swallowing up a dangerously high percentage of profits at many companies.

Not surprisingly, in China there is probably no better business to be in than banking. Chinese banks, almost all of which are state-owned, earned one-third of all profits of the entire global banking industry, amounting to $292 billion in 2013. The government is trying to force a little more competition into the market, and has licensed several new private banks. Tencent Holdings and Alibaba, China’s two Internet giants, both own pieces of new private banks.

Lending in China is a market rigged to transfer an ever-larger chunk of corporate profits to a domestic rentier class. High interest rates sap China’s economy of dynamism and make entrepreneurial risk-taking far less attractive. Those looking for signs China’s economy is moving more in the direction of the market should look to a single touchstone: is foreign capital being more warmly welcomed in China as a way to help lower the usurious cost of borrowing?

Peter Fuhrman is the founder, chairman and chief executive of China First Capital, an investment bank based in Shenzhen, China.

 

http://asia.nikkei.com/Viewpoints/Perspectives/Chinas-loan-shark-economy

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China’s Most Profitable Industry Becomes One of the Toughest

4 Comments / July 7, 2011

Chinese real estate is no longer the easiest legal risk-adjusted money-making business in the world. It’s been a swift reversal. For the better part of twenty years, there’s been no simpler way to amass a great fortune than developing property in China.

The business model was as simple as it was profitable: acquire a piece of property from friends in government at a fraction of its market value, mortgage the property heavily with obliging state-owned banks, sell out most of the units (either offices or apartments) within weeks of construction beginning, and then pocket returns of 500% or more before the building was even occupied.

Continuously rising property prices, often increasing by 10% or more per month,  provided incentive to hold onto some units for later sale. A final wrinkle was to demand a cash advance from the construction company when awarding the building contract, so limiting even more the amount of capital needed, and improving return-on-equity even more.

There was just about zero risk in deals like this. Then, the Chinese government began clamping down, starting gingerly about a year ago and then with added ferocity in recent months,  in an effort to restrain property prices and overall inflation. At this point, what was once the easiest business in China has become one of the hardest. Sweetheart land deals are far more rare, as the central government in Beijing is no longer turning a blind eye.

More importantly, banks have all but stopped lending to property developers. This has dried up liquidity in an industry that was for many years awash in it. The projects getting built now, for the most part, are those where little or no bank debt is required. That means heavy upfront equity investment, or taking money from loan sharks who charge interest rates of 25%-30% a year. This fundamentally alters the arithmetic of a real estate deal in China. The more equity and high-interest debt that goes in, the lower the returns and, it seems,  the more likely a project is to hit problems.

And problems have become the norm. Another government change, little reported but absolutely crucial to the change in fortunes of the real estate business in China, is that it’s no longer easy and cheap to get current residents off the land, so it can be sold at a high price to a developer. New rules make it very expensive and risky for any developer to undertake this process of relocation and demolition.

Any delay, and delays are rampant, can quickly drain away a developer’s cash. For example, if one old tenant refuses to take the relocation money and move out, it is no longer a simple thing in most instances to get the local government, or hired goons, to force them out. Until all old tenants are resettled, no construction can begin. This can push back by months or even years the date that developers can begin pre-sales. Meantime, you keep paying usurious interest rates to lenders who have taken the whole project, as well as many of other unrelated assets, as collateral.

A final nail: residential real estate prices are now rising far more slowly. This is the result of tighter mortgage rules, property taxes in some cities, as well as new regulations that limit the number of apartments people can buy. In Beijing, for example, you need to prove you have paid local Beijing taxes before being allowed to buy.

Of course, taking the easy money out of real estate is a prime policy objective of the Chinese government. That the government would be successful in this was never much in doubt. The speed and geographical scope of the impact, however, has caught a lot of people (including me) by surprise. Projects that six months ago looked like sure things are today struggling. The sudden evaporation of bank finance, in particular, is playing havoc. Banks in China are state-controlled. When they responded slowly, earlier this year, to government suggestions they slow the flow of funds to the real estate sector, the government took more active measures, including raising six times banks’ reserve requirements.

Rocketing property prices are a major contributor, directly and indirectly, to inflation, which is now, by official figures, at its highest level in China in over three years. So, the government’s actions had a broader purpose than altering the return formula for real estate investment in China. At the moment, though, that’s been the main impact, to make it far harder to do both residential and commercial real estate projects in China. When and by how much inflation will be curbed is unclear.

The bigger question is: has the game changed permanently in Chinese real estate, or will things revert as soon as inflation is down to where the government wants it to be. The rising real estate prices of the last 20 years have not only helped the country’s real estate barons. They have also been a main source of rising middle class wealth in China. That’s where the government policy becomes more an art than science: how to strip away real estate developers’ easy profits, while keeping the middle class feeling flush and contented. I’ll write about that in a following blog post.

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The New Equilibrium – It’s the Best Time Ever to be a Chinese Entrepreneur

1 Comment / January 7, 2010

China Private Equity blog post

As I wrote the last time out, the game is changed in PE investing in China. The firms most certain to prosper in the future are those with ability to raise and invest renminbi, and then guide their portfolio companies to an IPO in China. For many PE firms, we’re at a hinge moment: adapt or die. 

Luckily for me, I work on the other side of the investment ledger, advising private Chinese companies and assisting them with pre-IPO capital raising. So, while the changes now underway are a supreme challenge for PE firms, they are largely positive for the excellent SME businesses I work with.

They now have access to a greater pool of capital and the realistic prospect of a successful domestic IPO in the near future. Both factors will allow the best Chinese entrepreneurs to build their businesses larger and faster, and create significant wealth for themselves. 

As my colleagues and me are reminded every day, we are very fortunate. We have a particularly good vantage point to see what’s happening with China’s entrepreneurs all over the country. On any given week, our company will talk to the bosses of five and ten private Chinese SME. Few of these will become our clients, often because they are still a little small for us, or still focused more on exports than on China’s burgeoning domestic market. We generally look for companies with at least Rmb 25 million in annual profits, and a focus on China’s burgeoning domestic market. 

For the Chinese companies we talk to on a regular basis, the outlook is almost uniformly ideal. China’s economy is generating enormous, once-in-a-business-lifetime opportunities for good entrepreneurs.

Here’s the big change: for the first time ever, the flow of capital in China is beginning to more accurately mirror where these opportunities are. 

China’s state-owned banks have become more willing to lend to private companies, something they’ve done only reluctantly in the past. The bigger change is there is far more equity capital available. Every week brings word that new PE firms have been formed with hundreds of millions of renminbi to invest.

The capital market has also undergone its own evolutionary change. China’s new Growth Enterprise Market, known as Chinext, launched in October 2009. In two months, it has already raised over $1 billion in new capital for private Chinese companies. 

In short, the balance has shifted more in favor of the users rather than the deployers of capital. That because capital is no longer in such short supply. This is among the most significant financial changes taking place in China today: growth capital is no longer the scarcest resource. As recently as a year ago, PE firms were relatively few, and exit opportunities more limited. Within a year, my guess is the number of PE firms and the capital they have to invest in private Chinese companies will both double. 

Of course, raising equity capital remains a difficult exercise in China, just as it is in the US or Europe. Far fewer than 1% of private companies in China will attract outside investment from a PE or VC fund. But, when the business model and entrepreneur are both outstanding,  there is a far better chance now to succeed.

Great business models and great entrepreneurs are both increasingly prevalent in China. I’m literally awestruck by the talent of the Chinese entrepreneurs we meet and work with – and I’ve met quite a few good ones in my past life as a venture capital boss and technology CEO in California, and earlier as a business journalist for Forbes. 

So, while life is getting tougher for the partners of PE firms (especially those with only dollars to invest), it is a better time now than ever before in Chinese history to be a private entrepreneur. That is great news for China, and a big reason why I’m so thrilled to go to work each day.  


A Step in The Right Direction – But Capital Allocation Remains Highly Inefficient in China

Leave a Comment / October 31, 2009

Vrard Watch from China First Capital blog post

Capital is not a problem in China. Capital allocation is. 

Expansionary credit policies by the government has created a boom in bank lending. This rising tide of bank credit is also lifting Chinese SMEs. Through the first half of this year, loans to SME have increased by 24.1% , or 2.7 trillion yuan ($400bn).  All that new lending, though, has not substantially altered the fact that bank lending in China is still directed overwhelmingly  towards state-owned companies.  So, while lending to SME rose by nearly a quarter, that equates to only a tiny 1.5% increase in the share of all bank loans going to SME. 

State-owned banks and state-owned companies are locked in a mutual embrace. It’s not very good for either of them, or for the Chinese economy as a whole. Faster-growing, credit-worthy private companies find it much harder and more costly to borrow.  Over-collateralization is common. An SME owner must often put up all this company’s assets for collateral, then throw in his personal bank accounts and property, and finally make a cash deposit equal to 30% to 50% of the loan value. 

China isn’t the only country, of course, with inefficient credit policies. Japan’s banking system still puts too much cheap credit in the hands of favored borrowers.  But, the problem is more damaging in China that elsewhere, for two reasons: first, many of China’s best companies are small and private. They are starved of capital and so can’t grow to meet consumer demand. Second, the continuing deluge of credit for state-owned companies distorts the competitive landscape, keeping tired, often loss-making incumbents in business at the expense of better, nimbler and more efficient competitors. 

In other words, China’s credit allocation policies are actually stifling overall economic growth and inhibiting choice for Chinese consumers and businesses. 

State-owned banks everywhere, not just in China, have the same fatal flaw. They like an easy life, which means lending to companies favored by their controlling shareholder, not those that will earn the greatest return.  They can turn a deaf ear to profit signals because, ultimately, profit isn’t the only purpose of their labors. They allocate credit as part of some larger scheme, in China’s case, maintaining output and employment in the country’s less competitive,  clapped-out industries.  

There’s a regional dimension to this too. China’s richest, most developed areas are in South,  particularly the powerhouse provinces of Guangdong, Zhejiang and Fujian.  The economy here is driven by private, entrepreneurial companies, not the state-owned leviathans of the North. As a result, a credit policy that discriminate against private SME also ends up discriminating against the parts of China with the highest levels of private ownership and per capital wealth. 

That’s not sound banking, or sound policy. The good news is that the situation is changing. SME are gradually taking a larger share of all lending. The change is still too slow, too incremental, as the latest figures show. But, with each cautious step, the private sector, led by entrepreneurial SME, gains potency, gains scale and gains more of the resources it needs to provide the products and services Chinese most want to buy. Â