“It’s a proprietary strategy. I can’t go into great detail.” That’s what Bernard Madoff told Barron’s in 2001, as he sought to disguise his Ponzi scheme. By the time he was exposed seven years later, CNBC estimates Madoff had wiped out $21.2 billion of investor funds.
It was only a matter of time before China had a Madoff moment of its own. And in this case the culprit Zhong Mingzhen exploited the country’s private loan business – a suitably murky area – for her own financial shenanigans. Her company, Xiamen Rongdian, collapsed this week, leaving billions in losses behind.
The scandal comes at a bad time. China’s financial system has already been battered by unwelcome news – last week we reported on the first default by a local government financing vehicle. Jittery analysts worry Chinese banks may need to write off loans worth (at least) Rmb3 trillion when others follow it and default too.
Likewise disconcerting: Rongdian reveals trouble is brewing in the shadows of the banking system too.
Rongdian in the wrong…
Rongdian was established in 2008, innocuously enough as an investment promotion vehicle for a district in Xiamen called Siming.
But Zhong Mingzhen had bigger ambitions for her wholly-owned firm, and she sought out a licence to become a guarantee company.
These are agencies which help smaller and medium-sized firms to get loans from banks. They can’t take deposits or lend directly – at least not legally. However, lending is very tempting – particularly as firms like Rongdian can charge usurious rates (recently, cash-strapped businesses have been paying as much as 1% per day for such loans).
Zhong used her ownership of Rongdian to solicit funds from a host of companies and individuals who were sitting on excess cash that earned minimal interest at the bank. Zhong offered them much more lucrative returns, borrowing their money and then lending it out at even higher rates. In sum: she’d soon created an unregulated bank.
Worse, the system became a Ponzi scheme. As long as Rongdian appeared financially sound and paid returns of more than 5% per month, it was able to attract new funds to repay loans coming due.
What went wrong? Rongdian’s shambolic finances came unstuck thanks to the usual cocktail of personal hubris and reckless expansion. According to 21CN Business Herald a loan to a metal products company from Longhai was the catalyst. When Zhong couldn’t recover her initial loan, she agreed to a debt-for-equity swap that gave her a controlling stake. At this juncture she was shocked to discover the troubled firm already had huge hidden debts. As owner, she was now accountable for them.
Poetic justice, perhaps. But the financial commitments drained her cashflow, meaning Zhong stopped paying the interest on earlier loans. On May 1, one of Rongdian’s disgruntled clients showed up outside the firm’s offices with a hired gang, and made a public scene using loudspeakers. This sparked a classic run as other creditors also demanded repayment. That spooked a local bank, which had been on the verge of offering Zhong a lifeline: a Rmb300 million line of credit.
When that line of credit was pulled, Rongdian “collapsed overnight” reports 21CN. In an indication of the scale of her unreported lending business the current rumours suggest Zhong owes her creditors Rmb3.7 billion ($572 million).
In Xiamen word of Rongdian’s demise spread quickly. But in an effort to contain the damage, the local government tried to keep the news under wraps while it looked for a backroom solution.
National media finally broke the story last week.
An isolated phenomenon?
The worry is that Rongdian could be the first of many ‘private lenders’ to go under.
No one knows the exact scale of the unregulated lending business in China. But in the past year or so it has probably been growing fast. WiC has written before about the underground lending business (see WiC104 for the tale of Wu Ying who faces the death sentence for indulging in the practice). Historically, the biggest source of such funds was the freewheeling city of Wenzhou, where estimates of private capital looking to be ‘invested’ in similar schemes run as high as $150 billion. But as Rongdian’s case shows unregulated lending has spread to Xiamen and elsewhere.
Why? China’s big state banks have never been very keen to lend to privately-owned small and medium sized enterprises. That’s created a gap in the lending market, and one that entrepreneurial ‘shadow’ bankers have readily exploited. The government has also been attempting to curb runaway bank lending in the past 12 months – which has meant that firms who might usually count on access to bank loans have been denied financing too. Combine that with deteriorating economic conditions and flagging cashflows, and you have fertile territory for private lenders to expand at a rapid rate, with increasingly desperate firms swelling client lists – and willing to pay exorbitant rates to borrow.
More bad news from Xiamen…
The Economic Observer reveals that the rot extends into the formal banking system too, with reports that a general manager with Xiamen International Bank has fled on news that he’d been operating his own private lending business on the side.
It’s now thought that the official had been carrying out the lucrative practice for several years. He had access to companies keen to borrow, and knew who had big cash balances in the regular bank. Like Zhong he’d offer higher returns to use their funds.
The banker in question disappeared last month, reportedly because a guarantee company he was cooperating with had (in a similar fashion to Rongdian) got into financial trouble. And in what looks to be a grey area, creditors are asking the bank to make good on its employee’s actions, warns the Economic Observer.
Who else is involved? The newspaper quotes an industry insider as saying “basically all the guarantee companies are involved in private lending too”. According to local data, Xiamen was home to 156 guarantee companies by the third quarter of last year, up from 58 in 2009.
Xiamen is currently in the spotlight. But you can bet similar problems are brewing right across the country…
Other concerns for the regulator
Burgeoning problems with the ‘informal’ banking sector are hard to quantify, although the China Banking Regulatory Commission (CBRC) at least has the excuse that it exists outside of its official remit.
But policymakers will be more irate at recent evidence that the ‘formal’ banking sector is routinely flouting lending restrictions too.
The CBRC this week decided to crack down on another of the more flagrant methods for hiding new loans. Having last year instructed the major banks to stop circumventing lending regulations via trust companies (see WiC98), the regulator has now turned its attention to rural credit cooperatives.
The trick being employed here: selling the cooperatives bank acceptances – basically credit notes linked to loans – and buying them back just before they mature. This exploits an auditing loophole as the rural credit cooperatives don’t account for these as loans, which means banks can move credit off their balance sheets, thus freeing up their quota for fresh lending. It’s a profitable ploy for the bank, as it earns interest from new lending, while paying a discounted rate to the cooperative where it has ‘parked’ its original loan, usually for a six month period.
The CBRC has traced spiking volume in such trades to rural cooperatives in Jiangsu, Henan and Hunan. On June 27 it ordered all commercial banks to submit “a self-inspection report” by last Monday. The National Business Daily says this is designed to smoke out banks’ involvement in the practice.
How widespread could it be? China Business News estimates that – collectively – the banks have used these discounted credit notes to hide new loans worth Rmb3 trillion in 2010. That’s the equivalent of 40% of ‘reported’ new lending last year.
Taken as a whole the picture looks even more worrying than it did a week ago. Bank exposure to dodgy local government financing platforms has got top billing in the news headlines. But now it is toxic loans in the underground lending sector getting attention, as well as the revelations that try though the regulators might, the wily banks continue to find creative ways to pump up their loan books. The CBRC close off one loophole, but then have to turn immediately to dealing with another one…
That may be one reason why China Everbright Bank postponed its $6 billion Hong Kong IPO this week. Investors have begun to take fright at all the bad news emerging from the banking sector – Bank of China’s credit default swaps have surged, for example.
WiC doesn’t expect China to have a day of reckoning like September 15, 2008 when Lehman Brothers filed for bankruptcy and confidence in the American financial system unravelled almost overnight. China has $3 trillion of reserves, and a closed capital account that prevents (most) of its domestic cash fleeing the country. It also has homegrown experience of cleaning up its financial system before. Unlike Wall Street’s collapse, China’s problems will be longer and more drawn out. More like watching a car wreck in slow motion, say the pessimists. Still gruesome, but at least there’s an airbag to dull some of the impact…
Keeping Track: in our Talking Point in WiC114 we examined the collapse of Rongdian, a ‘private lender’ which was operating a Madoff-like Ponzi scheme in the city of Xiamen. The guarantee company had seen a chunk of its own loans go bad, and when it stopped paying interest on them, a very public run on the (grey area) bank occurred. Now, according to the Economic Observer, Xiamen has four other guarantee companies experiencing something similar. The newspaper suggests the bad debt of the four exceeds Rmb10 billion ($1.56 billion) and speculation is mounting whether the failure of these ‘shadow’ lenders will cause losses at genuine local banks with which they are rumoured to have relationships. (Aug 19, 2011)
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