Economy, Talking Point

Financing revolution

Wenzhou’s shadow banks are to be legalised

Financing revolution

It doesn’t look much, but this city could trigger a transformation in China’s banking system: Wenzhou

Bank-bashing has taken a while to reach Chinese shores but Wen Jiabao made up for lost time last week, with a skewering of the Vampire Squid, Chinese-style.

“Frankly, our banks make profits far too easily,” the Chinese premier told state radio. “Why? Because a small number of banks occupy a monopoly position, meaning one can only go to them for loans and capital.”

Wen also referred to plans for a “general financial reform zone” in the city of Wenzhou, in which private companies and individuals will be encouraged to invest in lending agencies like loan companies and rural banks.

The broadside against the banks, coupled with the news that China’s vast network of unregulated ‘shadow’ lenders may be about to be welcomed into the official fold, saw banking shares drop sharply.

Talk, but where’s the action?

Policymakers say the Wenzhou pilot programme will run for up to a year, and could then be extended to other parts of China if it proves successful.

Currently the scheme is only being explained via a series of principles, with a commitment to disclose fuller rules by the beginning of May.

This leaves some analysts feeling underwhelmed, including Victor Shih, professor at Northwestern University and a long time China watcher, who told the Wall Street Journal that similar promises have been made for years but that he is yet to see any “drastic, concrete action”.

Could it be different this time? Traditionally the last few months before the leadership transition are a sedate period, as the new team prepares to take charge. But this year, the mood has been febrile, especially in the wake of Bo Xilai’s dramatic purge (see page 7).

There is also the suggestion that the current leadership wants to establish more of a reformist legacy, even though its period in office is almost over. Asked last month whether he had more work to accomplish, Wen told a news conference that he had “regrets and things left to do” and the speculation is that the Wenzhou plan could be part of a final push for financial reform.

Wenzhou often leads the way?

The city has a track record for taking the lead when economic reforms are being discussed. Previous breakthroughs in Wenzhou include the first granting of a private business licence in 1980 and the emergence of China’s first joint-stock company, a boot factory, in 1984.

As we began reporting two years ago (see WiC63), Wenzhou also has a reputation as an entrepreneurial hotspot that operates at the outer edges of the rules. In March last year we highlighted a single example, when local authorities announced new measures allowing Wenzhou natives to invest directly overseas (WiC97). The news earned wide attention as a potential first step in the dismantling of China’s capital controls. But not much else happened: it turned out that Wenzhou’s bureaucrats had proceeded without the necessary approvals from the central government, and they were soon slapped back into line.

This time around it looks different. Caijing magazine says that the pilot plan stems from six months of consultation coordinated by the State Council, and that at least seven of the key government ministries in Beijing have signed-off on the proposals.

Most of plan focuses on bringing underground lenders into the formal sphere. Regular WiC readers will be familiar with China’s shadow financial system, where individuals and companies lend capital at high interest rates to cash-strapped entrepreneurs. The plan for Wenzhou is to bring this unregulated network out of the darkness. As a starting point lenders will be encouraged to invest in rural banks, rural financial cooperatives and micro-credit lenders. In addition, there are plans to set up six private asset management companies and a private equity fund in Wenzhou, as well as a clearing-house facility that will support private fundraising in the city.

A change of mood on unregulated lending?

The measures have been forced on the current leadership by the scale of private lending now known to take place (estimated at $1.3 trillion by Beijing research firm IHS Global Insight, or the equivalent of the 2011 US government deficit, says Bloomberg).

Measures designed to tighten credit at the state banks last year saw hundreds of businesses start to collapse, unearthing a tangled network of underground lenders in the process. The crisis has since spread to other provinces (see WiC127) but Wenzhou has been at the epicentre, with company bosses committing suicide or going on the run (as chronicled extensively by WiC, see issue 124 for one report).

Wen Jiabao travelled to Wenzhou himself last October in an emergency visit, promising measures to help ailing small businesses (see WiC126).

He also called for a crackdown on illegal lenders, although it now seems that policymakers have had a change of heart.

Just as well, perhaps: plenty of commentators argue that illegal lending is meeting a critical need. Rather than lend to the smaller, privately-owned businesses that generate most of China’s jobs and growth, the leading banks prefer to work with the larger state-owned firms, trusting in what they see as an implicit financial guarantee from their government backers.

Yet small and medium enterprises (SMEs) need financing too. As such, local officials have often turned a blind eye to underground lending, although a moneylender from Zhejiang province called Wu Ying is now facing the death penalty in the best-known case to reach the courts. Public opinion has been strongly in Wu’s favour and there has been widespread unease at her sentencing (see WiC104 and 138).

“You cannot try to stop this just by killing people,” warned a delegate to the Chinese People’s Political Consultative Conference last month.

And now the banks are being portrayed as the villains?

Their casting comes on the back of the financial reporting season, with profits up by a third to more than Rmb1 trillion ($158.4 billion), reports China Economic Weekly. The sector looks a lot more profitable than its peers in the West, generating twice the return on assets of US lenders, and almost three times the return on equity.

Despite this, performance is probably not quite as stellar as the results suggest, especially if analysts are right to suspect that there could be a lot of bad debt lurking in the books.

Similarly, it’s far from clear that bank profitability is down to monopoly alone. China’s top four banks (ICBC, Bank of China, ABC and CCB) account for about 40% of total loans, with Han Fulin, a professor at the Central University of Finance and Economics telling the Shanghai Daily that the largest 20 banks comprise about 80% of the market.

But Han also says that this is much less concentrated in ownership terms than sectors like telecoms or petroleum. Instead, bank profitability is more a result of interest rate policy, with the central bank – the People’s Bank of China – determining fixed lending and deposit rates that guarantee the banks a minimum 3.5% interest spread.

About 80% of bank income is said to come courtesy of this margin.

Why such a favourable set up? Famously, a Wall Street banker claimed in 2009 to be engaged in “God’s work” and China’s interest rate rules are also endorsed from the top, although in this case from the State Council leadership including the current monopoly-basher Wen Jiabao.

The leading banks all have a genuine claim to be doing the State Council’s bidding. Most notably of all, from late 2008 they went on a massive lending spree at its behest, to counteract the effects of the global financial crisis and subsequent recession. For this and other contributions (they buy PBoC bills at very low yields, for instance), they get an interest rate cushion for their balance sheets.

The policy has been crucial to funding China’s economic growth model (which relies heavily on investment and exports). Capital is sourced from low-earning deposits, penalising household savers (over the last seven years, the real return on a 12-month time deposit has averaged minus 0.5%, says Tom Holland at the South China Morning Post). Then it is distributed as cheap funding to state-owned businesses and local governments.

Some would say that this makes Wen’s bank-bashing look a little disingenuous.

What does this mean for the Wenzhou reforms?

Caijing magazine forecasts that up to five private loan firms in Wenzhou will be turned into ‘official’ rural banks by the end of the year, with much of the Chinese media also believing that local loan providers will prove better at risk management than the big banks when it comes to SME lending.

Quite why they think this isn’t fully spelled out, but presumably the assumption is that a little local knowledge will lead to fewer loans going bad.

Caijing also cited a landmark event: on April 9 the Wenzhou Private Lending Registration Service Centre opened its doors in the city’s Lucheng district. Its purpose is to act as a clearing house, matching small corporate borrowers with those willing to lend, as well as offerring services to document loans properly.

But as Xu Zhiqian – who was in charge of the preparatory group establishing the new centre – admitted to the magazine, the pilot plan also faces “lots of uncertainties.”

Many wonder whether the underground lenders will take the bait and ‘go legit’. In terms of the benefits, there might be a chance to win a wider range of customers by making loans legally. Regulated lenders may also have more chance of recovering some of the loans that default. Nor will they risk arrest for unlicenced activity as they do today (not that this seems to serve as much of a deterrent at the moment: there are tens of thousands of illegal lenders in Wenzhou).

But private lenders will also want answers on whether they will have to cede an ownership stake to a pre-existing financial institution (under current rules, rural banks must have a recognised bank as lead shareholder).

More importantly still, they will want to know what interest rates they will be allowed to levy. Previously, rural banks and loan companies have been allowed to demand higher interest than the benchmark PBoC rate, to encourage growth in the sector, as well as to recognise higher risk levels. But underground rates are significantly higher than official ones (Wu Ying, the lender on death-row, was asking for more than 0.5% a day, according to Xinhua), so a higher multiple of the benchmark rate will be needed to lure prospective participants into legalised lending. Otherwise why bother going legitimate?

Notably, there was no mention of interest rates in the principles set out in the pilot announcement, despite the Wenzhou authorities asking for policy changes in their original proposals. Apparently that was a reform too far. “It was a pity it was not passed this time,” remarked Zhou Dewen, a spokesmen for the Wenzhou SME sector.

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