China's weak financial system supported by private lending; crackdown on private lending leads to more business failure

I have previously covered the Wenzhou saga, where factory bosses were fleeing their homes to avoid unpaid debt, and the recent scandal with Sichuan Sinopec, where an employee at a state owned firm at the very least appropriated company funds to turn the sales division into a real estate developer lender.

The loans have been going bad for awhile and AP has gotten around to covering some of the stories in China's unofficial lending falters, savers protest

Underground lending by ordinary Chinese like Zhang flourished over the past decade, providing trillions of yuan (hundreds of billions of dollars) needed by private companies that create China's new jobs and wealth. Its popularity reflects public desperation for an alternative to China's banks, which pay low deposit rates that fail to keep up with inflation and channel savings to government companies.

But the high cost of underground credit — interest rates of 70 percent a year or higher — and a slump in global demand caused a wave of business failures last year, prompting owners in cities such as Wenzhou in the southeast to flee.

In the Sinopec story, I mentioned how there was no sign of underhanded business in the Wenzhou cases. Extremely high interest loans are dubbed loan-sharking in Chinese and probably would be in English as well, but in most cases, there was no crime syndicates involved. Instead, the interest reflected the dearth of capital. In a nation awash in foreign investment and 20%+ money supply growth, private businesses operated in a credit desert. While state-owned firms drowned in liquidity, private business could only turn to family and friends, or underground lending syndicates that charged high rates for the high risk loans.

Only 19 percent of bank lending last year went to small businesses, while total loans fell 6 percent from 2010 to 7.5 trillion yuan ($1.2 trillion), according to the official Xinhua News Agency.

The underground credit market is estimated by China's central bank and private sector analysts at 2 to 4 trillion yuan ($325 to $650 billion), or as much as 7 percent of total lending. In some areas, informal lending exceeds that of official banks.

Both borrowers and lenders like the arrangement. The central government suppresses deposit rates in order to capitalize the banking system. Chinese consumers fund a never ending bailout fund for the banking sector, which itself is the key support system for state-owned companies. To put an exclamation point on the fact that most lending cases (in contrast to what's alleged at state-owned Sinopec) are mutually beneficial:

Yao Yafei, a manager of a chemical company with 20 employees in the central city of Linfen in Shanxi province, said it has used informal lenders since 2004. He said that in its latest round, the company borrowed 500,000 yuan ($80,000) in July and repaid it two months later with 2 percent monthly interest.

"Underground banking is popular here," Yao said. "They offer really good service and send the money to you just one minute after you ask. They even send the cash to your place if you want.

Regulators became worried when the obvious consequences of their market intervention led to market distortions:

Regulators started to worry about underground lending after high returns drew state companies and civil servants into the business, blurring the line between banks and informal lending, according to Guo.

"They could easily borrow from banks and earn a profit by re-lending the money," he said. "If a problem happened, it would become destructive."

Cheap credit to state-owned companies allowed them to profit simply by taking out massive loans and then relending the money at higher rates.

"There were no problems in the past two or three years, so people believed they could make money from it," she said by phone from Anyang. The borrowers paid 4 percent interest each month but when the six-month loan came due in September, they said they had no money left, she said.

"It was just gone," Zhang said.

Thousands of frustrated lenders in Anyang took to the streets on New Year's Day, demanding the government recover their money, according to Hong Kong news reports.

Police blocked some who tried to board trains to Beijing to complain to the central government and authorities in Anyang are investigating hundreds of people suspected of involvement in investment schemes.

To satisfy negative social mood and unrest stemming from the failures, the government is attacking these lending "schemes" and in some cases handing out death sentences. In these cases though, the illegality is banking outside of the banking system, not any type of moral crime such as theft. The firms unable to pay their loans are in trouble due to the economy, not fraud. There must be fraud cases out there, but they are the exception rather than the rule. The only difference between the lenders sentenced to death and the lenders at the big banks is that the big banks are state supported, complete with bailouts. The financial condition of the banks and the state-owned firms that borrow from them is no better, and possibly worse, than the condition of the private sector.

The propaganda department of Anyang's Communist Party branch said investigators have detained 160 people and recovered 1.8 billion yuan ($290 million) out of 4.6 billion yuan ($741 million) sought by lenders.

It's unclear what this means. If similar to the case of Wu Ying, it means that the government has seized the assets of ongoing concerns and auctioned off assets, in which case they will cause greater losses and then arrest those involved for fraud, possibly ending with death sentences. In other words, in their desire to "do something" and placate an angry populace, they are making the situation worse. Is it any wonder that wealthy Chinese are fleeing the country?