2012-06-29

Down come the dominoes in China; Big things have small beginnings

In a January post titled Financial firm fails in Beijing, I wrote:
Take out a loan from a bank, using a guarantee from a credit firm. Use part of the money to make short-term, high-yield loans to said firm. That firm then loans high-interest money to pawn shops.
That was specific to Zhongdan, but the practice is widespread in China.

Domino Risk Grips Zhejiang Bankers, Borrowers
The companies were financially linked to Tianyu through a province-wide, reciprocal loan-guarantee network. Tianyu's sudden failure raised the specter of a domino effect of defaults taking down every network participant and devastating their lenders.

"After Tianyu went bankrupt, banks in Hangzhou started calling in loans to other firms guaranteed by Tianyu," said the owner of a company tied to the network. "That had a ripple effect and affected a number of other companies."
People think China can bail out anyone because of their system of government, but even the Chinese suffer from the problem of complexity. Who do they bail out? Look at the chart below showing all the reciprocal agreements, these are industrial firms, not financial firms, with a massive web of financial interdependence. The policy implication is that Chinese regulators likely do not understand the relationships and will fail to stop the domino effect with targeted efforts. Instead, if there's a successful bailout, it will require the central government to spend vast sums of money.
Guaranteeing loans for each other has long been common in Zhejiang, said a risk officer at a major bank. Neither is there anything unusual about credit crises and subsequent government bailouts in the province.
The city of Shaoxing, for example, rode to the rescue in 2008 following the failure of a local petrochemical firm called Zhejiang Hualian Sunshine Petro-Chemical Co. Ltd.

Hualian Sunshine borrowed more than 8 billion yuan from eight banks and let a number of enterprises use that borrowed money to guarantee their own loans. Together, the network's participants borrowed more than 100 billion yuan, said an Industrial and Commercial Bank of China official.

The Shaoxing government intervened to arrange a restructuring of Hualian Sunshine's debt, assuming half the burden through a state-owned enterprise. Companies in the lending network also received government support.
This latest breakup is bigger. And there's another major Zhejiang firm involved in this type of lending and credit business: Evergrande.

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