China's wealthy bypass the banks

[R.A. Hettinga]

<http://www.iht.com/bin/print_ipub.php?file=/articles/2004/11/09/business/yuan.html>

 



China's wealthy bypass the banks

By Keith Bradsher The New York Times
 Wednesday, November 10, 2004


WENZHOU, China  The Wenzhou "stir-fry" is not a dish you eat. But it is
giving indigestion to Chinese regulators and could prove troublesome to
many investors worldwide, from New York money managers, Pennsylvania
steelworkers and Midwestern farmers to Australian miners.

 Here in this freewheeling city at the forefront of capitalism in China,
the dish is prepared when a group of wealthy friends pool millions of
dollars' worth of Chinese yuan and put them into a hot investment like
Shanghai real estate, where they are stirred and flipped for a hefty
profit. The friends often lend each other large amounts on the strength of
a handshake and a handwritten IOU.

 Both sides then go to an automated teller machine or bank branch to
transfer the money, which is then withdrawn from the bank. Or sometimes
they do it the old-fashioned way: exchanging burlap sacks stuffed with cash.

 The worry for Chinese regulators is that everyone in China will start
cooking the Wenzhou stir-fry and do it outside the banking system.

 In the last few months, borrowing and lending across the rest of China is
looking more and more like what is taking place in Wenzhou. The growth of
this shadow banking system poses a stiff challenge to China's state-owned
banks, already burdened with bad debt, and makes it harder for the nation's
leaders to steer a fast-growing economy.

 The problem starts with China's low interest rates. More and more families
with savings have been snubbing 2 percent interest on bank deposits for the
double-digit returns from lending large amounts on their own.

 They lend to real estate speculators or to small businesses without the
political connections to obtain loans from the banks.

 Not only is the informal lending rate higher, but the income from that
lending, because it is semilegal at best, is not taxed. For fear of shame,
ostracism and the occasional threat from thugs, borrowers are more likely
to pay back these loans than those from the big banks.

 Tao Dong, chief China economist at Credit Suisse First Boston, calculates
that Chinese citizens withdrew $12 billion to $17 billion from their bank
deposits in August and September.

 The outflow turned into a flood last month, reaching an estimated $120
billion, or more than 3 percent of all deposits at the country's financial
institutions.

 If the bank withdrawals are not stemmed in the months ahead, Tao warned,
"this potentially could be a huge risk for financial stability and even
social stability."

 And with China now accounting for more than a quarter of the world's steel
production and nearly a fifth of soybean production, as well as some of the
largest initial public offerings of stock, any shaking of financial
confidence here could ripple quickly through markets in the United States
and elsewhere.

 For instance, if the steel girders now being lifted into place by hundreds
of tower cranes in big cities across China are no longer needed, that would
produce a worldwide glut of steel and push down prices.

 On Oct. 28, when China's central bank raised interest rates for one-year
loans and deposits by a little more than a quarter of a percentage point,
it cited a need to keep money in the banking system. Higher official rates
should "reduce external cycling of credit funds," the bank said in a
statement.

 Eswar Prasad, the chief of the China division of the International
Monetary Fund, expressed concern about bank withdrawals in a speech in Hong
Kong three days before the central bank acted.

 The main Chinese banks have fairly substantial reserves, but they need
those reserves to cover huge write-offs of bad debts some day.

 The hub of informal lending in China is here in Wenzhou, 370 kilometers,
or 230 miles, south of Shanghai. Some of China's first experiments with the
free market began here in the late 1970s, and the result has been a
flourishing economy together with sometimes questionable business dealings.

 Depending on how raw they like their capitalism, people elsewhere in China
describe Wenzhou as either a center of financial innovation or a den of
loan sharks. But increasingly, Wenzhou is also a microcosm of the kind of
large-scale yet informal financial dealings now going on across the country.

 The withdrawals by depositors and the informal money lending has spread so
swiftly here that it is only in Wenzhou that the Chinese central bank
releases monthly statistics on average rates for direct loans between
individuals or companies. The rate hovered at 1 percent a month for years
until April, when the authorities began limiting the volume of bank loans.

 Borrowers default on nearly half the loans issued by the state-owned
banks, but seldom do so here on money that is usually borrowed from
relatives, neighbors or people in the same industry.

 Residents insist that the risk of ostracism for failing to repay a loan is
penalty enough to ensure repayment of most loans.

 Although judges have ruled that handwritten IOUs are legally binding,
creditors seldom go to court to collect. "If it is a really good friend, I
would lose face if I sued them in court," said Tu Shangyun, the owner of a
local copper smelter and a part-time "silver bearer," a broker who puts
lenders and borrowers in touch with each other, "and if it weren't a good
friend, I wouldn't lend the money in the first place."



 Violence is extremely rare, but the threat of it does exist as the
ultimate guarantor that people make every effort to repay debts.

 "Someone can hire a killer who will chase you down, beat you up and maybe
even kill you," said Ma Jinlong, who oversaw market-driven financial
changes in the 1990s in Wenzhou as director of the municipal economic
reform committee and is now an economics professor at Wenzhou University.

 An austerity policy was invoked, its goal to slow rapid economic growth in
the hope of stopping a spiral in the inflation rate. With consumer prices
rising at 5.2 percent a year despite price controls on many goods and
services, and with less-regulated prices for goods traded between companies
climbing nearly twice as fast, people lose buying power while their money
is on deposit at a bank.

 The interest rate for informal loans jumped last spring to 1.2 percent a
month, or 15.4 percent compounded over a year, and has stayed there ever
since. According to the nation's central bank, total bank deposits in
Wenzhou have been dropping by $250 million a month since April as companies
and individuals withdraw money, either because they can no longer obtain
bank loans for their investments or because they want to lend the money at
higher rates to each other.

 For lenders, these interest rates are much more attractive than earning a
meager 2.25 percent a year, even after the recent rate increase, on a
deposit at a government-owned bank. And while Beijing assesses a 20 percent
tax on all interest from bank deposits, nobody pays tax on the income they
receive from lending money on their own, Ma said.

 Most informal loans have traditionally gone to relatives or neighbors to
finance the starting of small local businesses. Wenzhou is now one of the
world's largest producers of no-brand sunglasses; Dong Ganming, the owner
of a 350-employee sunglasses factory here, said that his plant was just one
of almost 1,000 here involved in making glasses.

 Fierce competition has prompted local residents to borrow money to exploit
every possible niche in the industry, with some factories making nothing
but bridges for sunglasses so that they will not slide down customers'
noses, other factories making only the lenses, and so forth. Any government
crackdown on informal loans would carry the risk of stifling highly
efficient small and medium-size businesses that have little hope of
obtaining loans from the state-owned banks, which still allocate credit
based partly on political connections.

 Dong said that loans from friends and family allowed him to start his
sunglasses company with 10 employees a decade ago; he quickly paid off the
loans and has been reinvesting most of the profits ever since, putting very
little into bank deposits. "The interest in the bank is very low," he said.
"If you invest the money, you can get much more money."

 But more recently, residents here say, a lot of money has been flowing
into real estate here and in other big cities, especially Shanghai, helping
to fuel double-digit increases in interest rates.

 Deals increasingly involve people who have no family or neighborhood
connection, raising the risk of disputes.

 Kellee Tsai, a specialist in Chinese informal banking at Johns Hopkins
University in the United States, said that many overseas emigrants from
Wenzhou had also been sending their savings back here to be lent at much
higher rates than are available in the countries they have moved to.

 Some local investors have been able to pay for their investments with
profits from businesses here, like Chen Shen, the owner of four shops that
sell shoe-manufacturing equipment to the hundreds of shoe factories that
have popped up in this area. She said she paid cash for an apartment near
Shanghai's Bund, its riverfront district, that had appreciated as much as
60 percent in less than two years.



 Still, Chinese regulators do not like the practice, and officials have
been trying to stamp out such operations with limited success.

 They have outlawed the practice of pooling savings into various kinds of
informal banks that make loans for real estate and other investments:
Organizers are subject to the death penalty but are rarely caught unless
the informal banks collapse.

 Oriental Outlook, a Chinese current affairs magazine, reported late last
month on the trial of a man accused of operating an illegal bank northeast
of here that collapsed a year ago, leading to the filing of more than 200
civil lawsuits. Another man who lost money in the scheme and went bankrupt
as a result assaulted the defendant outside the courtroom, the magazine
said.

 The extent of such pooling is unclear. But it poses the greatest risks of
damage to financial confidence if bank runs occur at these informal
institutions, economists agree. Bank runs, with depositors lined up
clamoring for their money back, have been an occasional problem around
China for years, but are always quickly contained as the authorities rush
to distribute as much cash as necessary.

 "The policy with bank runs, even with illegal banks in some cases, has
been to flood the bank with liquidity and pay everyone off," said Michael
Pettis, a finance professor at Beijing University, who criticized as ill
advised the Chinese policy of bailing out even illegal banks.

 "One of the most salutary ways to let people know not to put money in
these is to let two or three go bankrupt."

-- 
-----------------
R. A. Hettinga <mailto: rah at ibuc.com>
The Internet Bearer Underwriting Corporation <http://www.ibuc.com/>
44 Farquhar Street, Boston, MA 02131 USA
"... however it may deserve respect for its usefulness and antiquity,
[predicting the end of the world] has not been found agreeable to
experience." -- Edward Gibbon, 'Decline and Fall of the Roman Empire'