Anatomy of the Chinese credit bubble


Cross-posted from Investing in Chinese Stocks.

Back in mid-June I posted Credit Guarantee Firms Go Down Like Dominoes:

Credit guarantee firms are a nexus point in the credit bubble. All manner of over leveraged borrowers (think rehypothecated copper and steel) with no experience in the credit market started or invested in credit guarantee firms. These firms helped marginal borrowers obtain credit, and some of them opened their own credit guarantee firms. Most recently was the story of Beijing residents going to credit companies for real estate spec loans. They can also serve as the link between companies’ mutual credit guarantees, such as the web of guarantees seen in a city like Xiaoshan or among the steel traders, who all opened credit guarantee firms and guaranteed each others’ debts.

In the article below, it gives Wenzhou as an example. 90% of the credit guarantee firms have closed or gone bankrupt. Zhejiang province’s bankruptcy case load jumped 145% last year and the amounts involved jumped 600%. This year is expected to be worse.

This quote sums up the situation (and does this not bring to mind AIG): “The profit model is an important reason for the large-scale collapse of credit guarantee firms, a 2% profit is not sufficient for taking on 100% of the risk.”

The South China Morning Post (SCMP) picked up the story in Bankruptcies rock loan guarantors in China:

At the end of last year, there were more than 8,000 licensed loan guarantors, with most of them focusing on serving small enterprises. The companies had a combined registered capital of 880 billion yuan (HK$1.1 trillion), according to the China Banking Regulatory Commission.

Online consultancy Forward said financing demands from the small firms topped 16 trillion yuan in 2012. Indeed, thousands of illegal loan guarantors have been offering guarantee services for the underground banks in the past decade. In April, a bank run in Sheyang, Jiangsu province, was sparked by the collapse of illegal loan guarantors.

In Guangdong, the financial authorities said more than 30 loan guarantors had failed so far this year, while in Sichuan, the provincial government revoked 12 loan guarantee licences. The problems with loan guarantors would weigh further on a mainland leadership already buffeted by complaints about the way government treats small firms.

“Without the privately owned small businesses, China’s economy won’t have a future,” said Song Weiping, the chairman of developer Greentown China. “They are the babies and they should be looked after carefully.”

The SCMP article touches on the heart of the problem. The credit guarantee system is very large because small and medium businesses cannot obtain bank credit. This demand brings in many investors looking to earn high rates of return lending to small and medium businesses. Given the way the firms are set up and run, with many firms thrown together by people with lots of cash to invest and little to no experience, to say nothing of those individuals using these companies as a way to defraud banks, the potential for crisis when credit growth in the economy slows is obvious.

Today, we have a very fresh example: the company at the center of the Qingdao port scandal, Dezheng. The story below is a result of Dezheng’s fraud, but keep in mind that Wu Xiaoling has fingered credit guarantee companies as part of the cause of the crisis, Wu Xiaoling: Qingdao Port Scandal Fault of Banks Relying on Credit Guarantees.

The article describes how a company in Nanjing, Nanjing Changhao International Trade, already had more than ¥200 million in debt, but it obtained bank credit using one of Dezheng’s companies as a credit guarantee. Following the revelation of the Qingdao port scandal, Everbright went to court to freeze Nanjing Changhao’s assets and the owner of the company, Liang Wei, is already believed to have fled jurisdiction. It’s unclear whether the firm has done anything illegal other than to be associated with Dezheng at this point, as the firm had been paying back the loan and the company is still operating normally according to an employee contacted by a 21st Century reporter.

Up to 10 firms are in similar situations due to obtaining credit guarantees from Dezheng. Most are in Qingdao, but there is also a Shanghai firm in the mix. The largest case: an Ordos wool company borrowed several billion yuan from four major banks thanks to credit guarantees from Dezheng. There could be more fraud involved in some of these cases, or these firms could all be innocent, but either way it’s a mess.

Credit guarantees played a role in fraudulent borrowing. These borrowers then open their own credit guarantee firms and either aid others in fraudulent borrowing, or use the credit guarantee firm as a way to earn a high rate of interest on their fraudulently obtained money. Much of this credit may be tied up in the real estate market. Low income borrowers can borrow their down payment from a credit guarantee firm. Real estate speculators can obtain capital through credit guarantee firms. Legitimate companies in need of financing may also have borrowed, such as glass or furniture companies strapped for cash due to the slowdown in the real estate market. This is why the Chinese press sometimes refers to “stranded capital.” Since real estate developers aren’t paying their bills on time, their suppliers can’t pay their bills, and this exposes credit guarantee companies to losses in the best of cases, and jail time in the worst of cases where fraud is involved.

At its most simple, this is the story of a credit bubble. Lenders all around the world chase high profit, high interest loans when the credit bubble inflates. Credit growth and a growing economy create a temporarily low risk environment where losses are limited. Poorly managed firms ignore or miscalculate the risk of the inevitable bust and when credit finally tightens, firms that didn’t get out ahead of time find that only a few bad loans can wipe out years of profits.

In China, these credit guarantee firms are networked. A city or industry could have several or dozens of companies all with interlocking guarantees. Dozens more companies are involved because they obtained credit through one of the guarantee firms. Dozens more are involved because they made private loans at high rates of interest to the credit guarantee firms. Failure of one or two key firms in a city or industry can freeze credit overnight as creditors try to figure out who owes what to whom. This is a nightmare even if no fraud is involved. Toss in fraud and now credit is completely frozen by court order, company bosses suddenly disappear and yet more tertiary companies are involved because companies they transact with cannot move their funds.

Finally, the risk to the banks is not small. At the end of the day, credit guarantee companies are the thin veneer between Chinese banks and a mountain of potential bad loans.

David Llewellyn-Smith
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