The Economist article on illegal banks (see below) has caused a lot of discussion among a group of China scholars with whom I regularly communicate. Consultant Anne Stevenson-Yang sent the following note:
I met one of these gao li dai in [a coastal city]. The company was partly owned by the [local] government, the proprietor said. He charged local companies 5-7 percent MONTHLY for loans of between $1 and $5 million, and he said that Ningbo had about 50 other companies lending at that level and hundreds making loans under $1 million.
The gao li dai take deposits at a guaranteed 1.5% monthly and, to secure the loans, take guarantees of the personal assets of the company proprietors. You can imagine what happens if you don't pay. One interesting part of the conversation was his comment that the PBOC "opens one eye and closes the other" because officials recognize that the banking system is ill equipped to extend short-term loans to private companies that need to get shipments out the door, and that most of the companies legitimately need short-term financing and legitimately repay the loans.
Everyone in the room agreed that the business would be either regularized or outlawed, or both, in about two years' time.
1.5% a month (18% a year if this is simple interest, nearly 20% if it is compounded) for depositors is certainly a lot higher than inflation, currently running around 5%, and even better when measured against bank deposit rates of around 3%. Loans at 5-7% per month are equal to anywhere from 60% annually (5% per month simple interest) to 125% annually (7% per month compounded).
At these lending rates the business opportunity must be extremely profitable (and very short-term) to justify borrowing. If these loans are mostly "legitimate" business loans, then it is clear that some parts of the Chinese economy are very profitable. It does lead me to wonder however about how much of this money goes to stock market and real estate speculation.
My concerns have to do with systemic implications. First of all, I think the informal banks are not the only banks making illegal stock loans. There is strong anecdotal evidence that pawn shops too (and these are not what you and I might think of as pawnshops -- some have hundreds of branches) are making illegal loans for real estate and stock speculation.
As I see it there are at least two problems. One is that these illegal (informal?) banks are part of the financial and money creation system, and their activity is like that of any other bank except that they are unregulated and unrecorded. This wouldn't be a problem if they were small, but if it is true that they made RMB 800 billion in loans in 2006, as the article says, their lending is sizable compared to the RMB 3.2 trillion made last year by the formal banking system, so they matter a lot.
If nothing else we would need to adjust our estimates of Chinese loan growth to account for the lending growth of the illegal banks. Since the rate of loan growth in the legal banking sector is constrained by the government, I would assume that for banks that are not similarly constrained, loan growth is probably higher -- just a guess, because I don't know for sure, but it seems plausible.
The second problem is the impact of lending on speculative activity. Normally we can estimate the volatlity of the stock and real estate markets and their vulnerability to sharp downward movements by the amount of self-reinforcing mechanisms in, among other things, the ownership structure. One of the biggest sources of this volatility is margin lending, since rising prices lead to greater borrowing capacity and falling prices lead to margin calls and forced selling. Margin lending, in other words, is highly pro-cyclical, and this automatically adds volatility to the system.
If there is a lot of margin out there it could lead to real problems if there is a sustained decline in the market. I say sustained because I'll bet the margin activity is not as automatic as it might be in the US. If your stocks decline to below the limit I suspect you won't get the "put up money by 5 p.m. or we sell at tomorrow's open" phone call that you would in the US. There may be a little more flexibility. But if stock prices stay below the limit for some days or weeks I'll bet that it is harder to negotiate for breathing space, and there would ultimately be forced selling. Since my understanding is that a lot of homes have been put up as collateral, the selling might even extend to real estate.
All I can say for sure is that when markets are frothy, the lack of information never seems to be a serious problem -- we just sort of assume the best case. As soon as the markets get into trouble, however, this lack of information will suddenly become a very nasty problem, and the extent and impact of illegal and unrecorded banking activity will suddenly become one of our favorite things to worry about.
> At these lending rates the business opportunity must be extremely > profitable (and very short-term) to justify borrowing.
Not necessarily. They could be (and I hope they are) being used as short term credit to provide working capital. Restaurant needs to buy food at the beginning of the week, but won't have the cash until the end of the week when the customers pay. Factory needs to buy steel now to make bolts to be sold at the end of the month.
If they are being used as revolving short-term credit, this is very, very good. If they are being used as long term financing or stock speculation, this is very, very bad.
One thing to note is that 18% to 20% interest rates are not unheard of. They are typical for credit cards in developed countries, and the similarity in rates I don't think is coincidental (and yes the credit card business in developed countries is extremely profitable).
A lot depends on the credit and risk management systems that are used in these informal banks. I wouldn't be surprised if these informal banks actually have better credit and risk management systems than the formal banks. A lot of finance involves looking at someone in the eyes and figuring out whether you can trust them or not, and informal banks are often much better at this than formal ones.
One funny part of financial history is how many financial institutions in the West actually started out in back alleys and curb sides.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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Comments (2) for "Illegal banks (2)"
- 8/15/2007 9:46 PM
November, 2007