My Blog

May 22, 2008

After yesterday’s stock market excitement, the government “quashed” rumors today that they were going to relax prices on refined oil products.  According to China Daily, “the National Development and Reform Commission (NDRC), China's economic planning agency, said rumors that the authorities plan to relax domestic oil and gas price controls are baseless.” The Shanghai Securities News, the official paper of the stock exchange, quoted an unidentified government official as saying that relaxing the pricing regime would hinder earthquake relief and reconstruction.

What may have started the rumors yesterday were indications that the government may instead help oil companies by reviewing the windfall profit tax imposed on all upstream oil producers.  Apparently PetroChina lat week appealed to the government for just such a review.  It is worth noting that the government is likely to be – and for good reason – very secretive about any plans to change oil prices since this is only likely to encourage hoarding in the short term.  Shortages continue to be a problem and low domestic oil prices – at roughly one-third the world price – have done nothing to stimulate energy conservation.  I think the problems of hoarding, shortages and smuggling are only going to get worse over the next few months, especially as the serious reconstruction in Sichuan kicks in, and we will see a resurgence of these rumors about relaxing price freezes from time to time.  It cannot be easy for the government to cope with the consequences of maintaining low domestic oil prices, and it certainly isn’t cheap.

The stock market reacted very strangely today to all of this.  The SSE Composite opened down and lost 2.1% from yesterday’s close within the first thirty minutes of trading, before bouncing around for much of the morning within a 1-1/2% trading band.  It suddenly shot up in the early afternoon to a few points above yesterday’s close, before collapsing in the last 90 minutes to 3586, down 1.65% for the day.  Neither I nor my student Shang Ning was able to get much of an explanation for the sharp ups and downs today.  This has the feel of a very uncertain market chasing its own tail.

Meanwhile there was an interesting article in today’s South China Morning Post about the increased cost of converting HK dollars into RMB.  Bank of China, the city's RMB clearing bank, widened the spread between the buy and sell rates for the RMB early this month from 10 basis points to 75 basis points.  This was reportedly done because the PBoC was worried that increasing demand for RMB in Hong Kong could affect its exchange management and its domestic monetary policy.

Sure enough, the exchange volume dropped significantly since the move, but the newspaper report quotes Joseph Yam Chi-Wong, the chief executive of the Hong Kong Monetary Authority, as saying that “some transactions may shift to money exchangers or even through underground channels if people are very sensitive to the buy-sell spread.”  They may shift?  I think it is a dead certainty that money is shifting to informal channels.  After all there is plenty of evidence that hot money inflows are high and increasing, and if there is a slowdown in the formal channels for RMB purchases, what else can one assume?

Along that line I missed a very interesting article in the April 23 edition of a local magazine, The Economic Observer.  The article, titled “Chinese Firms Tapping Informal Loan Networks,” discusses one of the things I have been wondering about a lot on this blog.  I have always assumed that one of the consequences of the stricter lending caps imposed this year would simply be to move borrowing out of the formal banking system and into less formal borrowing channels, and I had heard anecdotal evidence that this was indeed happening.  Apparently some economists at the All-China Federation of Industry and Commerce have been doing their own work on the subject.

Research by the Federation estimated that Chinese companies raised some 800 billion yuan through informal channels last year, among which researcher Chen Yongjie said over 20 billion yuan likely came from Wenzhou.  Businesses that raised money in this fashion would likely be charged a 5% monthly interest rate, amounting to around 60% in one year.

According to Chen, over five million private businesses made up 70% of China's total, making up 65% of China's GDP.  But despite the importance of this segment to Chinese industry, Chen's data indicated that the proportion of loans from banks to them decreased over the past three years. The proportion of short-term loans to private business was about 11% in 2005, but only 9% in 2006.  China Society of Private Economic Research chairman Bao Yujun had spent two weeks investigating in Shaoxing, Wenzhou and nearby regions, and discovered that underground fundraising was indeed gaining momentum in Wenzhou. 

Despite the fact that underground fundraising goes against regulations made by financial supervisory bodies in the Chinese central government, the local governments were turning a blind eye.   Bao spoke with a prominent politician of one city in Zhejiang who stressed that there was no way they could clamp down because businesses had to survive and that locals had to remain employed.

Wenzhou, for those who don’t know, is a city in the south famous both for the ferocious entrepreneurialism of its citizens and for its extensive informal banking sector – with the second characteristic probably not unrelated to the first.  The point the researchers are making is that as small businesses in China grow, they are getting less and less help from the large commercial bank, who prefer to concentrate their now-limited lending power to loans to the large SOEs – yet another way in which China’s financial system fails miserably in delivering capital to its most efficient users. 

Not surprisingly, these private companies are turning to the informal banks for funding, in spite of borrowing costs as high, according to the article, as 5% a month, which they describe as 60% a year but which I would qualify as 80% a year if correctly compounded (which at least gives some idea of the profitability both of the private companies and of the informal banking sector).  

The worrier in me would make two points about this – besides the obvious one about how the banking system misallocates capital.  First, such high borrowing rates can spell catastrophe if the economy were to suffer a sharp slowdown since borrowing at this rate must require optimal economic and profit conditions to be justified.  Second, any attempt to measure real loan expansion in China is likely to be overly conservative if we ignore the impact of these informal lending institutions.  Credit growth is almost certainly higher in China than what the numbers from the commercial banks suggest.

Comments (19) for "The informal banking sector ...

I don't think the profitability of the informal banking sector is as high as the 80% annualised yield would indicate. With such high borrowing costs, default and credit costs must be high as well. The lender needs to charge 5% monthly interest rate to cover potential credit costs. By Sonny - 5/22/2008 1:39 AM

I don't think you fully understand the implication of informal banking in China. Why cannot the large commercial banks lend to the small private sectors? Mainly because the banks cannot cover their creidt risks. No legal large banks can compete with small informal banks in this sector. Dare you not pay back the money, you might lose one of your hands at your lender's mercy. By fatbrick - 5/22/2008 4:40 AM

Sonny, at 80% interest rates even if one out of three borrowers defaulted every year and paid back nothing (which is almost certainly several times higher than the real default and collection rate), ROA would still be very high. The key to profitability in this case is not default rates but the cost of borrowing. Fatbrick, if that's what is driving the growth of the informal sector, then why has their share of borrowing dropped after the lending caps were made more strict? Of course there are many criminal lenders in China, but I think it is wrong to assume that all private sector companies in China are of the kind that need to turn to criminal lenders, especially since even the PBoC is worried about the inability of small, profitable and legitimate private busineeses to gain access to funding. The newspapers may like to write about the criminal lenders and may be forbidden to say much about more legitimate informal banks, but I suspect the majority of these lenders are not cutting off borrower's hands. By Michael Pettis - 5/22/2008 12:55 PM

The high interest rates are misleading since my understanding is that the informal banking sector is primarily intended to provide working capital to small and medium sized companies and that these loans are intended to be repaid very quickly. The main reason that this exists is that there is no Chinese equivalent to the commercial paper market, and these lenders fill a gap for short term credit. Most likely anyone that takes out one of these loans and doesn't repay them within a few weeks is going to be so far in debt that they will never be able to repay. One way of thinking about these loans is that they are "chicken and egg" loans. You need money to buy widgets so that you can make sprockets to sell to buy widgets. Pettis: The point the researchers are making is that as small businesses in China grow, they are getting less and less help from the large commercial bank, who prefer to concentrate their now-limited lending power to loans to the large SOEs – yet another way in which China’s financial system fails miserably in delivering capital to its most efficient users. Actually large commercial banks in the US really don't like lending to small businesses either and probably wouldn't to do without large government incentives to do so (i.e. government secured loans and community reinvestment acts). Small businesses in the US get their capital from friends and family and then once they reach a certain point, they end up looking for private equity and IPO's. Also, I'm not convinced that small business are more "efficient" than SOE's. The thing about SOE's is that they had government mandated social spending responsibilities that small businesses didn't. And so returns on small businesses are higher, but this socializes some of the public goods. The difference between small and big businesses is the a tradeoff between flexibility and capital availability. By Twofish - 5/22/2008 7:37 PM

I assume you are merely trying to argue because almost every study by either the government or by private sources suggests that the private sector produces a substantially greater share of GDP than its share of financing, assets, or employment. That sounds like a pretty reasonable definition of "more efficient" to me. Do you have any reason to assume that the private sector is less efficient than the public sector besides the point that some SOEs have social spending responsibilities (which many don't seem to fulfill anyway)? Are there specific numbers that show an indirect contribution to GDP on the part of SOEs large enough to make up the gap? By TR - 5/22/2008 9:04 PM

The private sector lending at such rates seems more akin to gambling (or playing the Chinese equity market). Twofish is right -- this is a high ROA, low absolute cash game. Even these private banks may be playing that game -- borrow from investors, lend out at onerous rates with rapid turnover of loans, provide a high return even if a few people default. But it should be concerning if collectively these raindrops coalesce into a much bigger lake. And that I think is the point. Outside the purview of the regulatory authorities, the risks to the financial system increases (not unlike how the growth of the derivatives-based shadow-banking has increased risks of crises in the US). In such a system, given even a slight downturn, you will see the domino effects ripple through and hurt the economy in a significant way. That I think is a bigger concern, apart from the fact that the monetary authorities have less control on the money supply, capital controls and other policies they may have on for various reasons. By MC - 5/22/2008 10:17 PM

My Peking University student Cui Enze sent me the following very interesting note. With students like this being a professor is easy. Dear Michael, Besides Wenzhou, there is another underground money center in China, it is called Erdos. It is located in Inner Mongolia and is very rich in various resources such as coal, natural gas, cashmere and rare earth. The loan rate here is often at least 24% per year, amazing. And for median and small borrower, this rate will reach 42%-60%. According to the vice mayor of Erdos in a meeting, in 2007 the deposit in Erdos is 48billion RMB but the loan is 50billion RMB. According to a report completed by Central University of Finance and Economics in 2006, the underground fundrasing is between 740.5B to 816.4B RMB. For MSE(Middle and Small Enterprises) the funding from informal banking is as much as 33% of total, and for farmers this figure climbs up to 55%. The report also points out that due to different economic development in eastern, middle and western China, the reliance on underground fund raising is also different. The percentage of funding from underground for MSE in eastern China is 33.99% as they can turn to stock market or formal banking as they are bigger and more mature. In western China the percentage is the highest, 43.18%, as they usually have younger operation and harder to borrow from commercial banks, the middle China is in between, as much as 39.8%. There are also two different models of underground fund raising in China which we can call South Model and North Model. South Model is very popular in Zhejiang and Fujian and eastern coastal areas. There is a private group in which the head of this group promises high interest rate to group members (20%-50%) and then lend these money to MSEs which need money badly at a even higher rate, and the head of this group earns the interest rate gap. However, the North Model is more direct, the companies directly seek nonpublic investment from the investors through various approaches, such as equity, liability, trust or deposit. But this model is very risky because it often happens that the company claims bankrupt to deny the borrowings. In some parts of northeastern China, it also happens that some big companies will borrow money from commercial banks and then lend these money to MSEs at a higher rate, thus earning a gap. Over all, the North Model is much less influential than South Model, no matter in scale aspect or popularity. I will keep an eye on this issue and if i find anything interesting I will share it with you. By Michael Pettis - 5/23/2008 2:40 PM

2fish, I think you are confusing different ideas of small businesses. When I was in banking, lending to small and medium size businesses was one of the most profitable areas of all, but this didn't mean mom-and-pop grocery stores or the guy selling ice-cream outside a school. It means small factory owners, wholesalers and distributors, franchisees, and other businesses with revenues above one or two million dollars (I would guess the corresponding revenue size in China would be five or so million RMB). They tend to be good credits, are not terribly price-sensitive, and do most of their banking activities, including the activities of the wealthy owners, with only one or two institutions. My mother owns just such a business (revenues about $15-20 million) and from the behavior of her bankers I am pretty sure they don't require government subsidies to do business with her. The reason formal banks in China seem to be ignoring these SMEs in China is not because they are unprofitable but rather because they are riskier than the large SOE's, who are believed effectively to be guaranteed by the state. Whether this is correct or not hasn’t been tested. In addition, in times of credit rationing, access to credit is not determined by efficiency of use but rather by political access – ties between SOEs and banks at high levels of seniority seem to be greater than ties between SMEs and banks. A number of analysts in China have commented on this problem of capital misallocation and one of my friends at the PBoC told me that there is quite a lot of concern about this but they don’t know what to do./ I suspect this is one of the reasons informal banks are tolerated. By Michael Pettis - 5/23/2008 2:58 PM

The fact that these money centers are unregulated may be a blessing. One concern about regulation is that when something is regulated there is often the implication that the government takes responsibility for the failures in regulation. If somone losses money in the informal money centers, they aren't likely to be looking for the government for a bailout. The other problem is that there may be linkages between the formal banking sectors and the informal one, and problems in the second may lead to problems in the first. Again, the fact that these centers are informal may be a good thing since they reduce the linkage between the formal and informal sectors. The big disadvantage in having both a formal and informal sector is that you increase transaction costs, and so there is some good reason for "formalizing" the informal sector. However, this has to be done very carefully since I think that a situation in which the informal sector is half integrated into the formal sector has all sorts of dangers that doing quite exist if the sectors are separate. One final thing is that I think the existence of the informal sector is why interest rates hikes don't do much in China. In the US, the commercial paper market is very strongly linked with other short term money so that a rise in the Federal Funds rate is going to ripple in very quickly to affect the capital decisions that companies make. The informal market isn't quite as tightly coupled with PBC interest rates, so changes in interest rate don't have that much of an impact, and the PBC has to rely on reserve requirements and direct production orders. By Twofish - 5/25/2008 2:12 AM

TR:     I assume you are merely trying to argue because almost every study by either the government or by private sources suggests that the private sector produces a substantially greater share of GDP than its share of financing, assets, or employment. And every study that I've seen has a number of fatal flaws that make that conclusion very questionable. The big flaw is that every study I've see has odd definitions for what constitutes the "private sector." Township-village enterprises are always counted as "private" or "semi-private" despite the fact that they are owned by the townships and villages. The rationale is that they are "essentially private" but that runs into the dolphin fallacy. Just because a dolphin looks like a fish doesn't make it one, and classifying a dolphin as a fish makes things more confusing. You also have similar problems counting min-ying enterprises, which have a very complex mix of public and private capital. What every paper I've seen seems to do is basically say that if an enterprise is sucessful then its private, and if it is not then its state, in which case the conclusions are not surprising. There is also the problem that "private" and "state" corporations are in different industry sectors and the difference in employment may be the result of industry effects. The danger of this is that it leads to bad public policy. If SOE's are losing money because of the industry they are in and because they have huge social welfare liabilities, then privatizing the SOE's aren't going to do anything except lead to massive asset stripping. The reason I think social welfare effects are important is that if you look into why SOE's were losing money in the mid-1990's, you see the "General Motors problem". SOE's had huge social and employment liabilities which made most of them highly unprofitable. This isn't obvious if you look at aggregate data, but if you select some a case studies for individual SOE's, it quickly became obvious that they were social-welfare units and not businesses. Former SOE's have now become highly profitable since 2002 when most of those liabilities have been transferred to the government. I haven't seen any papers that actually try to strip out the social service liabilities of the SOE's because its easy to run a spreadsheet against a database, and its hard to actually to into each SOE and see what is happening there. However, looking at individual cases of SOE's suggests that this is a big factor, and it's significant that the papers I've seen don't even consider it as a factor. Something that is very significant is that "state-owned enterprise" doesn't mean what a lot of people think it means in a Chinese context. Most companies owned by the "state" in China today aren't legally "state-owned enterprises". By Twofish - 5/25/2008 2:41 AM

I think there are even different types of small businesses. When I was thinking about small business, I was thinking about a twenty person software startup, and in the startups I've seen, the financing comes from private equity and almost never from banks. The problem with bank loans is that there is a very large chance that the company will fold, and if a software company folds, then you have nothing in the way of assets. Whatever hardware exists depreciates so quickly that its worthless if the bank has to foreclose. The sectors that I've seen banks concentrate are in real estate. Pettis: The reason formal banks in China seem to be ignoring these SMEs in China is not because they are unprofitable but rather because they are riskier than the large SOE's, who are believed effectively to be guaranteed by the state. Whether this is correct or not hasn’t been tested. Part of this is legal risk. We know more or less what happens when an SOE can't pay its debts. We're not sure what happens when an SME can't pay its debts, and we certainly have no idea what happens when SME's in large numbers can't pay their debts. The bankruptcy laws have been very new. Pettis: In addition, in times of credit rationing, access to credit is not determined by efficiency of use but rather by political access – ties between SOEs and banks at high levels of seniority seem to be greater than ties between SMEs and banks. Banking is inheritly based on human relationships. At its core, banking is about two people shaking hands, each trusting that they are going to get some money at some point in the future. The interesting thing about banking is that a loan isn't directly based on efficiency of use, the bank doesn't care much how you are using the loan. All they care about is that you get their money back, and whether in the US or in China, figuring out whether you are going to get your money back depends a lot on human relationships. A loan officer at a big commercial bank probably has dealt with enough SOE's to know when they can trust one or not. This isn't the case with SME's. Pettis: A number of analysts in China have commented on this problem of capital misallocation and one of my friends at the PBoC told me that there is quite a lot of concern about this but they don’t know what to do./ I suspect this is one of the reasons informal banks are tolerated. Capital misallocation isn't my top worry, since the current system of captial allocation in China seems "good enough." My big worry is crisis prevention. That somehow the formal and informal banking systems will interact in ways that will unexpectedly case a big problem. The trouble with crisis prevention is that it requires that the regulators have enough information to take preventive steps, but the people involved in the informal banking system are not going to provide that information if they think it makes it easier for them to be shut down. By Twofish - 5/25/2008 3:10 AM

If the informal banking system in Wenzhou is like anything else there, then it's probably run by large groups of families from that area, and the lending would be focused on relations originating from Wenzhou. This would make the short term lending a fairly safe bet as the lender has a good idea about what the money is used for and who is using it. I would think the interest rates is as all other thing in China negotiated on who introduced you, what you need and what you can give in return long and short term. I also think there is more then one surety in the equation, with a middle man from Wenzhou who takes a cut and in return has to carry some obligation if the debt is not repaid. This is a peer review leanding system and that probably why it can sustain interest rates at level that are mentioned. Twofish: Township-village enterprises are always counted as "private" or "semi-private" despite the fact that they are owned by the townships and villages. According to this statement nothing in China has been private, before the passing of the Property Rights Act last year, that not true. There are many different kinds of TVE and the Wenzhou model was based on individual households making very low tech products and the whole thing was depending on a extreme market coordinated production which Adam Smith would have loved. I suspect that the informal banking system is based on the same model. The model you talk of is the Jiangsu one where TVE goverment and collectives joined together or maybe the Pearl Delta TVE model with money from HK, but I would still think of that as private ownership between HK based business men and the local TVE. The difference between them and the SOE's were that private families owned their own production. Whereas the SOE had, as you say obligations to large parts of the system, which means that they (and their production) were owned by many different important players in the political system. The Program for a Medium-Long term national development plan on Technology and Science. (2006-2020) is not very clear on how SME should be supported, but I think focus in lending is going to be on business that is a spin off of the universities, goverment research unites and SOE research unites as the slogan of national "zizhu chuanxin" is coming of age. This would mean that captial allocation in China is focused on national R&D and the private spin off are left to find funds i FDI or the informal banking system, not a good deal for them or for Chinese economy in the long run. They can borrow to buy and sell things but no way anyone is going to put money in IT (maybe that why the Chinese IT sector is still trying to get no its feet) or something like that. By anders - 5/25/2008 5:23 AM

anders: According to this statement nothing in China has been private, before the passing of the Property Rights Act last year, that not true. This isn't the case. Since the late-1970's, China has permitted "getihu" which are definitely privately owned. I'd argue that even after the Property Rights Act, that TVE's still aren't private. The are owned by the collective. The Property Rights Act really didn't change all that much as far as industrial ownership structures. Chinese law divides property into state, collective, and private, and collective property is effectively owned by the local government. TVE's (even in Wenzhou) are collective property and if you go by legal definitions, they are definitely not private. (Also there has been a huge amount of misunderstanding about what the Property Rights Law did and didn't do.) anders: There are many different kinds of TVE and the Wenzhou model was based on individual households making very low tech products True, but the enterprises were (and still are) collective enterprises which means that they are still formally owned by the local governments. I agree that they function in much the same way that private enterprises function, but going back to my fish/dolphin, just because a dolphin looks like a fish doesn't make it one. anders: The difference between them and the SOE's were that private families owned their own production. Whereas the SOE had, as you say obligations to large parts of the system, which means that they (and their production) were owned by many different important players in the political system. True. But that still doesn't make the TVE's "private" in the sense of enterprise ownership. One could argue that the public/private distinction doesn't capture the full complexity and diversity of state/private interaction in China and I'd agree with you. The trouble is that if you *don't* look carefully at the actual situation, you end up with the same sorts of disastrously bad policies that you had in Russia. One other issue is to what extend the situations in a Wenzhou TVE's can be extended to other situations. If you let the manager of the factory pay himself whatever is available, this might work well in a family textile plant, but it causes huge problems in a large automobile company. One thing that I think is very significant in the Wenzhou model is that family ties prevent asset-stripping. anders: They can borrow to buy and sell things but no way anyone is going to put money in IT (maybe that why the Chinese IT sector is still trying to get no its feet) or something like that. When you get into IT, then the main driver in the US is private equity, and private equity is extremely informal. By Twofish - 5/26/2008 2:43 AM

Twofish: Township-village enterprises are always counted as "private" or "semi-private" despite the fact that they are owned by the townships and villages. Twofish: This isn't the case. Since the late-1970's, China has permitted "getihu" which are definitely privately owned My statement was focused on your remark about TVE "in fact" being owned by the township and villages, when they are not. 个体经营户是指除农户外，生产资料归劳动者个人所有，以个体劳动为基础，劳动成果归劳动者个人占有和支配的一种经营单位 I am not sure if this site supports Chinese, but Getijingyinghu is what was used in the Wenzhou model as I understand it, which is as I see it, one of the model ways of how the TVE developed in the late 70ies and early 80ies. With a getihu you only pay state and land tax but when the getihu grows out of its geti status and becomes a gongsi (company) then it starts paying revenue tax. So the locals ganbu in Wenzhou helped the individuals in the older danwei to create this form of TVE a getihu, which is different from the TVE in other parts of China for instant in the Pearl Delta or Jiangsu. As to what the The Property Rights Act means for TVE, then all the getihu and gongsi that grow out of the Wenzhou TVE model became private in this way: There was some insider privatization in the privatization process of TVEs, or the worker-owned joint-stock companies (this is used in Shandong, where I studied) or joint-stock cooperatives privatization with A shares given to the workers. It is true that the goverment sometimes still have a stake in the TVE firm, but according to B. Naughtons research it between 20 % - 50 %. There is also the choice of buying the firm at high price or at a low price with profit sharing as the catch for the locals. All in all TVE are very private. Private equity is not an illegal act in the US, private banking or lending is illegal in China, so before the informal banking system mentioned in this blog is formalized there is little chance that they would wait the 3-4 years it would take before the IT investment pays off (with the effective interest rate mentioned here no one in their right mind would borrow for long period), because there is not tax cuts, goverment support to help the investment. I know very little about Russia, so can't comment on that perspective By anders - 5/26/2008 4:23 AM

Dear Michael, I'm responding with regards to your comment by your student Cui Enze. Is there any chance he/she can provide a link to that 2006 Central University of Finance and Economics report on underground fund raising? Thank you, Sue Anne By Sue Anne - 5/26/2008 10:08 AM

anders: I am not sure if this site supports Chinese, but Getijingyinghu is what was used in the Wenzhou model as I understand it, which is as I see it, one of the model ways of how the TVE developed in the late 70ies and early 80ies. It's one of the ways, but not the only way, and my problem with a lot of the literature is that it counts all TVE's as private or semi-private, even if they have very little in common with the Wenzhou model. Also the fact that an enterprise is a gongsi tells you nothing about whether it is "public" or "private" since most state owned enterprises have been restructured as listed companies. The nice thing about the "gongsi" legal structure is that it is very flexible and you can put all sorts of different structures into a "gongsi." anders: As to what the The Property Rights Act means for TVE, then all the getihu and gongsi that grow out of the Wenzhou TVE model became private in this way: There was some insider privatization in the privatization process of TVEs, or the worker-owned joint-stock companies (this is used in Shandong, where I studied) or joint-stock cooperatives privatization with A shares given to the workers. As far as I can tell, this didn't have anything to do with the Real Rights Law. anders: It is true that the goverment sometimes still have a stake in the TVE firm, but according to B. Naughtons research it between 20 % - 50 %. There is also the choice of buying the firm at high price or at a low price with profit sharing as the catch for the locals. All in all TVE are very private. The problem I have with the statement that TVE's are "very private" is that it doesn't define what private means. Something with 50% state ownership, isn't private in one sense being that the largest shareholder is the state, and even a company with 20% state ownership can have the state being the dominant shareholder. What most people mean when they say that something is in China is "very private" means that they act in ways to maximize profit and in response to the market. The trouble with calling that "private" is that you can have a situation in which enterprise ownership is private, but the management *doesn't* respond to market forces, and this is precisely what happened in Russia. Alternatively, you can have a situation in which the bulk of the shares are state owned and you arrange the incentives so that management does respond to market forces. This might seem like nitpicking, but looking at the disaster in Russia is why these distinctions are important. What basically happened was that people figured that by distributing ownership to private individuals, that they would automatically become maximize the profits of the firm. The trouble is that without a good legal structure in place, they proceeded to loot the company. So when someone asks me if I think "privatization" is a good or bad thing, the first question is exactly what they mean by privatization. anders: Private equity is not an illegal act in the US, private banking or lending is illegal in China, so before the informal banking system mentioned in this blog is formalized there is little chance that they would wait the 3-4 years it would take before the IT investment pays off (with the effective interest rate mentioned here no one in their right mind would borrow for long period), because there is not tax cuts, goverment support to help the investment. Private equity is quite legal in China, and there are a lot companies that do private equity in China (both local and foreign) and it is a very, very hot field, and from what I've seen there isn't a lack of startup money for IT projects in China. What is explicitly illegal in China is to take deposits from the general public, and the problem with taking deposits is that you run the risk of losing someone's money. Creating an investment pool for equity investment is governed by a completely different set of laws. Also, it's not clear that these informal banks are illegal. Article 3 of the Commercial Bank law lists the functions of commercial banks, and Article 11 of the Commercial bank law says "No unit or individual may engage in commercial banking business such as taking in deposits from the general public, and no unit may use the word "bank" in its name, without approval of the People's Bank of China." The problem here is that its unclear from the language of the law, whether the prohibition extends to all of the functions in Article 3. It's also unclear what constitutes "taking in deposits from the general public." By Twofish - 5/26/2008 1:20 PM

2fish and Anders, your comments are very valuable to this discussion -- thanks a lot. The main point however, I think, is that the lending caps seem to create lending discrimination. However we define the private sector, and what we have may just be a rough proxy for the private sector, it seems that their share of total loans is declining even as their share of total production is rising. Since it is reasonable to assume that their financing needs have grown, not declined, and since there is some anecdotal evidence that the informal banking sector is booming, I would argue that the two are related and that this must affect, in some way, both the PBoC's attempts at tightening and the risks within the overall financial sector. By the way 2fish: "When you get into IT, then the main driver in the US is private equity, and private equity is extremely informal." I think we are getting into very different definitions of what constitutes "informal" finance. The informal sector in China is often illegal, and never regulated by the PBoC or other financial regulators (pawn shops are regulated by the Ministry of Commerce, but as far as I understand none of the MoC regulations can be thought of as credit or monetary regulations that might affect monetary policy within China). There is also almost no formal disclosure. In an open capital market like in the US the "informality" of PE firms is pretty irrelevant, but in a rigid system in which the authorities demand far more control, especially in the flow of funds, this informality is a very big issue. Two other points, 2fish: We must agree to disagree on your claim that capital allocation in China is "good enough." I would vehemently disagree. Second, even though informal banks are unregulated, I disagree with your suggesting that at least "If someone loses money in the informal money centers, they aren't likely to be looking for the government for a bailout." In fact there have been several bankruptcies among informal banks and in nearly every case investors did indeed look to -- and often get -- government bailouts. This was a surprise to me too, but I guess either the fear of bank runs on formal institutions, or the risk that the kinds of links you posit between the informal and formal banking sectors could create a systemic problem, led authorities to bail out the informal banks. Unfortunately it is hard to get good information. The authorities don't permit much discussion in the press except for very superficial and brief reports. By Michael Pettis - 5/26/2008 2:53 PM

anders: I am not sure if this site supports Chinese, but Getijingyinghu is what was used in the Wenzhou model as I understand it, which is as I see it, one of the model ways of how the TVE developed in the late 70ies and early 80ies. TwoFish: It's one of the ways, but not the only way, True all the other ways also lead to privatization. A joint - stocks to workers (Shandong) , insider privatization and trailed privatization (state to manager). Joint foreign and local ownership (Pearl river). TwoFish: and my problem with a lot of the literature is that it counts all TVE's as private or semi-private, even if they have very little in common with the Wenzhou model. I need more concrete evidence of why you think they are not private. Who owns the TVE then ? the local Xianzhang, cunzhang or shizhang ? If you argue that it might be people with guanxi, then sure, but that don’t make it less private just elitist. By saying “public” you create a very simple picture of the Chinese society that I don’t recognise, who are these dark “public” ganbu that “in reality” still own all the TVE? TwoFish: The nice thing about the "gongsi" legal structure is that it is very flexible and you can put all sorts of different structures into a "gongsi." This is not an argument that help your nor my argument, so I don´t see the point of it, but if a getihu changes into a gufen gongsi or a normal gongsi, then I don’t think “The public” will suddenly come from above and nationalise it, so I would guess 99 % of the TVE gutihu that turned gongsi are private. I also think that if the workers are given A-shares, then “The public” won’t come back and take them away. I also think that if a manager buys a company in an insider privatization, then “The public” won’t come back and take it away. Even if the manager is a member of the local CCP, then the TVE is still his private company. TwoFish: As far as I can tell, this didn't have anything to do with the Real Rights Law. The Real Rights Law is the first small step toward understanding that there are other rights besides that of the state, this means that the string of privatization which started in the late 70ies now has the official seal of approvement. If you read He Shiguang “On a Village Market Street” from august 1980 you will understand the change of mentality on private and public, and this was just the beginning. It will in time uphold all the various versions of privatization that I have mentioned. TwoFish: The problem I have with the statement that TVE's are "very private" is that it doesn't define what private means. Something with 50% state ownership isn't private in one sense being that the largest shareholder is the state, and even a company with 20% state ownership can have the state being the dominant shareholder. On the US, Asian and European stock markets there are a lot of state pension funds, who buy stocks in listed companies. Would you then argue that those companies are state owned? It depends on, who makes the decisions in the board room and on the floor of the company. I seems that most Chinese TVE are making market oriented choices. So when someone asks me if I think "privatization" is a good or bad thing, the first question is exactly what they mean by privatization. Privatization: The right of a person or economical entity to sell the products of its labour at a market price (I think this one goes for most TVE’s). The right of a person or economical entity to, within a legal frame work, claim property rights. I argue the Getihu did allow that in Wenzhou TVE, The joint shares system allowed that in Shandong TVE and the insider privatization in other parts of China. anders: Private equity is not an illegal act in the US, private banking or lending is illegal in China, so before the informal banking system mentioned in this blog is formalized there is little chance that they would wait the 3-4 years it would take before the IT investment pays off (with the effective interest rate mentioned here no one in their right mind would borrow for long period), because there is not tax cuts, goverment support to help the investment. TwoFish: Private equity is quite legal in China, and there are a lot companies that do private equity in China (both local and foreign) and it is a very, very hot field, and from what I've seen there isn't a lack of startup money for IT projects in China. What is explicitly illegal in China is to take deposits from the general public, and the problem with taking deposits is that you run the risk of losing someone's money. Creating an investment pool for equity investment is governed by a completely different set of laws. I never said that PE was illegal in China, I made money on setting up two PE deal in hospitality. I said private banking as mentioned in this blog was not legal. TwoFish: Also, it's not clear that these informal banks are illegal. Article 3 of the Commercial Bank law lists the functions of commercial banks, and Article 11 of the Commercial bank law says "No unit or individual may engage in commercial banking business such as taking in deposits from the general public, and no unit may use the word "bank" in its name, without approval of the People's Bank of China." The problem here is that its unclear from the language of the law, whether the prohibition extends to all of the functions in Article 3. It's also unclear what constitutes "taking in deposits from the general public." I always look things up before I write something, but I am 100% sure, that you are not, as a private person, allowed to collect interest of money, without the Chinese government approving it. This is the nucleus core of Marxism, so I think the old guard in the party would make a fuss. Holding or investing money for someone is another thing, but that was not at the root of this discussion. By anders - 5/27/2008 10:42 PM

but going back to my fish/dolphin, just because a dolphin looks like a fish doesn't make it one. But sometimes a fish is it just what is looks like....... a fish -nothing more nothing less. By anders - 5/27/2008 11:01 PM