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No Guarantee

May 19, 2012

In my debate with Andrew Batson in The Guardian in March, I noted that:

There really are two related but distinct things people have in mind when they talk about a “hard landing” for China. The first is a rapid deceleration of GDP growth – below, say, 7%. The second is some kind of financial crisis. I think we’re already seeing some signs of the first, and the second is a bigger risk than most people appreciate.

In my last several posts, I’ve focused on the former — the slowdown in China’s GDP growth.  I want to switch gears here for a moment and call attention to a rather alarming story involving the latter — the risk of financial instability — which somehow slipped under most people’s radar screens.

In early April, Caixin magazine ran an article titled “Fool’s Gold Behind Beijing Loan Guarantees”, which documented the silent implosion of Zhongdan Investment Credit Guarantee Co. Ltd., based in China’s capital.  “What’s a credit guarantee company?” you might ask — and ask you should, because these companies and the risks they potentially pose are one of the least understood aspects of China’s “shadow banking” system.  If the risky trust products and wealth funds that Caixin documented last July are China’s equivalent to CDOs, then credit guarantee companies are China’s version of AIG.

As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises (SMEs) get access to bank loans.  State-run banks are often reluctant to lend to private companies that do not have the hard assets (such as land) or implicit government backing that State-Owned Enterprises (SOEs) enjoy.  Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default.  Having transferred the risk onto someone else’s shoulders, the bank could rest easy and issue the loan (which it otherwise would have been reluctant to make).  In effect, the “credit guarantee” company had sold insurance — otherwise known as a credit default swap (CDS) — to the bank for a risky loan, with the borrower forking over the premium.

Now putting aside what happened at Zhongdan for a moment, let’s just consider what this means.  Like any insurance scheme, this arrangement only “works” if the risks are not correlated.  If you insure 100 people in 100 different towns against a tornado striking, you collect premiums and then, when a tornado strikes one of those towns, you make the payout to one claimant and the premiums from the rest cover it.  If you insure 100 people in the same town against a tornado, you collect premiums for a while at no cost — it looks like a fantastic business.  But if a tornado finally does strike that one town, you have to pay everybody at once and you’re wiped out.  That’s exactly what happened to AIG when it sold credit default swaps on mortgage-backed CDOs.  As long as the housing market didn’t collapse, all they did was collect premiums.  When it did collapse, they went under.  Or rather, they had to be bailed out so that all the banks and other customers who had bought insurance from them — who thought they were insured — wouldn’t go bust when AIG couldn’t pay up.

The concern in China is that — like that tornado — a drop in the local property market, or a decline in exports, could hit all borrowers at once, overwhelming the local credit guarantee company and leaving the banks high and dry.  The risk is exacerbated by the fact that many credit guarantee companies were capitalized with loans from the same banks whose other loans they are guaranteeing.  In effect, banks are insuring themselves, or each other, and would still end up holding the bag on loan losses that are supposedly insured.  (It would be interesting to know how such “guaranteed” loans are treated when regulators perform their much-vaunted stress tests on Chinese banks.  I suspect these loans are considered loss-proof, because they are “insured.”)

Zhongdan, the company in the Caixin article, took these risks one step further.  It persuaded borrowers to take out bank loans based on guarantees from Zhongdan, and then hand some or all of that money back to Zhongdan to invest in Zhongdan’s own “wealth management” products:

Under the arrangement, a participating company would take out a bank loan and give some of the money to Zhongdan for investing in high interest-paying wealth management products for a month or more.

The firm then apparently put those funds to work by buying stakes in small companies such as pawnshops and investment consulting firms, according to the sources. Some of the funds went toward a U.S. consultancy that later failed.

Since this use of funds completely violated banking rules, Zhongdan forged documents indicating the money was being borrowed to pay fictitious suppliers:

To nail one loan, [an executive for a building materials manufacturer] said, Zhongdan formed a shell building materials supplier and wrote a fake contract between the supplier and his company. The document was presented to the bank, which approved the loan. Zhongdan later de-registered the phony supplier.

The whole thing started to unravel in January when banks “reacted to rumors of a liquidity crunch” at Zhongdan:

Several banks that cooperated with Zhongdan smelled trouble and started calling loans they had issued to companies backed by the firm … The next domino fell when the creditor companies, seeking to appease the banks, turned to Zhongdan for help repaying the called loans.  But Zhongdan executives balked, and the domino effect accelerated as companies teetered under bank pressure and the city’s business community shuddered with credit freeze fears.

At that point, regulators stepped in and told everybody to freeze — and to keep all the assets as “good” on everyone’s balance sheets while they figured out what to do next.  Zhongdan had over 300 clients, and guaranteed RMB 3.3 billion (US$ 521 million) in loans from at least 18 banks.  The only liquid assets that the guarantee company appears to have available to pay banks is RMB 210 million (US$ 33 million) in margin accounts deposited with the banks themselves.  Good luck finding the rest:

“Of first importance is to determine the depth of the hole,” Beijing Finance Bureau Deputy Director Li Zhigang said … “If there are no new investors and no new liquidity replenishments, Zhongdan won’t be able to repay.”

Lest you think Zhongdan was just a colorful outlier, think again:

A branch manager at one bank involved in the Zhongdan case said most bankers are fully aware that most companies provide falsified contracts to qualify for loans. Others said they routinely skip certain procedures designed to catch tricksters.

“Banks argue that companies should be held accountable for fraudulent borrowing,” said a company manager who said he obtained several bank loans by working with Zhongdan. “They are determined that they will not admit to knowing these are fake contracts.

“I worked with other guarantee companies before,” he said. “I realized that, in fact, a lot of banks know about this.”

Read that last quote again.  The implication is that Zhongdan’s modus operandi (forging documents to channel loan proceeds into risky investment schemes) is common practice among China’s credit guarantee companies, and that Chinese banks have been willing co-conspirators.  I wish I could tell you the size of the problem, on a systemic level, but that’s part of the problem — it’s too opaque.  Nobody I’ve talked to knows.

One of the reasons banks may have been willing to go along with the charade was the need to fulfill their quotas when it came to boosting SME lending.  If so, it reinforces what I said years ago, that state-mandated set-asides are not the way to improve entrepreneurs’ access to bank lending, that banks need to revise their whole approach to lending:

China’s goal should not be to throw money at SMEs as though they were just another special interest to be subsidized.  It should be to develop a banking system capable of allocating capital to whoever can use it best–including good SMEs.

More importantly, the Zhongdan episode — which I’m amazed hasn’t attracted more attention and concern — illustrates the kind of hidden risks that have developed in China’s financial system, to which bank and regulators have been willing to turn a blind eye in order to meet the insatiable credit demands of investment-led GDP growth.

In a recent report debunking “myths” about China’s economy (which could have been titled “China:  Don’t Worry, Be Happy”), CLSA’s Andy Rothman maintains (in Myth #13, p. 46) that there are “no shadow banks” in China.  “Anything in the shadows sounds scary,” he says, but never fear because all of China’s financial institutions, banks and non-banks, are under the firm control of the Party.  “They are,” he quips, “Party animals.”

Indeed.  Zhongdan and other credit guarantee companies certainly seem to have been partying it up.  Only now is what they have done beginning to emerge from the shadows.  It looks pretty scary to me.

45 Comments leave one →
  1. George H permalink
    May 20, 2012 5:09 am

    Excellent post Patrick.

  2. Hua Qiao permalink
    May 20, 2012 7:11 am

    It’s important to understand the mentality of lenders, especially at the big state owned banks. First, to be successful and climb the corporate ladder, you generally do not do so by being a standout performer. Instead you do a satisfactory job while you spend time developing your relationships with superiors, schmoozing, essentially. While you could strive to be a standout performer, it is fraught with personal risks, especially in the financial industry where supernormal returns usually mean risk.

    So what develops is a pattern of behavior where all employees seek to minimize personal risk within the job. Never sign anything if you can avoid it. Always make sure you have someone else to blame. And above all, characterize your behavior as falling within policy. Indeed, a kind of safe harbor for bankers is if you can show you acted within policy. Doesn’t matter how stupid the business decision is, if you complied with and supported policy, then you are less apt to be criticized.

    So, everyone knows the guarantee companies are shams. But in most cases policy will require additonal collateral support for small, weak credits such as SMEs. By adding a guarantee from a guarantee company, the banker complies with policy. Most guarantee companies that i looked at would be laughed at by any good analyst…usually highly undiversified portfolios with poor liquidity.

    A similar kind of behavior is seen in the coastal/eastern provinces like Zhejiang, Shandong and Jiangsu where small unrelated Industrial and commercial companies guarantee each other. Kind of a “you wash my back i wash yours” arrangement, these structures are absolutely air balls when it comes time to pay. Although there often is some kind of relationship, family, friends, buyer, supplier, the upshot is that none of these companies would allow a payment obligation under such a guarantee to bankrupt their own operations.

    Inflated collateral is still another area where Chinese banks knowingly paper the file. I know a real estate lender that told me that the reason you see so many “see through” office and commercial buildings is the developers have an implied deal with bank lenders that if the market is soft during lease up, the borrower owner will not cut rents but instead leave the property unleased. This is because banks have latitude in massaging pro forma vacancy and leaseup times but they do not have the ability to fudge rents if the building begins to lease up for less than the proforma rents used in underwriting. That would cause a downward revaluation of the property and require a Loan to Value adjustment and therefore a loan pay down; kind of like a margin call. I don’t know how rampant this game is but it sure explains a lot.

  3. Lao Fu permalink
    May 20, 2012 4:24 pm

    The CLSA Report you link to is far less dire-sounding than most of your blog posts. Aside from expressing concern over the lack of genuine rule-of-law, Mr. Rothman sounds positively upbeat about China’s political and economic prospects in the near, medium, and long-term.

  4. andao permalink
    May 20, 2012 7:45 pm

    Good post professor.

    That CLSA report is pretty shocking, thanks for sharing that. I’d like to see how they think there is no housing bubble when Shenzhen homes are comparably priced to San Francisco ones, and Shenzheners probably make 1/4 of what San Franciscans do. So that 80%+ home ownership rate coupled with super high housing cost-to-salary ratios, and consistently high savings rates means the money has to be coming from somewhere. Something shady is going on, for sure.

    They also predict 8-8.5% GDP growth this year?! FT reported last week that electricity numbers would indicate a growth rate of 6%. Maybe factories will outperform in the summer?

  5. May 21, 2012 10:44 am

    Thanks for the heads up, Patrick.

    Regarding the possibility of a financial crisis, I doubt there can be a Lehman-style credit crisis in China. With the Party in control of the regulators, central bank and government, they will definitely paper over the losses by printing money.

    But if they do that, then what they can’t control is price inflation and capital flight, which will most probably result in either the the depreciation of the RMB or capital controls.

  6. geoih permalink
    May 21, 2012 9:51 pm

    “If there are no new investors and no new liquidity replenishments, Zhongdan won’t be able to repay.”

    Can you say Ponzi?

  7. Peter permalink
    May 22, 2012 6:58 am

    Patrick great observations. Here’s a question from a China neophyte.

    People are looking for a Lehman moment everywhere now. Jim Grant in Grant’s Interest Rate Observer the other day asked if we should not be paying attention to “tail risk” at the other tail, i.e. inflation rather than a market crash.

    When you go back to Lehman, the reason LEH was a surprise was because markets expected the Fed to buy LEH they way they bought Bear Stearns. The political tough love impulse to let markets fend for themselves was similar to the bubble-busting m.o. the Japanese pursued in the early 1990s. Japan’s credit bubble was huge (give Christopher Wood credit for covering this in his books). Japan got deflation but there was no single domestic or global market calamity that I’m aware of. Japan’s relatively isolated capital account, export dependency and MoF support for the currency probably kept the problems at a slow burn. Over the course of the 1990s, the world moved on without incident while Japan deflated.

    It’s certainly possible that China’s credit bubble is isolated enough systemically that you won’t get another Lehman, but what might we get instead?


  8. Rui permalink
    May 22, 2012 7:44 am

    Good post, I see this as a most important sources of risk for this Chinese economy.
    CLSA report seems very optimistic (if not a little shocking) to me, if the only big problem is the rule of law and there is no property bubble, seems China is not at all in trouble.

    But now, there is clear possibility of hard landing, besides the real estate prices seem extremely high considering the “normal” wage of a Chinese worker. At the same time, the government has been paying attention to this problem and implementing policies to cool down the real estate market. ‘

    Because the enormous consequences to the local government finances and the banks is likely to bring down the market but will enforce some price controls if they think is necessary.
    At the same time, seems the government consider the banks to be ‘healthy’, specially after a ‘record profit report’ early this year. Most of this profits probably are not so, but just reflection of bad business practices.

    Looks like the government has been paying too much attention to real estate market but little to the banks. This means the trouble could emerge from financial institutions, not exactly from real estate market although has play a mayor role in bad performing loans. If we see a credit crunch, this will reach all areas of the economy.

    The ‘not existing’ shadow banking has been reported before, see Wall Street Journal here:
    And the risk of credit guarantee non performing companies were reported by FT here:
    Maybe the trouble Zhongdan is just one company going out of business, nothing more… or maybe not. The question is how big is the mess and are they too big to fail too…?

  9. Shanghaier permalink
    May 22, 2012 8:55 am

    This article on Reuters leave a few questions as well.

    How will the creditors be prioritized in these situations?

    And just how big is the amount of credits with these companies?

    In our line of business it seems a lot of foreign SME’s are must bear the brunt of the credit.

  10. grinch permalink
    May 22, 2012 12:28 pm

    So wheres the safe haven? Should we be planning for market event? Here in Canada the economy could be severely impacted due to its heavy reliance on resource exports. Copper and Coal prices are weakening…..

    • The Digit Man permalink
      May 28, 2012 2:48 pm

      word on the street suggests the Party are so nervous about a hard landing they may throw more cash about pre 2013 in order to keep the kite high in the air (7.5% GDP growth), rather than risk it floating too low and hitting overhead power lines (think 6% growth) … this will only add to the Non-Performing Loan problems building since the 2009 stimulus package … will they ever learn, grasshopper ?

  11. May 22, 2012 5:59 pm

    Great post,read something similar earlier this year but not as much detail:

    The fall-out will have reverberations, no doubt

  12. Chi Tran permalink
    May 24, 2012 5:40 pm

    Andy Rothman’s reports on China are always amusing yet disturbing to read. It is amazing how he would twist practically every bit of data coming out of China into positive news or else dismiss them as being ignorant claims of people who just don’t understand China. For example, his arguments for China not being as dependent on exports for growth as one would believe are absolutely bizarre for someone who claims to be an economist. If we only look at the net exports, as he does, to determine export dependence of a country, then South Korea, whose growth everyone knows is extremely tied to exports (52% of GDP), would seem even less dependent than China (SK’s net exports = 2% vs 4% for China). It is scary that he still enjoys a large following as is often interviewed as the ‘China expert’.

    Thank you so much, Professor Chovanec, for offering an intelligent, insightful, and informed counterbalance to the Rothman camp!

  13. Steven Zhu permalink
    May 24, 2012 9:31 pm

    The problem is there is no way to define the scope of such Loan. It is true that there are loans in Shadow, but until you understand the relative size of such loan in total loan portfolio, it will be hard to measure the potential loss and further impact. It is a risk, but the hard part is no one can measure how big it is.

  14. Prometheus permalink
    May 25, 2012 10:39 am

    Thanks once again for your insightful post.

    Personally, I feel that this issue you pointed out in this post is probably going to be the Chinese version of the “Jusen” problem in Japan during the early 90s, which pretty much was the tacit admission by MoF that the asset bubble was now officially over, and asset prices are never going to go back to the old bubble days.

    The Chinese government would probably want to delay announcing the inevitable until the once-in-a-decade power transition at the top has been made, but as the Jusen issue has demonstrated, it’s going to become more painful if you go on prolonging the inevitable.

    Welcome to the age of the “lost decade” China!

  15. Bruce permalink
    May 31, 2012 6:35 am

    Great post. Have you spoken to these credit companies? What service do they say they sell to the SME borrowers (e.g., insurance polity, ways to examine borrowers collaterals)?


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