Deadly Loans: Why China’s ‘Shadow’ Capital Market Persists

[From TeaLeafNation]

Zeng Chengjie, a Chinese businessman from Hunan province sentenced to death for charges of illegal fundraising, was recently executed without authorities notifying his family, a lapse which sparked considerable backlash among Chinese Internet users. Zeng was not the first entrepreneur to receive a death sentence for financial crimes: Wu Ying, a businesswoman from Zhejiang province, was sentenced to death for defrauding investors of over 300 million RMB (about US$49 million) just several years ago. Unlike Zeng, her sentence was commuted to ‘death with a two-year reprieve,’ which in China’s judicial system is usually then commuted to a life sentence after two years. Yet both cases show that harsh sentences often await those convicted of economic crimes in China, without regard to the flaws in the system that have led to their actions in the first place.

Zeng turned to private lending to finance his business, a practice not uncommon in China due to the difficulty Chinese entrepreneurs face in obtaining loans from banks. While some media have called Zeng ‘China’s Bernie Madoff,’ the comparison unfairly discounts the questionable proceedings of Zeng’s trial and conviction as well as the differences in the actions of the two. Zeng’s assets were alleged to have been liquidated at a very low rate by the government, which led to a conviction of insolvency. Also, Zeng raised capital to keep his real estate development business afloat, rather than for personal use like Madoff. Yet when his business failed, he was tried, convicted, and executed.

Why, if death awaits some business people who fail to repay their debts, do private sector entrepreneurs like Zeng look to private lending as their only source of financing? A closer look into China’s banking system reveals the answer. In China, private entities are not allowed to run banks, so commercial loans can be only obtained from state-owned banks. Since state-owned enterprises are controlled by the government, they are sometimes more driven by political incentives than market incentives. Unsurprisingly, the people who run private enterprises are on the bottom of the banks’ lending list, because state-owned enterprises are always given higher priority no matter how bad their balance sheets look.

Further strengthening the government’s banking monopoly, laws also bar inter-company lending, meaning that companies cannot lend money to each other. Lastly, the tradition of borrowing money from friends and neighbors to get through hard times has deep roots in Chinese society. These combined factors have led some Chinese entrepreneurs to seek private financing despite the risks.

Traditionally, individual loans are made based on personal relationships. However, since China’s banking system does not allocate capital fairly, a huge “shadow” capital market has emerged where the enormous demand from desperate private enterprises is met by the supply of money from ordinary people seeking a better return on their investment than the below-inflation rates offered by banks. Business owners who need capital can get credit from friends of friends, and even from total strangers, through loan matchmaking agencies. Because this “shadow” loan market is unregulated, risks abound. Borrowers might undertake very risky projects or simply take the money and disappear. Using borrowed money to speculate on stocks and futures is not uncommon; one person even raised money to run casinos, despite the fact that gambling is illegal in China.

Private lenders, on the other hand, are generally left in the dark, under the impression that their hard-earned money has been locked in at “guaranteed” high yield rates, when they may have nothing more than a handwritten IOU. Lacking awareness of the risks, lenders usually invest far more than they can afford to lose. When a bubble bursts, many may lose all they have, and the borrowers are always blamed, because there is no clear line separating legal private lending and illegal fundraising – the crime for which Zeng was executed.

It is this information asymmetry between the borrowers and lenders that causes so many credit crises in private lending. Under normal circumstances, banks mitigate this asymmetry by acting as profit-driven intermediaries with their expertise in diversification and risk control. When banks cannot provide this service, problems begin to appear.

There have been moves toward reform: on July 5, China’s State Council published ten guidelines for financial market restructuring, the ninth of which specifically emphasizes the legalization of privately-run banks and the regulation of private lending markets. Hopefully, authorities can implement these guidelines quickly enough to save ordinary investors from bad decisions, and entrepreneurs like Zeng Chengjie from death.

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