China Puts Light On Shadow Loans-华尔街日报

Many smaller private companies, unable to obtain bank loans because of the government’s tightening of credit to fight inflation, have turned to so-called shadow lenders for funding. Such lenders often charge exorbitant interest rates, and many smaller enterprises, struggling to repay the debt, have gone under.

After a meeting presided over by Premier Wen Jiabao, the state council said that private, informal financing channels will only be encouraged ‘within the bounds of the law.’ The council, China’s cabinet, said the government will crack down on illegal practices such as pyramid schemes and lending at excessively high interest rates.

The government also will strictly prohibit participation in such informal lending by employees of financial firms, the cabinet said.

With the new government crackdown on underground lending, analysts say there is now a risk that this source of credit could dry up, bringing down even thriving companies, with ripple effects on the formal banking system.

Shadow finance in China has been around for years, but the recent surge in such lending is unprecedented, analysts say. The lightly regulated underground lenders pool money from property developers, coal miners or other cash-rich individuals hunting for higher returns.

A significant portion of shadow lenders’ funds comes from the banks themselves. Shadow lending has become sizable enough to challenge the government’s tight control of credit and interest rates, two critical tools for steering the world’s No. 2 economy.

As a result of the increase in shadow lending, China has an ‘unusually high level’ of gross debt compared with other developing economies, according to a recent International Monetary Fund report on global financial stability. The IMF calculates that the stock of domestic loans, including those both on and off banks’ books, reached 173% of China’s gross domestic product as of the end of June.

In an indication of how much lending isn’t reflected on banks’ books, credit extended through banks, but moved off their balance sheets, stands at roughly 12 trillion yuan ($1.9 trillion), UBS economists say. Total loans outstanding , both on and off banks’ balances sheets, stood at 55.7 trillion yuan as of August.

Dragonomics, a Beijing-based research and advisory firm, estimates that shadow finance accounted for more than 40% of new loans issued in the first half of this year. Much of this kind of informal lending actually is conducted by, or through, the major state banks.

According to analysts and banking executives, it has been a common practice among Chinese banks to move parts of their loan portfolios off their books by repackaging those loans into so-called wealth-management products that often promise rates of return higher than buyers can get from savings deposits.

The practice allows banks to get around lending quotas set by the government. Banks remain on the hook for those loans, though, as they need to make sure that the investment products sold to their customers pay off as promised, If underlying loans go bad, banks must find ways to pay their customers as promised.

The China Banking Regulatory Commission early this month unveiled new rules aimed at improving disclosure about certain investment products sold by banks, noting that problems have appeared along with the robust growth of such products, including banks misleading investors about the risks. The rules will become effective on Jan. 1.

The informal credit boom has boosted fee income at China’s banks, which have historically been heavily dependent on making loans to generate profit. As China’s central bank maintains a fixed margin between deposit and lending rates, making loans to creditworthy state-owned companies─banks’ main customers─has been an all but risk-free way for lenders to maximize their returns. In recent years, though, the country’s banking regulator has been encouraging banks to find alternative revenue streams as it prepares to liberalize interest rates─a change that would overturn the banks’ traditional business model.

Ma Weihua, president of China Merchants Bank Co., a large bank in the mainland, said in an interview that Chinese banks should focus more on business that throws off fee income than on traditional lending. China Merchants aims to raise nonlending income to 30% eventually, from the current 21%, Mr. Ma said.

via China Puts Light On Shadow Loans-华尔街日报.

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