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Introduction
In a casual analysis, the struggles faced by the Chinese financial sector can be
thoroughly perplexing. It appears to be a paradox that the worlds fastest growing
economy also houses some of the worlds most unprofitable banks. The inefficiency
of Chinas banks can be altogether staggering: the total amount of bad loans
outstanding currently stands at USD 268.3 billion, or 10.54% of GDP. In total, it is
estimated that over 50% of the loans extended by Chinese banks in the reform era
have been non-performing1. The cause for poor performance is straightforward a
vast majority of the loans2 extended by the banking system in China are issued to
State Owned Enterprises (SOEs), which are on average much less efficient than
Chinas private sector3. It is astonishing just how unprofitable the companies that
receive bank loans in China are compared to their private counterparts: on average,
a company receiving a bank loan in China has an ROE of negative 32.81% over the
following two years4. In sum, these statistics imply not only a misallocation of
capital within the Chinese financial system, but also a sizeable destruction of value.
However, the unfortunate state of the banking sector in China only further
confounds the puzzle of Chinas economic miracle. The literature on the importance
of savings mobilization and, by extension, financial intermediation to economic
growth is widespread5. Yet while less than 1% of total bank loans are extended to
the privately owned enterprises6, this sector continues to be the primary driver of
GDP growth in China7. And so the question remains how has this growth been
financed?
The short answer is that in the absence of formalized finance, the capital needs
of the private sector in China have been satiated by an informal financial system
which has proven to be vastly more efficient than the state-owned banks 8. This
informal financial system, while often criticized by the media, has nonetheless
supplied in excess of 75% of private sector credit 9. The fact that these localized,
informal financing mechanisms have developed to the point whereby they finance a
large portion of the Chinas growth stands as a remarkable testament to the
adaptiveness and ingenuity of the Chinese people. Indeed, informal finance in
China is as diverse as the nation itself, ranging from simple interpersonal lending
within a guanxi network to full service illegal private banking institutions.
4 Bailey, Warren B., Huang Wei and Zhishu Yang. "Bank Loans with Chinese
Characteristics: Inside Debt, Firm Quality, and Market Response." 2008: p. 45
5 For more information with regards to the importance of savings mobilization
on economic growth, refer to Amaral and Quinton (2007), Minsky (1967), and Stiglitz
and Weiss (1981)
6 In total, .66% of loans extended by the Chinese banking sector go to private
and individual enterprises: Tsai, Kellee S. "Congressional Testimony on China's
Financial System." US-China Economic and Security Review Commission.
Washington D.C.: USCC, 2006: p. 1.
7 SMEs, which comprise 98% of the private sector, are responsible for 65% of
Chinas economic growth, 75% of industrial output created since 1990, 80% of
employment, and 69% of exports: Jia, Chen. "Development of Chinese Small to
Medium-sized enterprises." Journal of Small Business and Enterprise Development
(2006): pp. 140 - 145
8 Overhead costs of the formal Chinese banking system stands at 12.2% of
assets: Allen, Franklin, Jun Qian and Meijun Qian. "Law, Finance, and Economic
Growth in China." Journal of Financial Economics (2005): 57-116: p.71.
9 Tsai (2006): p. 2
10 Central bank bills are short term discount notes perceived by the market to
be risk free (indeed, they are backed by the full faith and power of printing presses
of the U.S. Treasury). These notes are the primary collateral used by banks in
overnight Repo transactions, which are used to mitigate short term funding
shortfalls.
11 A notable exception is the management of the RMB exchange rate by SAFE
in export-dominated areas.
12 To illustrate usurious activity, illegal lenders often charge interest rates
much higher than the official rates set by Chinas big four banks (sometimes as
high as five to six percent per month). For an example of how informal finance can
threaten social stability, refer to the growth of taihui (escalating rotating credit
association) in Wenzhou in 1986, which devolved into Ponzi schemes: Bradsher,
Keith. "China's Informal Lending Poses Risks to Its Banks." New York Times 9
November 2004.
We must severely attack all actions in the financial arena that are illegal or in
the violation of regulations. We must guarantee that all financial laws,
regulations, and rules are implemented thoroughly. We must emphasize the
prohibitions against banks using high interest rates to monopolize deposits,
illegal fund-raising in society, and haphazard financial activities.
North America shows that] investment demand seems to have been the driving
force behind private saving and accumulation, past and present 21. At first glance a
hypothesis of investment-motivated savings may seem odd to posit because of the
extremely low rates offered to savers at Chinas formal banks with such low
interest rates, there would seem to be little incentive for a Chinese household to
hold large deposits.
Yet in the absence of formalize finance, it is important to remember the local
reality is that savers, investors, and potential entrepreneurs are not three separate
and disparate groups but are intricately related within their social network. To
illustrate, suppose a family decides that it would like to open up a light factory to
do so, because of Chinas lack of availability of both personal credit and venture
debt, the family would be required to save up and pay in the startup capital. In
other words, the familys venture would largely be self-financed, and self-financing
by definition implies an accumulation of savings in advance.
This hypothesis can further illuminate the nature of the savings and investment
in China. Refer to Exhibit 4: during the 1980s, investment in urban enterprise was
miniscule compared to that in rural areas and that of Chinas SOEs similarly, the
savings rate for non-rural workers was never above 13%. As the urban savings rate
has steadily increased since 1992, so has the share of urban investment. This
contrasts against rural and SOE investment, which has remained roughly constant
as a percentage of GDP. Above all, what is remarkable about the tandem growth in
urban savings and investment is that the savings have been mobilized completely
independent of a banking system.
It is vital, therefore, to understand the mechanism by which these savings are
converted into investment and where this investment precisely comes from (to see
the breakdown of financing undertaken by private Chinese companies, refer to
Exhibit 5). Of surveyed Chinese entrepreneurs, the top five sources for start-up
capital were: family savings, close friends, suppliers, extended family, and
19 For example, Latin Americas average personal savings rate has averaged
around 4% over the past decade; African countries have posted even lower personal
savings rates. It would be a stretch to assume that the social safety nets in these
locations were many orders of magnitude better than Chinas: EarthTrends. Country
Profile: Brazil. Washington D.C.: World Resources Institute, 2003.
20 Woo, Wing Thye and Liang-Yn Liu. "Savings Behavior Under Imperfect
Financial Markets and the Current Account Consequences." The Economic Journal
(1994): 512-527.
21 Woo (2005), p. 10.
colleagues22. Notice that while accumulated family savings was the top source, the
remainder comprises of loans and investment from members of the entrepreneurs
guanxi network. These sources are rarely institutionalized, which implies that these
local lenders would similarly be required to accumulate cash savings beforehand.
Informal Financing Mechanisms
Interpersonal Borrowing
Perhaps the simplest and most common mechanism in Chinas informal financial
system is interpersonal borrowing within ones guanxi network. In excess of 60% of
Chinese entrepreneurs report that have used interpersonal borrowing in order to
meet financing needs23. This practice of borrowing and lending among friends,
colleagues, and relatives has a long history in China, beginning in the Western Zhou
dynasty24. The terms of these loans can vary wildly: they can be principal-only
(generally between friends and relatives), or carry significant interest charges
(typically between entrepreneurs). Also, different parts of China have different
cultural norms with regards to interpersonal lending: loans in the south of China are
more commercial, with higher interest rates (2.80% versus .83% 25), a shorter
maturity (4.5 months versus 11.2 months), and a larger face value (on average 2.28
times larger in the south). In addition, in Chinas coastal south, entrepreneurs are
far more likely to charge interest on their loans than those in the industrial north:
28% of lenders had charged interest in the south, compared with 7% in the north 26.
Rotating Credit Associations (Hui)
Of course, while widespread, interpersonal borrowing is only a small segment of
Chinas informal financial system there are far more institutionalized alternatives.
One popular financing mechanism is a rotating credit association (usually consisting
of about 15 people) called a hui. With a history dating back to Tang dynasty
China, a basic hui (also termed lunhui) is a simple interest free scheme whereby
22 Pistrui, David, et al. "Entrepreneurship in China:Characteristics, Attributes,
and Family Forces Shaping the Emerging Private Sector." Family Business Review
(2004): 141-152: p. 150.
23 Tsai (2002): p. 57
24 Hu, Biliang. Informal institutions and rural development in China. Chicago:
Routledge, 2007: p.102.
25 Respectively, 39.29% and 10.23% annualized.
26 Tsai (2002): p. 55-59.
each member contributes a fixed payment a collective pot. In this basic hui, the
member that receives the pot rotates every meeting, which would traditionally
either be monthly or semiannually27. The advantage of the hui structure over an
individual accumulating cash savings is obvious hui allow for the pot recipient to
immediately collect a large sum of cash with simply by paying smaller intermittent
payments over the course of the rotation. In essence, for the first recipient, the
rotating association is structurally identical to taking out a loan. Of course, if a hui
participant is last in the rotation, the cash flows coming from the hui would be
exactly the same as if one had simply saved the periodic payments.
Over time, the basic lunhui evolved to a diverse array of different structures, of
which the yaohui28 and the biaohui are most popular. Originating from Guangdong,
the Biaohui is a clever and fascinating structure for a rotating credit association (in
the locations where hui are most prominent, the biaohui is the most common type
of hui used to finance private businesses). Unlike the other schemes, in the biaohui
interest is charged to the recipient of the pot both the recipient and the interest
rate is determined by an auction process whereby the participant willing to pay the
most interest wins the pot29. Economically, this structure is far more efficient than
the others auctions (when designed correctly) are highly informational efficient 30,
and the money is allocated to the individual with the largest expected utility of the
pot.
Pawnbrokers
While certainly not unique to East Asia, another informal financial institution
with a long history in China is the pawnbroker, the usage of which dates back
Buddhist monasteries in middle of the Six Dynasties. A pawnbroker is a creditor
who provides loans, albeit back by collateral (i.e. a good that the broker would be
able to take in the event of default). In some ways, it is ironic that pawnbrokers are
a widely used informal financing mechanism, due to the abhorrence of the practice
by the Chinese Communist Party in the years leading up to 1949. Indeed, while the
term pawnbroker conjures images of loan sharks charging usurious interest rates
on peasants and stealing family heirlooms, the pawnbrokers in mainland China
today service mostly small to medium sized businesses, which account for 97.9% of
27 Tsai (2002): pp. 25-27
28 In the yaohui, instead of having a fixed rotation, the recipient of the pot is
determined by chance (traditionally with a roll of the dice): Tsai (2002): p. 26
29 Tsai (2002): pp. 71-72.
30 For more information regarding the informational efficiency of auctions, refer
to Goeree (2000) and Andersson (2002).
American cultural context. China already has a financial system that is congruent
with Chinese social norms and functions on a localized level, but the central
government insists on its continued illegality.
It is difficult to fashion the institutions required to make an effective financial
system; some argue that even Japan and South Korea still do not have a financial
sector that can efficiently mobilize their nations savings. And while Chinas
informal financial sector is obviously in dire need of regulation and bureaucratic
supervision, building a banking sector on the financing methods already practiced
by Chinese private companies does not have to be outside of the realm of
possibility. To help mobilize bank deposits from the lumbering SOEs to more
profitable sectors, I strongly feel that SOEs in China should be given the authority to
broker loans that is, while the SOE would not have the authority to issue new
loans (and thus expand the money supply), they would be allowed to, as they see
fit, transfer the capital they received from the formal banks to a private enterprise
and make a spread on interest rates (i.e. charging the private company a slightly
higher interest rate than the bank charged the SOE). From a local perspective, this
makes sense because while an entrepreneur may not have a connection to one of
Chinas banks, many SMEs do have connections to local SOEs, as evidenced by the
popularity of Red-Hat disguises.
Furthermore, pawnbrokers and rotating credit associations (particularly of the
bidding variety) are not necessarily incongruent with financial theory. Modern
pawnbrokers in China rarely use durable goods as collateral anymore; much more
common is lending against real estate and accounts receivable. This is, it should be
noted, not materially different than the asset-backed securities market in the United
States. Indeed, as the banking sector in the mainland has struggled with creating a
domestic mortgage market36, it seems strange to not develop the market using
Chinas pawnbrokers, which have decades of experience lending against real estate.
In addition, the biaohui that are widespread throughout the Guangdong,
Zhejiang, and Fujian province have a similar potential for formalization. While
certain localities in China (e.g. Wenzhou City) have faced periodic crises relating to
rampant speculation in hui37, the OECD has faced similar situations with regard to
investment funds. Simply because a financing vehicle has the capacity to be
abused does not necessarily mean the vehicle is without worth it merely
necessitates supervision and guidance on the part of regulators. Furthermore, if
biaohui were structured so as to allow for the investment from outside investors, it
could give the PBoC a mechanism to control the monetary expansion inherent in
such an institution (and, if need be, mitigate contraction in the event of a crisis). In
conjunction with allowing SOEs to broker loans on a local level, biaohui have to
36 Chinas mortgage market, once adjusted for GDP, is a similar size as
Thailands: Guangdong Provincial People's Congress. "Mortgage industry untapped,
says BIS." Guangdong News 13 December 2007.
potential to evolve into a far superior financing mechanism for SMEs than bank
lending with an investment in just one hui, an investor would be able to get
exposure to fifteen different entities, lowering the transaction costs involved in
investing in small businesses. In addition, because there is significant social
pressure again the default amongst hui members, the monitoring costs (another
significant cost of investing in SMEs) would also be greatly alleviated.
From both sides of the Pacific, there seems to be a general impression that
China needs to and inevitably will move toward a financial system modeled after
those in the West. With 80% of Chinas SMEs reporting difficulties obtaining
financing38 and a sizable destruction of value within the formal financial system, it is
an indisputable fact that Chinas financial system needs to vastly improve its
allocative efficiency. Yet it is important to understand that while Chinese SMEs do
indeed struggle with financing compared to their OECD counterparts, SMEs in most
countries face similar difficulties. In the United States, 55% of small businesses
report having difficulty securing credit in fact, 44% of all external financing used
by American SMEs comes from credit cards39. While the media often reports of
usurious interest rates charged by the informal financial system in China, is credit
card financing necessarily a preferable alternative?
To quote John Kenneth Galbraith, the enemy of conventional wisdom is not
ideas but the march of events. Ever since reform began in 1978, Chinas growth
has confounded developmental economists. The Chinese Communist Party bears
little resemblance to the enlightened developmental state, the country has little in
the way of institutions that define and protect property rights, and the dominance of
SOEs in the financial system would make a public choice theorist irate. And yet, the
flexibility and resourcefulness of the Chinese private sector has overcome all of
these factors that should supposedly hold it back. The Chinese story has repeatedly
redefined how economics views development against this backdrop, should China
feel pressured to redefine itself because of how developmental economists view it?
37 These practices culminated in the existence of taihui, or escalating
associations. These hui are structurally the same as a Ponzi scheme (i.e. new
deposits fund the dividends on the original investments); there was word of some
hui participants being involved in dozens of taihui in order to fund their involvement
in the others. Needless to say, the situation ended badly, and in 1987 the PBoC
forced the Wenzhous governments hand and hui were completely outlawed in the
city.
38 Liu: p. 5.
39 NSBA. NBSA Small and Medium Sized Business Survey. Survey. Washington
D.C.: NSBA, 2008: pp. 16-19.
Indeed, why should China attempt to eliminate its informal banks, the same
institutions that have financed in excess of thirty years of growth? While formalized
financial institutions are certainly important for effective implementation of
monetary policy, there are less radical courses of action available to Chinas
policymakers. Beijing should not necessarily be so quick to replace what is effective
with what sounds good.
Works Cited
Allen, Franklin, Jun Qian and Meijun Qian. "Law, Finance, and Economic Growth
in China." Journal of Financial Economics (2005): 57-116.
Bailey, Warren B., Huang Wei and Zhishu Yang. "Bank Loans with Chinese
Characteristics: Inside Debt, Firm Quality, and Market Response." 2008.
Bradsher, Keith. "China's Informal Lending Poses Risks to Its Banks." New York
Times 9 November 2004.
Brandt, Loren and Thomas G. Rawski. China's Great Economic Transformation.
London: Cambridge University Press , 2008.
Consulate General of Switzerland in Shanghai. China's Banking Sector with a
Focus on Shanghai. Survey. Shanghai: Consulate General of Switzerland in
Shanghai, 2007.
EarthTrends. Country Profile: Brazil. Washington D.C.: World Resources Institute,
2003.
Fallows, James. "The $1.4 Trillion Question." The Atlantic Monthly January 2008:
2-3.
Guangdong Provincial People's Congress. "Mortgage industry untapped, says
BIS." Guangdong News 13 December 2007.
He, Xinhua and Yongfu Cao. "Understanding High Savings Rate in China." China
& World Economy (2007): 1-13.
Hu, Biliang. Informal institutions and rural development in China. Chicago:
Routledge, 2007.
Jia, Chen. "Development of Chinese Small to Medium-sized enterprises." Journal
of Small Business and Enterprise Development (2006).
Liu, Chen Xiang. "SME Financing in China." Economics Working Papers,
University of Paris (2007).
NSBA. NBSA Small and Medium Sized Business Survey. Survey. Washington D.C.:
NSBA, 2008.
Pistrui, David, et al. "Entrepreneurship in China:Characteristics, Attributes, and
Family Forces Shaping the Emerging Private Sector." Family Business Review (2004):
141-152.
NPLs as % of GDP
12
10.54
10
8
6
4
3.2
2.4
2.1
1.4
0.7
0.8
USA
0
China
Indonesia Taiwan
SOE Investment
15
SOE Investment
Investment as a % of GDP10
5
Rural Investment
0
2050
1950
Urban Investment
Exhibit 5
Source of
Financing
Paid-in Capital
Retained
Earnings
Informal
Channels
Formal
Channels
Percent of
Total
26%
30%
37%
7%