China shadow lending: In from the dark

After a spate of suicides among entrepreneurs in 2012 in the southeastern Chinese city of Wenzhou, the central government discovered an epidemic of questionable lending practices. Before the global financial crisis, individuals had borrowed large amounts of money from unlicensed financial institutions with the intention of speculating on the country's then booming economy.

However, when the crisis hit, those customers found themselves saddled with debts they couldn't pay back. Their defaults precipitated the collapse of the city's underground lending system, and even damaged established banks that themselves had ties to the unregulated segment.

The government's actions over the Wenzhou case affected only a small part of China's wide-ranging and largely lawless shadow banking sector. While the authorities have tried to legitimize the institutions that caused the 2012 crisis, they play a constant game of catch-up. Lenders continually devise new products to skirt the newly established rules for investors that still see value in their services, and businesses and individuals continue to turn to unregulated providers for funds that they cannot get anywhere else.

The authorities are always scrambling and kind of one step behind, trying to get a better hand on regulating these components, to prevent them from becoming risky, or too large, by bringing them into the regulated map - Stephen Schwartz

"Actually, some of the sources of capital in the shadow banking system the government would very much support, because it's giving companies a better source of capital that's more efficiently priced," says Benjamin Fanger, co-founder and managing director at China distress specialist Shoreline Capital. "Some sources the government would very much not support, such as loan sharks, for obvious reasons."

Fanger points out that the shadow banking system can also provide deals for firms such as his; for instance, a rise in non-performing loans that started several years ago can be traced back to a previous explosion of credit, including loans from unofficial sources.

The extent to which there is actual crossover between China's shadow banks and institutional private investment firms offering equity or debt-based financing is unclear. But even in those areas where unofficial institutions may encroach on the territory of more traditional finance providers, they are unlikely to supplant them. Differences in the nature of the solutions provided by each type of player, and in the companies to which they are likely to appeal, means they have little to fear from each other.

Hard to define

Moody's Investors Services put the value of China's shadow banking sector at RMB41 trillion ($6.5 trillion) last year, up from RMB19.2 trillion in 2011. But monitoring the sector can be difficult, because the term encompasses a wide and constantly shifting range of financial activities. While shadow banking is not difficult to define - it simply means financial activity that is not carried out by the existing banking system - it is that broad definition that makes it hard to discuss the practical operations in this space.

"What is shadow-banking? It's non-bank lending. If you are doing solid, well-underwritten transactions onshore then you are participating in non-bank lending, and it is useful for any economy. We are proudly doing this," Rob Petty, managing partner and co-founder at Clearwater Capital Partners, a credit and special situations investor, told AVCJ earlier this year.

Components of the system include those that are highly disreputable, and sometimes illegal, such as loan sharks. On the other end of the scale, the sector can also involve instruments that are completely legal, but not part of the formal banking system and therefore not subject to existing regulations.

"They are sometimes the things that are making headlines in the news, even when they're relatively small, just because they're new and faster growing," says Stephen Schwartz, a senior vice president at Moody's. "And the authorities are always scrambling and kind of one step behind, trying to get a better hand on regulating these components, to prevent them from becoming risky, or too large, by bringing them into the regulated map."

The more recently devised aspects of the shadow bank sector include ventures such as peer-to-peer lending, e-financing and umbrella trusts. Despite their relatively late introduction, these financing models have become common enough for Moody's, in its latest shadow banking monitor report, to group them together as "non-core" activity, differentiating them from such "core" components as margin financing, entrusted loans, and trust loans.

Wealth management instruments provided by shadow bankers tend to change often, in order to circumvent the banking regulations set up to rein them in. Often the unofficial lenders will still be linked to the legitimate banking system.

In one arrangement that investment professionals have seen in recent years, banks team up with trust companies to offer credit to customers. The trusts sell beneficiary rights to the banks and loan the proceeds to their clients, which means that while the banks are financing the loans themselves, the actual debts are not on their books. Banks have been caught out in the past using structures like these to circumvent reserve ratio requirements under which they must hold a proportion of total assets on account, so it can't be lent out.

Indeed, though all societies have some form of shadow banking, the incarnation in modern China owes much to the restrictions outlined above, and in turn to the country's recent economic developments.

"What really gave rise to what we might call the unhealthy and concerning growth of the shadow banking system was the government's efforts to tamp down overall credit growth, and then this money finding its way around those regulations," says Schwarz. "So starting in 2011-2013, the authorities increasingly implemented regulations to bring those flows back into the regulated credit channel, and they've been succeeding."

Cyclical impact

The economic trends that have alternately heated and cooled the Chinese economy have also contributed to the vicissitudes of the shadow lending sector.

During the global financial crisis, the central government implemented economic stimulus measures that were largely channeled through banks. This at first caused people to turn away from shadow banking due to the ease of obtaining credit through formal means, but the sector rebounded when the stimulus-inspired demand proved too much for the government's measures.

In the first half of 2009, average monthly new bank lending was RMB1.23 trillion. As this credit growth was pared back in relative terms as the year wore on, so the informal lending sector stepped in: Data from Moody's shows a sharp rise in the rate of growth of core shadow banking starting in the third quarter of 2009, far outstripping nominal GDP growth.

"Sometimes the market gets a lot of liquidity and people are very bullish for a certain period of time. But this level of business in China typically doesn't last more than a year," says Wee Yap Yeo, head of mezzanine capital at UOB. "After a year problems emerge and the new deals suddenly will just dry up. And then these companies will basically say: ‘This source of capital has dried up; I need to look for another source, which may be more expensive."

The burst in shadow financing declined somewhat in the following years, but had a slight recovery when the authorities pulled back again on stimulus financing. With demand for credit still high, but less credit available through banks, borrowers turned to other sources. Moody's data shows shadow banking growth returning in the second quarter of 2012, before dipping again under pressure of new regulations. By the second quarter of 2015 nominal GDP was once again growing more quickly than shadow bank lending.

The companies that turn to shadow banking in today's China are not a random sampling. Daniel Kwan, head of mezzanine capital at OCBC, believes the recipients of shadow finance today are those enterprises that rode the initial wave of China's development when the economy was export-focused. Those companies, which benefited greatly from foreign investment at the time, are now not as attractive to traditional lenders because of the growth of the country's technology and services sectors.

"The companies that actually do very well nowadays, or in recent years, are those that have looked inwards, to serve the Chinese market, rather than the overseas market," says Kwan. "For example, mobile phone makers, which are focused on the domestic market, have realized that the domestic market actually makes more money than the overseas market."

Because of the declining interest from outside investors in China's manufacturing sector, these companies have increasingly turned to non-traditional channels to meet their financing needs.

Though individual investment professionals differ on the specifics, all agree that there are definite commonalities among the companies that are more likely to receive shadow financing. Shoreline's Fanger shares Kwan's belief that the old-economy businesses are more likely to receive credit from unregulated lenders, but feels that the reason has more to do with the unattractiveness of the new-economy enterprises to the shadow sector.

"Usually they wouldn't be able to get shadow banking money, because much of the shadow banking system is actually secured debt, so the lenders would be looking for hard assets," says Fanger. "Lenders in China are more likely to fund manufacturers or real estate developers. Lending to services businesses or tech companies that only have intellectual property is less common. And for those companies, as long as there's growth potential I think they're more likely to go to private equity."

Competitive threat?

While use of shadow banks is often taken to indicate problems with a company, investors emphasize that this cannot be assumed. A firm may have good reasons to consider a loan from a shadow lender to be more attractive than a more traditional source of credit, and in fact Shoreline has at times lost deals to shadow lenders.

Factors that can influence a company to consider going to the informal sector for funds include the speed of closing the deal; shadow lenders may not raise the kind of due diligence issues that a traditional investor will. Company management may also prefer to pay high interest on a more informal loan, rather than give up a stake in the company and open themselves up to challenges over control from an outside investor.

"It all depends on what the situation is before they start to borrow, and what the focus of the borrowing is. They need to put the borrowing to good use, such that it can create cash flow coming out on time to service those debts," says Yeo. "And if they can figure out how to make themselves stronger, more credible, more credit-worthy, then they can tap back in to the commercial banks, and get everything back to an even keel again."

The utility of the shadow lending sector is an important reason why it is unlikely to disappear. Even the central government has shown no interest in wiping the sector out; its focus is more on reducing the abuses of the most egregious areas, while bringing the more useful offerings into the regulated banking system.

Shadow lenders can even benefit other players in the investment system. Fanger says that shadow lenders can help PE firms by providing an outlet for riskier deals. While the resulting options might be fewer, they will most likely be more focused than a bigger pool that includes riskier bets.

"In 2010, you could lend to a real estate developer that had a half-built building as collateral at a 50% LTV [loan-to-value ratio] for a 25% return," says Fanger. "But that doesn't make sense in an efficient market. And therefore, the emergence of the shadow banking system is actually in some ways a good thing for China, because it allows for more efficient pricing of risk."

However, though investors share the view that the shadow lending sector is sure to survive, none are sure what form it will take in the future. Many feel that the previous wave of growth, which was touched off by unmet demand following the government's encouragement of bank lending, is unlikely to repeat itself, since the authorities have learned from their previous attempts.

Though additional stimulus measures are expected in light of the current downturn - China's GDP growth came in at 6.9% for the third quarter, the lowest since the first three months of 2009 - the government is likely to be more cautious this time around.

"With respect to government stimulus, we would not expect the current round to be as significant as the 2009-2010 period," says Schwartz. "While the overall policy stance will likely be eased to prevent a sharp deceleration of growth, the authorities appear to be limiting the degree of stimulus so as to avoid a further buildup in leverage and financial risks."

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• Topics
• Credit/Special Situations
• Expansion
• Greater China
• Financials
• Mezzanine
• Financial Services
• Structured finance
• China
• Mezzanine
• Special Situations
• Shoreline Capital Management
• OCBC