PE and China's financial sector flaws

Too much short-term money, the central bank decided, was being used to support longer-term investments. It tapped into broader concerns about the use of "shadow banking" - notably off-balance-sheet products offered by the likes of trust companies - to meet financial needs, and perhaps cover up a litany of financial weaknesses.

The move also prompted questions about China's financial sector as a whole. What did it mean for impending interest rate reforms and, by extension, the desire to allow banks greater freedom while retaining control over the supply of credit? And what of the lack of depth in China's financial sector, characterized by its still immature bond markets? And of the way local governments accumulated enormous liabilities by using non-traditional funding sources?

In recent weeks, some of these questions have been answered - and there are implications for PE that go beyond macroeconomics. 

First, the lower limit on interest rates that banks can charge borrowers has been removed. Most lending is done above the benchmark rate so the immediate impact will be limited; but as a precursor to a removal of the upper limit on deposit rates, it is significant.

If banks are able to compete with one another, as well as other forms of financing, for deposits by offering higher rates, the benefits would be twofold. On one hand, customers wouldn't be inclined to flood into other products with as much vigor because, unlike recent times, bank rates would exceed the inflation rate so depositors wouldn't be lose out in real terms by putting in the bank. On the other, banks would be less likely to offer less regulated wealth management products to retain customers.

These reforms do not, however, pose an immediate threat to the niche financial services opportunities or direct lending activities that are drawing interest from private equity. The viability of these opportunities hinges on that fact that smaller companies struggle to get bank financing in China and so look elsewhere. It would take a more fundamental change in policy, and lender attitudes, to rectify the situation and it isn't happening any time soon.

Second, China's National Audit Office has been ordered by the State Council to conduct an audit of government debt. Concerns about local authorities' liabilities are nothing new; they date back to the post-global financial crisis period when when the central government announced stimulus measures but left it to the provinces to finance them. They relied on standalone investment vehicles once they bank and bond channels were exhausted.

In 2011, an audit of local governments specifically arrived at a debt figure of RMB10.7 trillion ($1.75 trillion), or about 25% of GDP, which many analysts claimed was an underestimate. Earlier this year, the IMF said overall Chinese government debt was likely closer to 50% of GDP.

The general assumption is that, when Beijing sees a number it doesn't like, local governments will face restrictions on fundraising, leading to less capital investment and downward pressure on GDP growth. There will be fallout for infrastructure projects that authorities can no longer afford and for companies in the heavy industry and property supply chain that find themselves in a capital vacuum.

The question is whether distressed investors can take advantage. If opportunities do materialize, they are likely to be fringe benefits.

The labyrinthine nature of China's financial system - and the state's role within it - means there are usually numerous ways of raising capital before allowing foreign PE players to secure equity stakes in struggling ventures or enforce non-performing loans on defunct ones. Identifying the good stuff will require scouring far-flung geographies or sifting through overlooked portfolios of assets.

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• Topics
• Financials
• Greater China
• China
• Financial Services