Cracks appear as credit crisis bites
As the Chinese economy boomed, few cities soared faster or higher than Shenmu, a community of nearly 500,000 in the northwest.
Top luxury clothing stores in this city's downtown were recording as much as $US500,000 ($545,130) a day in sales. Tables at the best restaurants had to be reserved weeks in advance. The new Fortune Garden Club for the business elite made headlines by paying $US1 million for a king-size mahogany bed, to be used by members and their companions.
But a painful credit crisis is now spreading across Shenmu and cities nearby, as thousands of businesses have closed, fleets of BMWs and Audis have been repossessed and street protests have erupted.
Now the leading purveyors of Western fashions are deserted, monthly sales at restaurants are down as much as 97 per cent and the marble entrance to the Fortune Garden Club is shuttered. All but one of the city's car dealerships have failed. The owner of the city's largest jewellery store was detained by the authorities a week ago after creditors found him secretly packing millions of dollars' worth of gold and jewels into cases and accused him of preparing to flee the city without settling his debts. A top restaurant closed a day earlier, and its owner left town, as have the founder of the Fortune Garden and many other executives.
"It's an economic crisis just like the US has had; just like it," said Wang Ting, an operator of an illegal casino in Fugu, near Shenmu. "There's no cash, everyone stays home without a job, there's no way the economy can recover."
Shenmu, and nearby cities like Ordos and Fugu, are at the leading edge of broader troubles that are beginning to afflict the entire Chinese economy.
Across China, growth has slowed. With the slowdown have come rising defaults on loans made outside the conventional banking system, chronic overcapacity in industries like coal mining and steel production and, in particularly troubled cities like Shenmu, a sharp decline in previously debt-fuelled prices for real estate and other assets.
The cracks are showing in many sizeable cities like coastal Wenzhou, where informal lending, a big part of so-called shadow banking, has dominated for 25 years. Cities with economies linked to commodities with falling prices have also been affected, as more people defaulted on loans. The biggest, most economically diverse metropolitan areas like Beijing and Shanghai seem less affected, but also have many small and medium-sized businesses that depend on informal lending.
Lending has collapsed in northern Shaanxi province, where it had been particularly speculative and frenzied, and where the coal industry has also been crippled by steeply falling prices.
As some borrowers began defaulting early this year, worried lenders in the informal sector raised interest rates for small and medium-size businesses, previously 25 to 40 per cent a year, to as much as 125 per cent a year. The increase set off a much broader wave of defaults in recent weeks, as owners found themselves unable to repay billions of dollars in bad debts, many of them handwritten and hard to enforce in court.
"Almost no one will give you a loan," said a construction executive who gave only his surname, Xie, as he stood outside a project that had been halted.
Although changes are being slowly introduced, state-owned banks have long been allowed to lend only at low, regulated rates barely above the inflation rate, with the total value of loans controlled by quarterly quotas. All over China, these loans go overwhelmingly to large state-owned businesses, government officials and politically connected individuals, who then re-lend the money at much higher interest rates to small and medium-size businesses in the private sector.
The Chinese are finding it harder to repay loans because the economy is slowing. Most analyses of China's economy look only at the real growth rate, about 7.5 per cent this year. But for companies' sales and profits, which determine their ability to repay debts, what really matters is the nominal growth rate, which is real economic growth plus inflation.
Private sector businesses could afford to borrow at double-digit interest rates because nominal growth at 16 to 23 per cent a year from 2004 through 2011 exceeded the rates. But nominal growth slowed last year to 9.8 per cent and then fell again in the first half of this year, to 8.8 per cent.
The popping of the real estate bubble has been the most serious blow to the economy. Real estate prices had soared in cities across China. In Shenmu, 100 square metre apartments that sold for less than $US20,000 a decade ago reached $US330,000 by last northern hemisphere winter. Real estate brokers say they are advising sellers to avoid price cuts of more than 10 per cent. But business owners who buy and sell apartments say deals are now being done for as little as $US115,000, a decline of 65 per cent.
Public discontent is fuelling street protests. Several thousand residents turned out last month for a demonstration, demanding that municipal officials revive the stalled economy.
Recently, a smaller group of migrant workers protested, demanding the local government pay their back wages after construction was halted on a row of apartment buildings. Yet a Shenmu merchant said he had sympathy for officials, who even put up banners last year warning residents of the dangers of participating in informal lending schemes.
Frequently Asked Questions about this Article…
Shenmu — once a boomtown where luxury stores could record up to US$500,000 in daily sales — is now facing a painful credit crisis: thousands of businesses have closed, cars like BMWs and Audis have been repossessed, and protests have broken out. For investors, Shenmu is a clear example of how rapid, debt-fuelled growth can reverse sharply and create ripple effects across local economies and asset prices, which matters if you have exposure to Chinese property, commodities or companies tied to these regions.
The article describes widespread informal lending — often called shadow banking — where loans outside conventional banks have dominated in places such as Wenzhou and northern Shaanxi. As borrowers defaulted, informal lenders pushed rates from typical 25–40% up to as high as 125% a year, triggering a broader wave of defaults because many of these loans were handwritten and hard to enforce.
Defaults rose as some borrowers began missing payments and worried informal lenders raised interest rates dramatically (from about 25–40% to as much as 125% per year). The sharp rate hikes made it impossible for many small and medium businesses to service debts, leading to billions of dollars in bad loans and a cascade of repossessions, business closures and bankruptcies.
Real growth measures inflation-adjusted output (about 7.5% this year in the article), while nominal growth adds inflation back in — the figure that determines companies’ sales and profits. Nominal growth was 16–23% from 2004–2011 but slowed to 9.8% last year and 8.8% in the first half of this year; when nominal growth falls below borrowing costs, businesses struggle to repay high-interest loans.
The correction is dramatic in some boom towns: in Shenmu a 100-square-metre apartment rose from under US$20,000 a decade ago to about US$330,000 at the peak, but recent deals have been done for roughly US$115,000 — a decline of about 65%. Brokers are advising sellers to avoid cuts larger than 10%, but market transactions show much steeper falls in actual prices.
Cities tied to commodity industries (like coal and steel) and those that relied heavily on speculative or informal lending — such as Shenmu, Ordos, Fugu and Wenzhou — are most exposed. Larger, diversified metros like Beijing and Shanghai appear less affected overall but still have many small and medium businesses that depend on informal credit and can therefore be vulnerable.
Visible warning signs include mass business closures, fleets of repossessed cars, shuttered luxury clubs and restaurants (monthly restaurant sales down as much as 97% in some places), detained business owners accused of hiding assets, halted construction projects and public protests demanding pay or government action. These indicators suggest severe local liquidity and confidence problems.
State-owned banks lend at low, regulated rates barely above inflation and operate under quarterly lending quotas, so most of that credit goes to large state firms, officials and politically connected borrowers. Those recipients often re-lend to private small and medium businesses at much higher rates, which fuels informal lending, elevates default risk and amplifies the crisis when economic growth slows.
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