'Shadow' bankers show sector's flaws

Financial repression has contributed to the system, writes Joe Zhang.

In the autumn of 2010, as deputy head of China investment banking at UBS, I spoke to a group of wealthy investors in Beijing about the outlook for Chinese stocks.

A rumpled, 50-something man from Hangzhou named Wang Zhigang pulled me aside afterward and asked for my advice about investing. Until then, he had made his money through kerbside lending, not stocks. But, he lamented, his returns had dropped from more than 30 per cent a year to a mere 23 per cent. He worried about his personal fortune, which he had built up from nothing to almost 3 billion yuan (about $US490 million then).

He hardly needed my advice, I told him. "With your performance, even Ba-Fei-Te should farm out some money for you to manage!" I said, referring to Warren Buffett's name in Chinese.

Intrigued, I flew to Hangzhou a few days later to find out how Wang had done so well. He drove me to the Haining Leather Market to meet some of his customers. They were merchants of leather shoes, handbags and accessories. Their network was wide and close-knit, and they sold products globally through traditional channels, as well as online.

Twenty years ago, these guys would have looked like small fish to a traditional bank. Even after their businesses had grown exponentially, they couldn't supply the kind of collateral banks demanded. Yet these merchants needed money and fast. So they turned for help to "shadow" bankers such as Wang.

There has been a lot of talk lately about shadow banking in China. Between kerbside lenders, microcredit institutions, pawnshops, trust loans, "wealth management products" from banks and other components, this murky and unregulated financial universe is now worth an estimated $US5 trillion ($5.5 trillion), challenging the dominance of the traditional banking sector. Such unrestrained growth naturally worries China's central bank, which fears a flood of bad shadow loans could prompt a financial meltdown similar to the US subprime crisis in 2008.

A liquidity squeeze in June, when the central bank allowed interbank lending rates to rise as high as 20 per cent before intervening, was widely interpreted as a warning to banks to clean up shadow portfolios.

China's shadow bankers are easy to demonise. Like Wang, many are seemingly unsophisticated. Their methods are unorthodox, possibly even unsavoury. Their loans don't show up on balance sheets. They look like a disaster waiting to happen. I believe these fears are misplaced, and I should know: Eight months after my visit to Hangzhou, I became a shadow banker.

Since 2011, I have run a microcredit firm in Guangzhou, which provides loans to thousands of small-scale entrepreneurs: florists, restaurateurs, fish farmers, vegetable growers, hawkers.

Although we charge about 24 per cent annually for our money, demand remains virtually unlimited. Our customers are too small and unstable to get traditional bank loans. At the same time, because we keep our loan amounts small - $US20,000 apiece on average - and because we have close contact with our clients, the business has proved reasonably secure. Our bad debts have not strayed above 5 per cent since the firm was founded five years ago.

This month, I visited Wang again. A few borrowers had defaulted in recent months, he told me, but unlike some competitors, he had been "extremely lucky". He was scrupulous about lending only to clients and businesses he knew well, and experience had given him a good eye. "This is my hard-earned money; I have to be careful," he said. "My family was dirt-poor when I was a child. I am just so afraid of becoming poor again." Wang's fortune had almost doubled since I last saw him.

One cannot defend a $US5 trillion industry with a couple of examples. Two of Wang's colleagues had been wiped out in the past year after large borrowers defaulted. Several other informal lenders in Hangzhou had ended up behind bars after disgruntled investors accused them of fraud. In recent weeks, news reports have described mass bankruptcies among small businesses that had borrowed heavily from shadow banks at exorbitant rates.

But neither should one condemn all of shadow banking because of stories like these. Shadow banking is well diversified and serves a legitimate customer base. By and large, it has much lower leverage than banks or corporate China. Losses at shadow banks are often absorbed by entrepreneurs themselves, without affecting the taxpayer.

Even the "wealth management products" offered by regular banks are not to be feared, because they are just deposits, pure and simple, whatever the theoretical distinctions. I buy them myself.

Certainly, the sector could stand greater supervision. But many of the regulations in place are vague and unreasonable. Authorities have never clearly defined something as fundamental as what constitutes "illegal fund-raising".

Microcredit operations, such as ours, are allowed to borrow from no more than two banks for any more than 50 per cent of their equity capital. Why only two banks? Why only 50 per cent? These restrictions are arbitrary and limit our ability to lend to underprivileged customers.

The government and the media are making a scapegoat of the wrong culprit. Shadow banking has flourished in China for one reason: financial repression. By keeping interest rates artificially low, authorities have forced savers to search for more lucrative financial products. By favouring banks - which, in turn, favour state-owned or well-connected private-sector companies with loans - they have forced small enterprises to seek out people like me and Wang.

Meanwhile, projects that might look sketchy at 9 per cent interest rates suddenly look feasible at 6 per cent. Under such conditions, traditional banks have steadily lowered their lending standards - from prime loans to subprime and then to simply silly loans.

Sound familiar? That's how the 2008 financial crisis began, too. Leaders are right to worry about the possibility of a banking crisis in China. But instead of focusing their ire on shadow bankers, they should raise benchmark interest rates in order to reduce the amount of credit flowing to dodgy loans through the formal banking sector. The threat to China's financial system is right there - out in the open - not lurking in the shadows.