No Guarantee

In my debate with Andrew Batson in The Guardian in March, I noted that:

There really are two related but distinct things people have in mind when they talk about a “hard landing” for China. The first is a rapid deceleration of GDP growth – below, say, 7%. The second is some kind of financial crisis. I think we’re already seeing some signs of the first, and the second is a bigger risk than most people appreciate.

In my last several posts, I’ve focused on the former — the slowdown in China’s GDP growth. I want to switch gears here for a moment and call attention to a rather alarming story involving the latter — the risk of financial instability — which somehow slipped under most people’s radar screens.

In early April, Caixin magazine ran an article titled “Fool’s Gold Behind Beijing Loan Guarantees”, which documented the silent implosion of Zhongdan Investment Credit Guarantee Co. Ltd., based in China’s capital. “What’s a credit guarantee company?” you might ask — and ask you should, because these companies and the risks they potentially pose are one of the least understood aspects of China’s “shadow banking” system. If the risky trust products and wealth funds that Caixin documented last July are China’s equivalent to CDOs, then credit guarantee companies are China’s version of AIG.

As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises (SMEs) get access to bank loans. State-run banks are often reluctant to lend to private companies that do not have the hard assets (such as land) or implicit government backing that State-Owned Enterprises (SOEs) enjoy. Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default. Having transferred the risk onto someone else’s shoulders, the bank could rest easy and issue the loan (which it otherwise would have been reluctant to make). In effect, the “credit guarantee” company had sold insurance — otherwise known as a credit default swap (CDS) — to the bank for a risky loan, with the borrower forking over the premium.

Now putting aside what happened at Zhongdan for a moment, let’s just consider what this means. Like any insurance scheme, this arrangement only “works” if the risks are not correlated. If you insure 100 people in 100 different towns against a tornado striking, you collect premiums and then, when a tornado strikes one of those towns, you make the payout to one claimant and the premiums from the rest cover it. If you insure 100 people in the same town against a tornado, you collect premiums for a while at no cost — it looks like a fantastic business. But if a tornado finally does strike that one town, you have to pay everybody at once and you’re wiped out. That’s exactly what happened to AIG when it sold credit default swaps on mortgage-backed CDOs. As long as the housing market didn’t collapse, all they did was collect premiums. When it did collapse, they went under. Or rather, they had to be bailed out so that all the banks and other customers who had bought insurance from them — who thought they were insured — wouldn’t go bust when AIG couldn’t pay up.

The concern in China is that — like that tornado — a drop in the local property market, or a decline in exports, could hit all borrowers at once, overwhelming the local credit guarantee company and leaving the banks high and dry. The risk is exacerbated by the fact that many credit guarantee companies were capitalized with loans from the same banks whose other loans they are guaranteeing. In effect, banks are insuring themselves, or each other, and would still end up holding the bag on loan losses that are supposedly insured. (It would be interesting to know how such “guaranteed” loans are treated when regulators perform their much-vaunted stress tests on Chinese banks. I suspect these loans are considered loss-proof, because they are “insured.”)

Zhongdan, the company in the Caixin article, took these risks one step further. It persuaded borrowers to take out bank loans based on guarantees from Zhongdan, and then hand some or all of that money back to Zhongdan to invest in Zhongdan’s own “wealth management” products:

Under the arrangement, a participating company would take out a bank loan and give some of the money to Zhongdan for investing in high interest-paying wealth management products for a month or more. The firm then apparently put those funds to work by buying stakes in small companies such as pawnshops and investment consulting firms, according to the sources. Some of the funds went toward a U.S. consultancy that later failed.

Since this use of funds completely violated banking rules, Zhongdan forged documents indicating the money was being borrowed to pay fictitious suppliers:

To nail one loan, [an executive for a building materials manufacturer] said, Zhongdan formed a shell building materials supplier and wrote a fake contract between the supplier and his company. The document was presented to the bank, which approved the loan. Zhongdan later de-registered the phony supplier.

The whole thing started to unravel in January when banks “reacted to rumors of a liquidity crunch” at Zhongdan:

Several banks that cooperated with Zhongdan smelled trouble and started calling loans they had issued to companies backed by the firm … The next domino fell when the creditor companies, seeking to appease the banks, turned to Zhongdan for help repaying the called loans. But Zhongdan executives balked, and the domino effect accelerated as companies teetered under bank pressure and the city’s business community shuddered with credit freeze fears.

At that point, regulators stepped in and told everybody to freeze — and to keep all the assets as “good” on everyone’s balance sheets while they figured out what to do next. Zhongdan had over 300 clients, and guaranteed RMB 3.3 billion (US$ 521 million) in loans from at least 18 banks. The only liquid assets that the guarantee company appears to have available to pay banks is RMB 210 million (US$ 33 million) in margin accounts deposited with the banks themselves. Good luck finding the rest:

“Of first importance is to determine the depth of the hole,” Beijing Finance Bureau Deputy Director Li Zhigang said … “If there are no new investors and no new liquidity replenishments, Zhongdan won’t be able to repay.”

Lest you think Zhongdan was just a colorful outlier, think again:

A branch manager at one bank involved in the Zhongdan case said most bankers are fully aware that most companies provide falsified contracts to qualify for loans. Others said they routinely skip certain procedures designed to catch tricksters. “Banks argue that companies should be held accountable for fraudulent borrowing,” said a company manager who said he obtained several bank loans by working with Zhongdan. “They are determined that they will not admit to knowing these are fake contracts. “I worked with other guarantee companies before,” he said. “I realized that, in fact, a lot of banks know about this.”

Read that last quote again. The implication is that Zhongdan’s modus operandi (forging documents to channel loan proceeds into risky investment schemes) is common practice among China’s credit guarantee companies, and that Chinese banks have been willing co-conspirators. I wish I could tell you the size of the problem, on a systemic level, but that’s part of the problem — it’s too opaque. Nobody I’ve talked to knows.

One of the reasons banks may have been willing to go along with the charade was the need to fulfill their quotas when it came to boosting SME lending. If so, it reinforces what I said years ago, that state-mandated set-asides are not the way to improve entrepreneurs’ access to bank lending, that banks need to revise their whole approach to lending:

China’s goal should not be to throw money at SMEs as though they were just another special interest to be subsidized. It should be to develop a banking system capable of allocating capital to whoever can use it best–including good SMEs.

More importantly, the Zhongdan episode — which I’m amazed hasn’t attracted more attention and concern — illustrates the kind of hidden risks that have developed in China’s financial system, to which bank and regulators have been willing to turn a blind eye in order to meet the insatiable credit demands of investment-led GDP growth.

In a recent report debunking “myths” about China’s economy (which could have been titled “China: Don’t Worry, Be Happy”), CLSA’s Andy Rothman maintains (in Myth #13, p. 46) that there are “no shadow banks” in China. “Anything in the shadows sounds scary,” he says, but never fear because all of China’s financial institutions, banks and non-banks, are under the firm control of the Party. “They are,” he quips, “Party animals.”

Indeed. Zhongdan and other credit guarantee companies certainly seem to have been partying it up. Only now is what they have done beginning to emerge from the shadows. It looks pretty scary to me.