When One Credit Door Closes, Another Opens

As the Chinese government has tightened its lending policies, property developers and other enterprises have turned to private and informal lenders.by Eve CaryIn September 2011, the president of Zhejiang Center Group Co. Ltd., the largest eyeglasses maker in China based in Wenzhou, Zhejiang, made news when he fled to the United States because he was unable to pay his company’s high-interest loans. That fall, more than 100 business managers in the city, facing similar repayment and credit crunch issues, disappeared, committed suicide, or declared bankruptcy. A number of entrepreneurs in Henan and Jiangsu provinces followed suit.

These incidents occurred during a period of deep liquidity issues for businesses, particularly real estate developers, sparked by central government policies aiming to avoid a property bubble through tightened monetary policy and limited bank lending. From 2007 to 2010, home prices rose by 50 percent. There are an estimated 10 to 65 million vacant housing units as a result of speculation. Additionally, a report issued by the Agricultural Bank of China in December 2011 stated that home prices in first-tier cities would need to drop by 10 to 25 percent and home prices in second-tier cities would need to decrease by 5 to 15 percent to reach a sustainable level. In response to these high housing prices, the central government tightened bank lending from the summer of 2011 to the summer of 2012.

The central government has also encouraged banks to slow lending to real estate projects. According to the People’s Bank of China (PBOC), the increase in cumulative loans related to housing projects totaled ¥1.3 trillion ($198 billion) in 2011, down 38 percent from 2010, and new loans to the property sector comprised 17.5 percent of total loans in 2011, down from 27 percent in 2010.

Local governments also became less reliable sources of financing during this period. In 2008, for example, local governments were flush with cash disbursed from the central government in a massive stimulus package. Now, local governments are facing significant pressure from the central government to enforce property development-related restrictions.

DOORS OPEN FOR DEVELOPERS

While the government has implemented these tightening measures, a number of avenues of credit (both official and unofficial) have opened or expanded for developers.

Private lending emerged as a significant player as early as 2008, including direct lending between individuals and companies, private equity funds, and underground banks, according to a PBOC report. Bank lending, according to a Citic Securities note, accounted for only 13 percent of small enterprise funding needs in 2008 (the most recent data available). Thirty-six percent of all lending came from informal lenders that year.

Shadow banking, or underground banking, is an informal, private lending practice. Though often used by private citizens who do not qualify for loans, shadow banking is also utilized by developers in some cases. It is difficult to know the size of the industry. Estimates range from ¥2 trillion ($314 billion), according to the State Information Center, to ¥17.7 trillion ($2.8 trillion), according to China UnionPay. Underground banks often charge sky-high interest rates for loans: an estimated 14 to 70 percent.

Trust companies also play a role in shadow banking by purchasing loans from banks, taking the loans off the bank’s balance sheet, and selling these loans to companies and individuals. In the first three quarters of 2011, trust companies distributed ¥322 billion ($51 billion) to property developers. Trust companies pose a number of risks to investors, including an inability to withdraw invested funds at times.

Private equity funds have also emerged as a crucial source of funding. Real estate investment funds are attractive to wealthy Chinese who would like to remain involved in the property market but face central government regulations, such as restrictions on the purchase of second and third homes. Property developers are attracted to the idea because it allows them to keep assets and take charge of their own finances. In Shenzhen, Guangdong, there are 2,200 real estate funds, and in Tianjin there are more than 1,000. Developers such as China Overseas Land and Investment Ltd., Gemdale Corp., and Shanghai Forte Land Co., Ltd. have set up their own funds, while others, such as China Vanke Co., Ltd., have set up joint funds with their competitors. In 2011, 29 property funds raised a total of $4.1 billion, an increase from the previous year’s $2.9 billion raised by 28 funds, according to consultancy Zero2IPO. Analysts expect that more than $6 billion will be raised in 2012, and they expect that number to grow by a rate of 40 to 50 percent in the next few years.

Property developers are also looking overseas for funding. Chinese developer Sino-Ocean Land Holdings, Ltd. collaborated with New York-based Kohlberg Kravis Roberts and Co. to raise a $200 million fund to invest in residential projects in China. In addition, China Overseas Land and Investment Ltd. set up a $500 million property development fund with ICBC International Holdings Ltd. and APG, a Dutch pension manager.

In early 2012, a number of major cities, including Shanghai and Beijing, started pilot Qualified Foreign Limited Partner (QFLP) programs, which allow foreign fund general partners to buy renminbi (RMB) and invest in an RMB fund (in an amount not to exceed 5 percent of the total capital of the RMB fund). This may allow the RMB fund to be more of a domestic partnership as opposed to a “foreign-invested partnership” that has a number of restrictions.

There has been a recent effort by private entrepreneurs to develop “home-grown” equity firms in China. As a result, investment by foreign funds dropped 45 percent last year, partly due to less stringent regulations for Chinese firms. Foreign investors face roadblocks by local authorities, who are not constrained by any nation-wide rules governing the private-equity industry, as well as currency conversion requirements. Joint investments with domestic funds have thus become popular. According to the Asian Venture Capital Journal, joint investments totaled $13 billion in 2011, compared with $5.1 billion in 2010.

CENTRAL GOVERNMENT RESPONSE

Recently, the central government has introduced targeted policies aimed at loosening some aspects of mainly government lending in response to the economic slowdown of the past few months.

In response to the Wenzhou credit crisis, Chinese Premier Wen Jiabao announced at a State Council executive meeting in March 2012 the creation of a new “pilot zone” or “special financial zone” in Wenzhou. Private informal lenders will be allowed to officially operate loan companies that focus on lending to small- and medium- sized enterprises (SMEs), though this project has not gained much traction so far. Wenzhou citizens will be allowed to invest up to $3 million overseas (in non-bank entities), and small firms are now allowed to issue bonds.

Among other policy measures this year, the PBOC in February cut banks’ reserve requirement ratios, freeing up an estimated ¥400 billion ($63 billion) in funds. In March 2012, the four largest state-run banks stated that they would provide more loans to “qualified” housing developers to construct “ordinary commercial housing.” A number of banks have also increased lending to SMEs. These moves indicate that the central government is aware of the potential for, and consequences of, a real estate slowdown.

Recently, banks have been increasing lending to local governments. Bank loans to the real estate industry totaled ¥11.3 trillion ($1.8 trillion) in the first half of 2012, up 10.3 percent year on year. Wen has shifted his rhetoric to note that the government wants to promote investment, though Lian Ping, the chief economist for the Bank of Communications, notes that there is a still “a controlled pace of lending.”

THE CREDIT CRUNCH AND DEVELOPERS

During the height of the credit crunch, many small firms had to rely on increasingly unsavory lenders to service existing loans, particularly in Wenzhou. These lenders charged such high fees that borrowers were caught in a cycle of increasingly high debts. Smaller firms often have to pay higher overall interest rates, and may not be able to survive the competition. Additionally, falling home prices and demand have reduced cash flows and made it difficult for developers to service existing loans, particularly since land is often used as collateral. Noah Wealth Management, a Chinese financial services company, estimates that ¥117.3 billion ($18.4 billion) of property trust products will be due in 2012, greatly exceeding last year’s total of just over ¥47 billion ($7.4 billion).

Anton Eilers, executive director of Greater China at CBRE Residential, anticipates a round of mergers and acquisitions due to failures to meet loan payments. When larger companies take responsibility for the debts of smaller developers, debt defaults can be avoided, and smaller, weaker companies will be weeded out in favor of larger, more robust property developers.

Some developers look like they will come out of the crunch stronger than ever, including China Vanke. The company focuses on properties that have flown under Beijing’s radar: smaller, first homes. Developers connected closely with local officials or with state-owned enterprise investors may also have an easier time, as they will be able to leverage their guanxi—or “relationships”—to ensure continuing loans from the state banks.

RAMIFICATIONS FOR CHINA’S FINANCIAL SYSTEM

The windows that have opened as a result of the credit crunch, and the windows of opportunity that the state is opening itself are extremely significant to China’s financial system. These new policies and programs, including the rise of private equity, the Wenzhou experiment, and the loosening of capital controls, could lead to an overall evolution of the Chinese financial system.

At the National People’s Congress in March, Wen called for increased access to funds, noting that “banks have yet to be able to meet those companies’ needs, and there is a massive amount of idle private capital. We need to bring private finance out into the open.”

Though there has been a loosening of bank lending, China is still stuck in a cycle of over-investment. In the future, there will surely be another round of tightening, leading developers to once again look to alternative funding sources.

However, there are still high legal hurdles, including inadequate legal protections for investors using these fledgling products. There are no specific regulations or laws for non-deposit lending institutions, just “guiding opinions” from the China Banking Regulatory Commission and the PBOC, and local government oversight bodies that provide general regulations and recommendations for the industry. As these new aspects of the financial system move forward, China will need to develop a regulatory infrastructure and educate investors to mitigate financial risks. Companies need a wide range of credit options to allow for longer-term investment and stable growth. Developing home-grown companies can provide a foundation for China’s future economic growth.

[author] Eve Cary ([email protected]) is a research assistant at the John L. Thornton China Center at the Brookings Institution. [/author]