*[This article was originally published by Knowledge@Wharton on November 9, 2011]

Analysis on the credit crunch being faced by small and midsized enterprises in China.

Despite the country's economic boom, China's small and midsized enterprises (SMEs) haven't had an easy ride. Their fixed costs are rising and orders from overseas customers are shriveling as the global economic climate darkens and China's currency strengthens. And as if that weren't enough, it's getting harder — and more expensive — to tap the funding needed to run the businesses.

Under orders from Beijing, banks have been putting the squeeze on lending generally. According to a research note published on October 24 by London-based Capital Economics, net new bank lending in the third quarter was up only slightly from a year ago — to RMB 1.65 trillion from RMB 1.73 trillion (US$260 billion from US$272 billion). But the total amount of financing extended under the broader definition used by China's central bank fell by nearly one-third, to just under RMB 2.5 trillion.

The worrying upshot? As Mark Williams, Capital Economics chief China economist, said in the research note: "Officials have reasserted control over total credit growth, at least for a while, but at the cost of pushing more borrowers into the arms of unregulated underground lenders."

Indeed, the government's reining in of bank lending, which hit record levels recently, is designed to avoid a financial sector crash. But the practice also has compounded the difficulties facing smaller Chinese firms. For all intents and purposes, they have been squeezed out of the formal credit channels, which is fueling the rise of loan sharks and other black market lending — from pawnshops, trusts or even wealthy individuals. "The number of private banks has exploded over last few years," notes Ben Simpfendorfer, managing director of Silk Road Associates, an economic and political consultancyin Hong Kong. "The tighter you squeeze in the formal market, the more you squeeze into the black market and you end up with a two-tier, or parallel, banking structure."

Going Under

Informal banking is also not unique to China. "Throughout history, they've been used all over the world," says Sara Hsu, a professor of economics at the State University of New York (SUNY) in New Paltz. Before the banking system was formalized in the U.S., for example, companies and individuals took out loans and credit lines from general stores.

And China's informal banking system is not new; it's been an important source of financial support for SMEs for a number of years. But black market banking, of course, has risks. At a surprisingly fast clip, there have been a number of high-profile defaults and company closures this year amid concerns that informal lenders are encouraging speculation rather than supporting the country's SMEs.

Part of the problem is that China's banks — several of which are now among the world's largest — prefer to focus on serving big, state-owned enterprise (SOEs), rather than SMEs. According to Gary Liu, deputy director of the financial research center at the China Europe International Business School (CEIBS) in Shanghai, one of the big challenges facing the banks is that they are barred from setting interest rates on their savings and lending products, and must instead keep within 1% of the benchmark rate set by the central bankers at the Peoples' Bank of China (PBoC). Currently, the rate is 3.5% for one-year savings products and 6.56% for one-year loans. Since banks are unable to adjust rates on their loans to reflect the risks of lending to different customers, they are unwilling to lend to SMEs, Liu noted in a recent article published in Global Times newspaper.

As the number of underground banks increases, and as interest rates from such lenders climb, China's regulators are getting nervous. Premier Wen Jiabao has been issuing public warnings of the dangers of underground borrowing, in which interest rates can run more than 100%. During a visit to the city of Wenzhou in early October, local press quoted Wen as stating, "Effective measures should be taken to contain the trend of usury, crack down on illegal fundraising and properly handle the problems of collateral and capital shortage in order to prevent risks from spreading and evolving on a regional scale."

The exact size of the informal banking sector is impossible to determine. The government estimates that it is around US$400 billion. Others say it's much greater. Even China's state-run banks offer their own alternative source of credit. "Entrusted" loans, for example, allow banks to serve as middlemen by identifying high-net-worth individuals who can provide corporate loans. According to Bloomberg, entrusted loans last year accounted for nearly 8% of the RMB 14.27 trillion raised in social financing — a term referring to loans and other funding sources, such as returns on stocks and bonds — compared with 0.9% in 2002.

But other sources of credit abound. A report by Standard Chartered Bank noted that pawn shops and loan guarantors — both of which fall outside PBoC regulations — also compete with small-loan companies, which have taken to lending beyond their original, regulated parameters. Adding to the complexity, SOEs also want a piece of the lending action. All told, "the wealthy are looking to increase their returns," says Simfendorfer.

The Wenzhou Model

It was in Wenzhou — a city famed for its entrepreneurial spirit — where China's underground banks got their start in the 1990s. Liu of CEIBS points to PBoC stats suggesting that around 89% of individuals in Wenzhou are involved in private lending.

As the country's economic reforms began in the late 1970s, "Wenzhou didn't receive a lot of [state] funds," says SUNY's Hsu. Local pawnshops and loan guarantors set up alternative businesses as banks, filling a gaping gap for many of the city's non-state companies since the firms "were an unknown entity to the banking sector," Hsu notes. That wariness continues today, in contrast to many underground lenders, which "know the borrower most of the time, or they know the person guaranteeing the borrower."

According to Simpfendorfer, however, underground banks have strayed from their role of supporting China's private SMEs. With increasing fixed-asset prices, particularly in China's property market, borrowers have been able to get faster returns through speculation than from, say, investing in the growth of their own companies.

Then there's the credit squeeze. After a year of wild lending, China started increasing banks' reserve requirements in 2010. Inflation was becoming a problem and concerns about bad loans and local government debt led to a gradual draw down of the country's lending policies. This year, the reserve ratio reached an all-time high, and the country's banks are now required to keep 21% of their deposits in reserve. The tightening, however, started at a time when many SMEs were committed to investments for which they would need to take out loans to complete. Many found themselves with no choice but to turn to underground banks and borrowing at increasingly high interest rates.

Vincent Chan, head of China research at Credit Suisse, says the situation has been exacerbated by how the PBoC has gone about tightening credit. "The biggest mistake they've made is to not increase the interest rate. The government is using old methods to deal with new problems."

China's central bank can increase reserve ratios on its own, but interest rate increases require the assent of China's State Council. So while reserve ratios are at record highs, interest rates have increased cautiously. With liquidity tight but demand for capital rising, interest rates started rising much faster at informal lending institutions. "When you don't raise the interest rate [in the formal sector], you're giving a subsidy to the enterprises that are receiving the loan," Hsu notes. "They're essentially getting something that in reality costs more."

Imbalancing Act

As the imbalances grow, Chan says, the risk of defaults increases. "In 2009 and 2010, people had high expectations, so they borrowed," he notes. "They are in the position of having to borrow at higher and higher interest rates — and it is [now] not a question of whether you can make money, but whether you can just get away safely. This is where the credit chain starts to break."

There have already been a number of high-profile defaults, including in Wenzhou. While bankruptcies during a credit crunch aren't a surprise, the underground sector has little recourse when it comes to defaults. "If companies default on underground banks, these banks might start to default on their borrowers, as they usually source money at around a 15% annual interest rate and re-lend at 30% to 40%," says Chan.

In September, China's state media reported that more than 200 businessmen in Zhejiang province, where Wenzhou is located, went missing when they couldn't pay their debts. In addition to those who have gone into hiding, a handful of businessmen have turned to suicide. One prominent eyeglass manufacturer in Wenzhou left his company mired in more than RMB 2 billion of debt, sourced from both official and underground banks.

In addition to default problems, however, an unregulated banking sector makes it more difficult for China's regulators to control the flow of credit or tighten the money supply. And changes in the formal sector can have unintended consequences in the informal sector. "In a certain way, it undermines government control," Chan states.

Both Chan and Simpfendorfer say China could have avoided the problems it is facing in the informal sector with faster banking reforms. "If, over the last 10 years, they had developed a private banking sector, they would have had a better handle on what was going on now," says Simpfendorfer. Hsu, however, notes that the informal sector did its job so well that China's regulators haven't had time to build a loan network for smaller companies. "The solution would be to have smaller institutions at the local level that are approved by the government and [are able to] get to know the smaller companies," she notes.

Despite their size, these companies are important. SMEs employ 80% of China's urban labor force, according to China's Ministry of Industry and Information Technology. Without informal banks helping SMEs, SUNY's Hsu says China would probably not have experienced the same level of growth that is has over the past 20 years. "The informal system has been necessary," she adds. "The government has given its tacit approval by not preventing its development."

Of late, SME closures and defaults have attracted enough media attention to draw a response from officials. Some local governments have announced plans recently to create official sources of credit for small enterprises. Shanghai, for example, has just set up a RMB 3 billion fund to support SMEs. In September, China's Ministry of Industry and Information Technology announced its first "growth plan" targeting SMEs. While the plan's goals include improving the business structure of SMEs, it's unclear what policies will come out of it.

In addition to supporting SMEs, Wenzhou officials have tried to rein in such lending by setting a ceiling for interest rates. According to a notice posted on the city government website, the interest rate on informal loans should not exceed the official interest rate of 6.56% for a one-year loan by more than 130%. A rule like this, however, will be hard to enforce. While some of the smaller lending programs have been successful, Hsu notes, it will take a much bigger effort to curb the informal banking sector's influence on the flow of China's credit. "It's really a whole new project the government would have to fund and promote," she says.

*[This article was originally published by Knowledge@Wharton on November 9, 2011]

The views expressed in this article are the author's own and do not necessarily reflect Fair Observer’s editorial policy.