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CGCs: China’s murky credit channels

Ostensibly designed as middlemen to safely channel bank credit to the neglected private sector, credit-guarantee companies have not been content with this fee-earning business.

Wei Ding perches himself on a high stool in the main bar of Beijing’s Kerry Hotel and chews his lip. A leading corporate banker at China Merchants Bank (CMB), one of the country’s best-run lenders, Wei is here to discuss credit-guarantee companies (CGCs), a burgeoning division of the country’s controversial shadow-banking industry.

He’s nervous, and for good reason. China’s CGCs have had an appalling couple of years, lurching from one humiliation to the next. His job puts him in daily contact with dozens of guarantee firms, all beseeching the banker to lend credit to their clients, a cross-section of China’s corporate economy, from small private enterprises to big state-owned enterprises (SOEs). "They ring [me] in the morning. They ring me at lunch. They ring me in the evening. They ring me on the toilet," he sighs wearily.

Mostly, these are the banking version of nuisance calls: guarantee firms ringing up to chance their arms. "They call to tell me that some company wants to borrow Rmb100 million ($16 million). I ask: ‘What is the name of the company?’ They can’t say. ‘How big is it?’ They can’t say. ‘What do they do?’ They can’t say – but they still expect [to get the loan]. They are crazy."

Nor is this far from the norm. CGCs barely existed five years ago. Now they are an integral part of China’s shadow or grey financial sector, an industry that encompasses everything from loan sharks and pawn shops to trust companies and pure underground banks, the latter congregating around the coastal city of Wenzhou. Around half of all new credit injected into the economy is provided by non-banks or through such operations as CGCs, up from 10% a decade ago. In many ways, CGCs are the least understood and the most maligned features of this murky industry. Barely a handful existed before the financial crisis. Precise numbers are hard to come by: the industry is patchily regulated, often supervised at the provincial level. But a reasonable estimate, reached by talking to dozens of people with knowledge of the sector, places the nationwide tally at between 25,000 and 30,000.

Most lack size or scale. A July 2012 report on the shadow-banking industry by Bank of America Merrill Lynch, quoting statistics from China’s Ministry of Industry and Information Technology, reckoned that just 29 CGCs with credit-guarantee licences from the China Banking Regulatory Commission (CBRC) boasted more than Rmb1 billion in registered capital as of end-2010. More than 70% of the 6,030 CGCs registered then were too small to guarantee loans valued at more than Rmb10 million.

What is so surprising is how little is known about a motley collection of companies reckoned to control assets worth between Rmb1 trillion and Rmb2 trillion.

Only rarely, do these monsters surface, offering glimpses of their misshapen hides. The last appearance involved the collapse of Zhongdan Investment Credit Guarantee, one of Beijing’s most prominent CGCs, which imploded in April 2012 with debts of around Rmb3.3 billion. Zhongdan’s silent failure – its bankruptcy is widely known in banking circles, but has never been admitted publicly – exposed 20 banks to substantial losses, say individuals involved with the issue.

The biggest loser was Bank of Beijing (BoB), the largest city commercial lender in the Chinese capital, whose leading shareholders include the Dutch financial services company ING Group, which was exposed to losses amounting to Rmb550 million.

BoB was particularly endangered: not only was it the bank most heavily exposed to financial losses following Zhongdan’s collapse, it was also by far the smallest. The second and third most heavily exposed lenders, Agricultural Bank of China and China Minsheng Bank (CMBC – one of only two privately run Chinese lenders), were far more easily able to absorb substantial losses. "This raises a further issue," notes a Beijing-based shadow-banking expert. "When a credit-guarantee firm collapses, or there is a failure in the shadow-banking industry in general, it tends to be the smaller banks that struggle to meet their liabilities. So you find that the institutions least capable of taking big balance-sheet hits are also those most likely to be exposed to CGCs in general."

Zhongdan’s collapse was unusual for two reasons: first, its sheer scale; second, that its failure was made public at all, thanks largely to the trailblazing efforts of Chinese media outlet Caixin. Moreover, the Zhongdan case shone a light on an industry hitherto almost wholly invisible to outsiders, yet which has, in a few short years, become an indispensable lubricant to China’s financial economy.

CGCs are both very simple and incredibly complex. In their basic form, and certainly in the early days of the credit-guarantee industry (roughly late 2008 to early 2011), their job was to help small and medium-sized enterprises access credit. SMEs struggled during this period, as China’s state banks, swollen by a glut of stimulus cash, channelled loans to favoured SOEs.

In an economy already profoundly skewed toward public-sector lending – at end-2012, fully 80% of all bank loans were directed toward SOEs, according to data from the CBRC – this seemed an eminently pragmatic way to keep the private sector functioning fluidly.

Yet in China’s distorted, malformed financial sector, sensible solutions rarely last long. The credit-guarantee industry meant well at the beginning. If, say, a fast-growing, privately owned maker of industrial tubing wanted to borrow Rmb10 million to finance new expansion, or conduct in-house research, it made little sense to approach a bank. China’s state lenders, seeing the firm for what it was – a corporation lacking scale, state support and hard assets such as land – would likely dismiss the prospective customer out of hand.

CGCs offered a back-up plan. Acting as a mixture of proto-bank, financial conduit and de-facto ratings agency, their job was to sit in the middle of the lending process, guaranteeing the credit quality of our tubing company, while pledging to pay for any losses in the event of a corporate default.

The bank, assured that its loan was backstopped, could relax and issue the loan through the CGC, effectively creating a credit default swap. Borrowers would (happily) pay a mildly higher rate of interest on the loan than normal, typically no less than 2% and no more than 3.5%, which would wind up in the pockets of the middleman.

Many CGCs soon realized that the deck was stacked against them, assuming they meekly complied with the rules. Merely guaranteeing credit for China’s army of needy private firms meant that CGCs, notes a shadow-banking expert in Hong Kong, "were taking 100% of the credit risk in return for the profits on a 2% loan."

This is where the shadows start entering the system. Recognizing the relative inequity of the system, guarantee firms became bold, even reckless. In many cases, CGCs would advise clients to borrow more than they needed. Thus, a guarantee firm would tell our tubing maker to borrow not Rmb10 million, but five times that amount. The collateral would then be channelled by CGCs into their ‘investment divisions’, which would then siphon that money into riskier investments: for example, property deals or straight stock market speculation.

In some cases, borrowers would be persuaded to take out higher loans with the promise of soaring returns on the principal. In others, borrowers would seek a loan, only finding out later, when the principal was called in, that their supposed partner had applied for credit worth several times the agreed amount. That, notes a Beijing-based shadow-banking expert, "happens all the time and every day. Zhongdan is the most prominent and public example, but it’s just the tip of the iceberg."

The Zhongdan case is particularly instructive. Before collapsing, the Beijing firm used client capital – properly and improperly sourced – to invest in a dizzying array of diverse assets, from pawn shops to a now defunct US-based consultancy. When banks got edgy about several loans, they called in every loan, effectively creating a run on the CGC and its clients.

When borrowers baulked at making early repayments, they called on their credit-guarantee partner to help out. But Zhongdan, having committed much of its capital to outside investments, offered just Rmb210 million to antsy lenders. Eventually, and at the urging of Beijing’s Municipal Finance Bureau and Banking Regulatory Bureau, the 20 banks involved quietly took the hit on their balance sheets, say sources close to several of the financial institutions involved.

Sometimes, the credit-guarantee industries of entire cities are wiped out in a few weeks. When Wenzhou’s private lending networks collapsed last year, hit by mass credit shortages and rolling bankruptcies, it stripped out virtually every local CGC. Just a tiny handful remain today, compared with around 800 at the start of 2012. Borrowers and banks were caught up in the fallout. Total non-performing loans at Wenzhou-based lenders rose nearly three-fold, to Rmb23.9 billion at end-2012, from just Rmb8.6 billion 12 months earlier. A mass credit-guarantee failure was also recorded last year in Zhengzhou, capital of central Henan province.

Then there is the granddaddy of all CGC failures, that involved Shenzhen-based Credit Orienwise, which dragged in capital from top-tier investors before going belly-up. Carlyle Group, General Electric and Citigroup Venture Capital International all piled in, investing around $100 million, before wishing they hadn’t. In 2007, Orienwise was the biggest privately run guarantor in China; a year later it was defunct, forcing all investors to accept big markdowns.

Not that such events make CGCs consider their actions. Few are able to survive just by acting as straight middlemen. "What is scary is that I’ve yet to meet a CGC that makes more money from guaranteeing credit than through its internal investment divisions," says a Beijing-based financial expert who has done extensive research on the industry. Many, notes a Hong Kong-based shadow banking expert, also boost profits by padding their charges, levying, ‘advisory fees’ on unsuspecting borrowers, raising interest costs on loans to 15% and beyond.

All this is not to say that CGCs are entirely bad. "On the one hand, credit guarantee firms as a whole endanger the stability of China’s economy as they create so much turbulence helping channel lending to borrowers who will never be able to repay their loans," notes the chairman of a leading Chinese CGC, who preferred to remain anonymous. "On the other hand, if you take [CGCs] away, the private sector is seriously fucked because there is no one left to finance it."

The problems swirling around the industry boil down to issues of trust and competence. The latter is key. Leading lenders such as Industrial and Commercial Bank of China (ICBC) have little use for the services of CGCs: they already have their pick of leading SOEs and big private enterprises.

But as you go down the food chain, from leading second-tier lenders such as the highly respected China Merchants Bank – another lender caught up in the Zhongdan collapse – down through China’s assortment of city commercial banks and rural credit cooperatives, the problems really start. This group employs millions but boasts little management expertise. Denied the pick of central and sometimes even local SOEs, many, seeking new avenues of growth, turn to CGCs, which are only too happy to dish up local private enterprises just bursting with potential.

Except that, all too often, these sure things are anything but. CBRC rules are theoretically stringent here: lenders can channel credit to firms that lack a history of creditworthiness or are not well established only after fully vetting them first. Yet banks often rely on CGCs to vouchsafe the viability and creditworthiness of borrowers. Since CGCs stand to benefit from acting as middlemen on loans, the conflict of interest here is palpable.

All too often, CGCs simply make up paperwork to suit the needs of a particular bank. Li Yongding (not his real name) was sacked by a leading Beijing-based CGC last for doing just that. "We would do whatever we could to get loans approved," he says. "I made up entire companies to get loans approved." Asked if the process of skipping procedures designed to reveal frauds was akin to the broking hothouses of the 2000 movie Boiler Room, he smiles. "I know that film," he says. "It was a bit like that, but much more boring."

Li was sacked in mid-2012, not for breaking the rules, but for channelling credit to a series of borrowers that in turn defaulted on their loans. He now works for a Beijing-based city commercial bank: ironically, his new role involves certifying loans to CGCs.

There is even a double conflict of interest involved here, given that bank loan officers have been known regularly to channel loans to dubious companies for a cut of the deal. Does he do that, in his new position? "No," says Li, with a twinkle in his eye. "I would never do that. It’s against the law."

Banks are finally starting to get wise to the ways of particularly nefarious CGCs. Many are cracking down on corrupt internal loan officers. The humiliating public failure of Zhongdan, and mass CGC failures in Wenzhou and Zhengzhou, have given the industry a bad name: executives increasingly rarely admit to working for CGCs, and most banks have greatly trimmed down their list of approved CGC partners.

The threat to the CGCs’ public image goes deeper. CGCs often act like loan sharks, sending heavies, armed with blunt language and threatening instruments, to recoup capital from vacillating or insolvent borrowers. The process is very old school, and a world away from the whitewashed image that China’s lenders prefer to exude.

"We are a listed bank, so it’s hard for us to deal with [credit-guarantee] firms who use mafia measures to get their money back," says CMB’s Wei. "Typically, [CGCs] send big guys to follow customers around and threaten them. In China, commercial banks’ loan officers are very close to borrowers, so we hear about this sort of thing all the time. One borrower was followed back to his doorstep and threatened in front of his family. This isn’t the sort of image we want to present to the public."

CMB and its peers are reacting positively to this threat: another sign of the increasing, if sometimes lurching, sophistication permeating China’s formal banking system. In Minsheng Bank’s case, the private lender is busily setting up its own targeted funds to lend directly to private enterprises.

This has two direct benefits: it reduces the bank’s direct exposure to the darker recesses of the credit-guarantee industry, while cutting the cost of lending to smaller firms. The first, a Rmb30 million fund, created in mid-2012 by raising money primarily from retail investors, which is then leveraged up by CMB, lends capital to jewellery firms.

Several industry-specific funds, the largest topping out at Rmb500 million, have followed. "In Beijing we have four or five funds set up already, and we are launching hundreds more around the country," says a corporate loan officer at Minsheng Bank. "It’s still an expensive way of lending, but it’s much better for us and for borrowers."

Patrick Ho, head of chief investment office research at UBS Wealth Management in Hong Kong
Patrick Ho, head of chief investment office research at UBS Wealth Management in Hong Kong

That doesn’t mean CGCs are going away. Patrick Ho, head of chief investment office research at UBS Wealth Management in Hong Kong, reckons the next five years could be the "most exciting yet" for them. This is partly because of the unique role established by CGCs across China. "They have grown quickly because there is a big gap in China’s financial sector, in terms of private-sector firms requiring capital to grow," says Ho. "It’s also difficult in China to assess reliability and creditworthiness, particularly at private firms, yet these are often the country’s most vibrant firms. For these reasons, and for better or worse, credit-guarantee firms are essential to the wellbeing of China’s economy."

There’s another compelling reason for the industry’s rise. CGCs started out as entrepreneurial outfits, born and bred in China’s private sector, lacking control, regulation or direction by the state: in many ways, the perfect free-market financial product.

That’s now changing. The majority of CGCs remain privately owned, catering to the private sector. But an increasingly number are now owned and managed by local governments. State-run CGCs numbered no more than 100 two years ago; at end-2012, according to CBRC data, there were 8,427. Names such as China National Investment & Guaranty, and Beijing Shouchuang Investment & Guarantee, began to dominate the market, along with a welter of smaller state-run CGCs.

All too often, new state-run CGCs are formed to perform one function: to serve the financing needs of local governments. China’s stimulus-spree years (from late 2008 to mid-2011) were accompanied by jaw-dropping levels of investment in the public sector. Central and local governments channelled trillions of dollars-worth of capital into big infrastructure projects via investment conduits known as local government financing vehicles.

Every provincial-level government had an LGFV; many lowly county-level authorities did too. Their aim was simple: to pump as much capital as possible through the maw of the state as quickly as possible. At one level, this plan worked: China’s economy avoided slipping into recession in 2009. But at almost every other level it failed. LGFVs now hold up to $2 trillion-worth of loans on their books; experts have long reckoned that up to 30% of that stock of loans might turn bad.

Belatedly recognizing the need to avoid the mistakes of previous decades, Beijing acted from around late 2011, denying local governments access to easy bank credit. This didn’t sit well with provincial communist party chiefs: many were addicted to cheap loans, siphoned through LGFVs. Yes, this process added to the country’s yawning stock of national debt, but it also helped bolster local economic growth figures, long viewed by officials as essential to ensuring personal enrichment and promotion.

So over the past two years, they have changed tack. With bank lending off the menu, local governments have nimbly moved to set up their own CGCs. This sneaky manoeuvre allows LGFVs to raise credit from banks indirectly, using their own CGCs to secure loan guarantees. And since each LGFV is merely a pawn of local governors, the cash is put to whatever use deemed appropriate by local Party officials.

In other words, this dodge merely adds to China’s stock of local government debt. The only difference is that now, state-run CGCs controlled by LGFVs are merely holding billions of dollars-worth of fresh debt off the books, away from prying eyes, deep in the country’s financial shadows.

"This process allows local governments to continue investing and for local banks to pretend everything is alright," says a Beijing-based shadow banking expert. "This structure is very vulnerable. It’s a regulatory dodge and it’s increasingly widespread. Within just a couple of years, the credit-guarantee system has become critical to both local governments and their LGFVs. This isn’t how things should be run."

Zhang Zhiwei, chief China economist Asia ex-Japan at Nomura, adds: "This defeats the purpose of credit-guarantee firms: they were set up to push lending to private companies."

Eventually, most industry experts believe, the chickens will come home to roost. Not all state-run CGCs are bad – CMB’s Wei says he prefers to work with state-run CGCs, noting that many have "higher levels of transparency and corporate governance".

It’s almost certain that the industry will need to be better regulated in future. Currently, the process is a patchwork quilt: country-level CGCs and those with financial guarantee licences are regulated by the non-bank financial institutions division of the CBRC, which established a department of credit guarantee in 2009. At the provincial level, CGCs are regulated by different government agencies. Within China’s 33 provinces (31 of which boast working CGCs) 19 ensure their CGCs are supervised by the office of public finance, 10 are overseen by the bureau of SMEs, with the remaining two regulated by the local department of finance.

Critics are divided over CGCs’ status, and their legacy. Some believe they do more harm than good. "Nothing good will come from credit-guarantee firms," insists Anne Stevenson-Yang, cofounder and research director at Beijing-based financial consultancy J Capital Research. "Everyone knows they are empty, so why can’t the leadership see that? Their sole aim is to provide as much fuel as possible to the current economic expansion, while hiding it all off the books. The entire situation is utterly ludicrous."