The Leak In China's Banking System

Frustrated with low returns, Chinese savers are taking money out of state banks and lending it themselves

The People's Bank of China's surprise decision to raise interest rates for the first time in nine years on Oct. 28 has spurred a furious reading of the tea leaves. One camp thinks the move by PBOC Governor Zhou Xiaochuan signals the beginning of a series of increases aimed at keeping the lid on the country's rampant investment growth. Another group says it marks the beginning of a liberalized interest-rate regime, which would be a precursor for revaluation of the yuan. A third suggests that the rate hike is Zhou's bid to nip inflation in the bud.

Zhou and his bosses in China's State Council may have all three goals in mind. But there is another, equally compelling explanation -- that Beijing has decided to raise rates because it's desperate to lure depositors back to banks and away from the huge, informal lending market. "The central bank is very worried about the gray market draining funds" out of the banks, says Frank F.X. Gong, head of research and chief economist for China at JPMorgan Chase & Co. (JPM ).

The PBOC is right to be worried. For decades the state-owned banking system has loaned recklessly to state enterprises, and the number of problem loans has risen to scary levels. Now more than ever the banks need the $1.4 trillion the Chinese have accumulated in savings. But depositors are restless. Because of rising inflation in the past year, they have been losing money on their savings accounts in the official banks. One-year deposits still yield only 2.25% after the PBOC's October hike -- well below the 5% rate of inflation. Even the least sophisticated saver realizes this is like "putting a big ice cube in the bank and watching it melt," says Dong Tao, regional economist at Credit Suisse First Boston (CSR ) in Hong Kong.

These negative real returns have triggered a stampede of capital into the vast gray market in loans, which fills a real need by channeling capital to private businesses, which have traditionally been locked out of the formal banking system. This underground network can range from informal loans to a cash-strapped businessman by relatives and friends to sophisticated lending cooperatives formed by wealthy entrepreneurs looking for better returns on their cash. It's all technically illegal. But whatever form the gray market activity takes, lenders can get 8% to 20% on their money.

A 20% return on a loan beats a savings account any day. CSFB's Dong estimates that in August and September some $17 billion worth of savings -- 1.2% of gross domestic product -- fled the formal banking system to be invested elsewhere. If this gusher isn't capped soon, China's established banks have a huge problem. The PBOC's Zhou is in the midst of an urgent restructuring of the whole banking sector, which involves cleaning up rotten loan portfolios, taking big write-offs, teaching banks to pay attention to issues like risk management, and taking the strongest institutions public. In a bold experiment like this, the banking sector needs its capital base to be strong.

So what can the PBOC do? Analysts think the central bank's strategy is to move deposit rates up gradually, by perhaps 200 basis points over the next 12 months to give depositors a real return. (Officials expect inflation to decline to about 3% over that period.) At the same time the PBOC is giving the established banks much wider latitude by removing the ceiling on lending rates and choosing clients. If the banks start lending successfully to private companies, they could offer an alternative to the gray market, and limit the opportunities Chinese depositors have to leave the banks and put their money to work elsewhere. In reality, however, it will be hard for the PBOC to uproot the established lending network anytime soon.

The range and scale of gray-market lending is as varied as China's private economy itself. A loan might be as small as a few thousand dollars, with a toymaker borrowing from friends and neighbors to finance his working capital in the months before Christmas. Or the transaction might be a structured deal worth several million dollars to underwrite the construction of a new factory or apartment building. In these cases, a broker might act as guarantor, and the actual transaction will be made legal by paying one of the banks a nominal fee of 0.1% of the transaction cost for a lending license. This is just a fig leaf, since the loan doesn't actually go on the bank's books.


Such informal networks are mushrooming. They are most developed where the private sector is strongly rooted -- cities such as Shenzhen, Guangzhou, and Ningbo. "The informal lending sector is key for companies' survival," says Tony Wang, president of Ningbo-based HKE Electronics Co. One center of private lending is Wenzhou, in the eastern coastal province of Zhejiang, a city that would do Adam Smith proud. The city's nearly 60,000 small and midsize enterprises account for 95% of the local economy. Curb lending is so widespread that the PBOC and the China Banking Regulatory Commission have begun informally monitoring it to keep track of prevailing informal lending rates.

China's informal markets are also fulfilling a function that the banks have not taken on. While China's state sector accounts for less than a third of the economy, it sucks up more than 70% of the lending from state-owned banks. "It is almost impossible for a company like [mine] to get money from a bank because we are private," says Zhou Yi, founder of Shanghai-based industrial design house S.Point Design. The informal lending system is so well established that it's even common for state-owned enterprises to borrow cheaply from Big Four banks and then re-lend the cash to private borrowers at higher rates. That's one way to get the money into the right hands -- but it's a convoluted way of doing so. "This is very common at big SOEs," says one Hong Kong-based banker. "That's why we are very careful about dealing with SOEs with large amounts of cash."

The other surprising aspect of the gray market in loans is its relative soundness. Regulators fear that informal lending is fueling speculative investment in real estate and other sectors. But analysts and entrepreneurs say that, by all reports, the default rate on informal loans is very low. Lenders and borrowers usually know each other, either through their business relationships, schools, or communities. Often family members put up collateral, which makes default unthinkable. "The relatives who put up the money would lose face," says CSFB's Dong.

However sound the informal loans are, all that liquidity sloshing around outside the banking system makes Beijing's attempts to steer the economy to a soft landing much more complicated. But if the banks were doing a better job of allocating capital in the first place, there would be less need for a curb market. The PBOC is taking the right steps to save its banks and correct the situation. Until the government creates a modern banking system, though, the informal market will beckon many a borrower and lender.

By Frederik Balfour in Hong Kong, with Dexter Roberts in Beijing

— With assistance by Dexter Roberts

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