China's Shadow Lending

Over the last few years when I present at seminar, I frequently speak about China's Shadow Lending system. By some estimates 50% of all corporate lending in China is through Shadow Lending, maybe even up to $5 Trillion USD. Not a small number. And it is an unforeseen risk for your business. So....what is Shadow Lending?

Basically it's non-bank lending. Why does it occur? In China (as written in an earlier article) banks are overwhelmingly government owned. They overwhelmingly only loan money against assets (land, buildings, equipment) not for operating capital. More than ten years ago, most Chinese companies held a lot of cash. They kept cash because they wanted to grow their businesses, because there were not many investment options, etc. So when they needed money, they self financed.

In the last 5-10 years more business owners have been using their profits to invest in other companies, in the stock market, overseas investments, real estate, legacy building (hotels, golf courses, etc with their name or brand). When the business needs cash flow...now they have to borrow it. Who do they borrow it from?

The Shadow Lending world is made up of a wide variety of lenders. Small credit unions / banks in villages all over China that take deposits (as investments) and then turn around and lend that money out to businesses. Online lending platforms, like micro lending. Pawn shops, that sometimes take cars or apartments, not just small objects of value. There are also loan shark lenders, part of the Chinese underworld. So the borrowing landscape is varied and full of risk.

The largest lenders in this market are Trust companies and Banks themselves. Trust companies are set up as such, and they take in investor money and lend it out to businesses. Banks have been doing the same, as "Entrusted Loans." money they pay their investors interest on, and then collect interest from the borrower. What's interesting about these Entrusted Loans is that they are off balance sheet....they don't show up on the Bank's balance sheet as assets or liabilities. Sounds like a lot of risk, doesn't it?

The government can't shut down this market, these loans keep the economy humming. So they have started to issue more regulations to better control them. You will still occasionally see articles about a riot or protest in China, caused by a small bank lender who didn't properly communicate the risk of the investment to the investors. The investors lose their savings on a loan that bank made. Businesses cannot make loans directly to other businesses, so they either provide money as an investor or they use one of the middle men (banks, trusts, micro lenders) who then pool money and lend it out.

Why do we need to know about this? If you are buying or selling in China, its important to know how your partner is financing their business. Part of your due diligence must be questions about their financial situation and lending. Don't rely on their financial statements (if they would share them with you). Ask about it. As part of the qualification services we do I often call these "James Bond" visits. The stated purpose of the visit to the Chinese partner is to review their facility / product / etc. The unstated purpose is to chat with the owners and employees and find out about the business; what their motivation is (money to live on, to finance immigration overseas, to develop their brand domestically, etc), who are the decision makers, do they have a transition plan when the entrepreneur owner retires, and how are they financing the company.

One of my clients called me to help them set up a company because they had to replace their only distributor when he was found face down in a foot of water at the edge of a pond. He owed money he couldn't pay. Another company called me, they were doing turn around consulting in China, they wanted my help with a Chinese company that owed $2 million USD to banks, and $3 million USD in Shadow Lending. The owner had been jailed for failing to make payments. After looking at the businesses P&L, I realized at it's height it only had generated $300,000 a year in profit. Banks (and Shadow Lenders) are not keen on writing down the value of their loans. I told these guys to back out of their advisement role, quickly and quietly. Last year we were doing an accounting clean up project for the factory's Hong Kong customer. We found the local supplier had ten bank accounts, all of them personal, and was 3 months behind in payroll. Recently we were negotiating a purchase agreement with a Chinese company, to be followed by a JV agreement. The Chinese investor "had" $3 million USD...but did he? Or did he have some of it, and was relying on shadow lending for the balance? I had to explain to the US client, that the JV needed money for the initial startup costs (land, building, their equipment, etc) and also operating capital...because the banks don't lend for that.

I often tell companies, if you haven't met your partner in person, at least once a year, and spent time in a low key discussion about life, business, family, and the future....then you are at risk. If you can't visit in person, send in a representative have these conversations for you, send us in. I love the James Bond visits.