Book proposal and book review

169 The China Business Model. Copyright © 2017 T. Selmier II. Published by Elsevier Ltd. All rights reserved.

http://dx.doi.org/10.1016/B978-0-08-100750-1.00008-5DOI:

CHAPTER 8

Folk Lending and P2P: Monitoring Maturation in Chinese Financial Contracting Travis Selmier II Indiana University, Bloomington, IN, United States

8.1 INTRODUCTION: DEVELOPMENT OF PRIVATE MONITORING IN CHINESE FINANCIAL CONTRACTING

Between the 1949 Revolution and the introduction of the Four Modernizations program in 1978, China suffered from too few finan- cial institutions, too little financial capital and weak informational capi- tal (Eckstein, 1977; Lardy, 1998). The Four Modernizations program made brief explicit mention of finance intermediation (de Wulf, 1985) although implicitly—through promoting a comprehensive economic program—set the stage for considerable broadening and deepening of Chinese bank- ing and finance. Over the four decades since, China has matured from a capital-starved, mono-bank-centric financial system to a capital-rich sys- tem with great variety of financial intermediation (Cousin, 2007; Lardy, 1998, pp. 60–61; Tanaka & Molnar, 2008). Although the sophistication of Chinese banking and financial contracting has increased dramatically over those years, further progress is needed in delegated monitoring functions in banking and finance.

Delegated monitoring is a costly, delegated role, defined as one in which a financial intermediary (extended, in this paper, to investors act- ing in financial contracting roles) gathers and uses information ex post and ex ante to structure and renegotiate a financial contract.1 Monitoring

1 This chapter implicitly relies on Krasa and Villamil’s (1992) model of a finite number of monitors (financial intermediaries). This reliance is due to three reasons: (1) the Chinese government has attempted to limit the number of financial intermediaries through many policies; (2) this limitation has served to increase informal financial intermediation, result- ing in (3) increasing inefficiency in Chinese financial contracting due, in part, to ineffi- cient, ineffective, or corrupted monitoring.

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is costly, because information collection and analysis requires expertise, time, and money; it is delegated in that societies have given over to finan- cial intermediaries this role to improve efficiency in banking (Diamond, 1984; Krasa & Villamil, 1992) and in traded financial markets (Allen & Santomero, 1997). Delegated monitoring provides information, discipline, risk management, and managerial improvement in intermediated finan- cial markets. These benefits ripple through an economy. As banks embrace social and business responsibilities in order to monitor financial con- tracts (Diamond, 1984; Schumpeter, 1939), covenants are constructed and enforced around this monitoring function (Krasa & Villamil, 1992; Rajan & Winton, 1995). Through these mechanisms, financial intermediaries overcome financial market inefficiencies by acting as information conduits (Allen, 2001; Allen & Santomero, 1997; Rajan & Winton, 1995).

We can examine monitoring in Chinese financial contracting by flip- ping the title of this chapter around. First, this chapter monitors maturation of banking and financial contracting in China to examine how and why moni- toring remains the last major step in Chinese financial modernization. The formal and informal challenges faced by Chinese banks and other financial intermediaries in performing this monitoring function have eased since 1978, but still remain. Discomfort with uncontrolled information flows has retarded development of monitoring in China. As monitoring provides both a gov- ernance component as well as a social responsibility component, Chinese government officials have been uncomfortable with delegating governance authority to private actors (see, for instance, Selmier, 2016a; Yang, 2014).

Secondly, this chapter examines maturation of monitors themselves by focusing on the informal sectors in Chinese financial contracting. In this, I look at how informal finance channels credit to small- and medium- sized enterprises (SMEs), mostly through examining Wenzhou, a smaller city in southern Zhejiang Province which, for a quarter century, was the fastest-growing municipality in China’s fastest-growing province. SMEs in Wenzhou, as elsewhere in China, became dependent on so-called “folk- lending”—loans and investment funds channeled through friends, or friends of friends. Wenzhou has also recently become a pan-China cen- ter for peer-to-peer online lending. These sources of capital were abso- lutely critical to SME growth as large state-owned banks would not lend to them (Bailey, Huang, & Yang, 2011; Lin & Chen, 2012; Zhang, 2002), while smaller banks focused on specific sectors and better-heeled clients (Tanaka & Molnar, 2008; Zhang, Xu, & Qin, 2013). Tsai (2009, p. 80) cal- culated in 2007 “only 1.3% of the loans extended by state banks went to private enterprises.” Yet SMEs provide an important, fast-growing share

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of the Chinese economy, recently accounting for “60% of the country’s gross domestic product (GDP) and over 75% of urban job opportunities” according to Cunningham and Rowley (2010, p. 125).

In effect, monitoring the maturation shows the impressive develop- ment of Chinese banking and financial intermediation. But the matura- tion of the monitors is still lagging. To examine changes in SME financing, the financial intermediation chains servicing SMEs, and the governance challenges that arise, this chapter employs a mixed-methods approach: Integrating macroeconomic data gathered through online and published government sources, extant papers (primarily in Chinese and mostly anec- dotal), and 18 face-to-face semi-structured interviews conducted with local and national bankers, government officials, and financial academics in Wenzhou, Hangzhou, and Beijing in 2014 and 2015.

Section 8.2 monitors maturation in financial intermediation in China by focusing on six key developmental steps where Chinese financial intermediation broadened and deepened, but did not much progress in monitoring. In effect, the Chinese government did not delegate author- ity to financial intermediaries to monitor. Section 8.3 looks at transac- tional and relationship banking theory and examines the challenges faced by Multinational Enterprises (MNEs) in obtaining financing. Section 8.4 examines the challenges of monitoring in Wenzhou SME finance by dis- cussing two channels of informal lending: folk-lending and peer-to-peer online lending platforms. Section 8.5 gives final thoughts as to the intimate linkages between delegated monitoring and the soft budget constraint.

8.2 MONITORING LAGS IN DEVELOPMENT OF FINANCIAL INTERMEDIATION IN MODERN CHINA

Over the four decades since 1978, China has matured from a mono-bank- centric system to a that with great variety of financial intermediation since the late-1970s (Cousin, 2007; Lardy, 1998, pp. 60–61; Tanaka & Molnar, 2008). Sometimes change was gradual: a bankruptcy law which would allow arms-length restructuring required nearly two decades to implement (Tanner, 1999, pp. 135–166). Sometimes change was rapid, revolutioniz- ing the nature of banking and financial intermediation in China, as in the mid-1990s when state-owned Chinese banks were dramatically altered from redistribution mechanisms for regional development and put on the path to modern commercial banks (Brandt & Zhu, 2007).

Yet, great hurdles remain. The specter of financially weak state-owned enterprises (SOEs) being kept on life support continues to haunt China’s

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state-owned Chinese banks to this day (Steinfeld, 1998; Tan, 2013). Equity markets retain their casino-like nature, rather than developing into a more-efficient capital allocation mechanism (Allen, Qian, & Qian, 2005; Branstetter, 2007)—partly due to informal financial intermediaries provid- ing capital to speculators (Hess, 2015; Interviews in Wenzhou and Beijing, 2014, 2015a). Real estate remains a highly speculative investment class. And SMEs continue to be capital-deprived and more dependent on infor- mal financing (Shi & Ye, 2001; Tanaka & Molnar, 2008; Zhang et al., 2013). All these hurdles are partly due to underdeveloped, inefficient or even sty- mied monitoring functions in Chinese financial intermediation.

Banking theory posits that banks and other financial intermediaries embrace a social responsibility to monitor financial contracts (Diamond, 1984) and that covenants are constructed around this monitoring func- tion (Rajan & Winton, 1995). Through monitoring, financial intermediaries overcome financial market inefficiencies by acting as information conduits (Allen, 2001; Rajan & Winton, 1995). Chinese banks and other financial intermediaries lag in fulfilling this social responsibility. To understand this lag we need to understand better how far Chinese banking and financial intermediation has progressed. Six key steps have already been taken in this process of development. Each of these steps might have catalyzed monitor- ing improvement, but fell short. The steps are: (1) splitting the system into separate banks and financial services firms in the early 1980s; (2) the slow establishment of a bankruptcy law between 1985 and the late 1990s; (3) the establishment and growth of equity and bond markets since the late 1980s; (4) major reform of banks between 1994 and 1999; (5) the slow internation- alization of Chinese financial over the last decade; and (6) a second round of bank reform which began in the 2000s and continues until this day.

Although nominally a banking system with three banks in 1978, China was effectively a one-bank system in which the Peoples Bank of China (PBoC) controlled the Bank of China while the China Construction Bank acted as a captive capital distribution wing of the Ministry of Finance (Branstetter, 2007, pp. 28–30). Splitting the system up in the early 1980s established the four large state-owned banks—the Big Four— and began establishing smaller, often specialized financial intermediar- ies focused on investments and regional development, while carving out a modern central banking role for the PBoC beginning in 1984 (Lardy, 1998, pp. 61–64, 66–76). This institutionalized a government role in moni- toring banks and the financial system, but monitoring through private institutions and individuals was left underdeveloped (Table 8.1).

Table 8.1 Six key steps in modernization of Chinese financial intermediation Time period Key step Effect on monitoring Notes

Early 1980s Splitting the system up into separate banks and financial services firms

Only addressed capital allocation aspects, not governance through monitoring

Just the beginning of an ongoing sophistication process in financial intermediation

1985–mid- 1990s

Slow establishment of a bankruptcy law

Might have given banks “teeth” in pursuing assets of SOEs

Still considered quite underused by legal scholars

1980s until present

Establishment and growth of equity and bond markets

Did not link corporate governance to corporate ownership

Firms rely mostly on internal financing and bank loans

1994–99 Major bank reform Began separation of regional, national, and party interests in bank governance

Concurrent with SOE reform

1999 until present

Slow internationali- zation of Chinese financial firms

MNE effect: 1. overseas listing 2. reporting

requirements through M&A

3. foreign banks monitoring Chinese MNEs

RMB internationalization requires PBoC to manage economy

Little direct effect yet on Chinese banks

Beginning with WTO, more prominent after second round of bank reform

2000s until present

Second round of bank reform, including considerable information systems upgrading

Big Four have become more oriented toward delegated monitoring

Better linkage between lending and client performance for big banks

Little effect on smaller banks

Effect through bankruptcy, Big Four lending to SMEs not yet noticeable

Financial intermediaries still restrained by government; considerable informal intermediation

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Two crucial steps were started in the mid-1980s which may have enhanced private sector monitoring: passing of a bankruptcy law, and the establishment of equity markets. That neither has fulfilled their prom- ise indicates deeply entrenched political influence over financial interme- diation. The slow establishment of a bankruptcy law beginning in 1980 required significant policy entrepreneurship (Tanner, 1999) and, to this day, has not had much impact in de jure outcomes (the legal capacity to follow through to liquidation of a company’s assets, see Jiang, 2014) or de facto outcomes (i.e., informational content sent to economic participants through monitoring actions of a financial intermediary filing a bankruptcy action against that company). The 1986 law required 6 years of negotia- tion and was a very tentative move forward in dialogue about bankruptcy; updated in 2007, it is still rarely invoked (Bufford, 2015). Branstetter noted in 2007 (p. 58) “as China’s banks and asset management compa- nies have discovered, the de jure legal right to force a debtor into bank- ruptcy does not translate into a de facto right to acquire control over the debtor’s assets,”. Recent bankruptcy filings by state-owned shipbuilders like Wuzhou Ship Repairing & Building and Sainty Marine (Bao, 2015), and the related asset filings by these firms’ banks, will test whether this is changing; if so, this would represent progress toward private sector moni- toring, particularly steps taken by the Big Four.

Establishment of equity and bond markets required a similarly long gesta- tion period. Discussions around the governance benefits of equity ownership began in policy circles shortly after the Four Modernizations began (Steinfeld, 1998, pp. 130–137). These discussions resulted in a lightning-rod editorial published in the top economics newspaper, Jingji Ribao [经济日报] in 1985. The young economists who wrote this piece ascribed lofty ideals to investors:

The main purpose of risk capital is not to profit, but for future development; not to accelerate business [and profits], but rather to accelerate innovation.2

The authors were purposefully controversial, invoking Adolf Berle’s paean to corporate protection of property rights and corporate social responsibility, The 20th Century Capitalist Revolution.3 An important part of

2 “风险资本主要目的不是为了眼前利润，而是为了未来发展; 不是为了促进企 业, 而是为了促进创新。” translation by this author.

3 Jiang (2009, pp. 27–30) notes the disjoint between “traditional culture concept” in which “personal moral objectives” held sway and the present market economy in China result in a “culture lag” which has affected informal finance, an idea which could be extended to formal finance in China and beyond. While Wu’s (1985) essay may appear naive now, but a strong belief in moral economics provided a powerful argument in post-Cultural Revolution China.

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their argument was the monitoring capacity of equity markets. But what Branstetter (2007, p. 54) noted a decade ago is still true today: “… equity prices were meant to serve as a summary statistic of the performance of the firm, guiding capital to the most productive, best managed enterprises. Equity prices do not… play this critical signaling role…” The main equity markets in Shenzhen and Shanghai were established a quarter century ago, yet China remains a bank-intermediated financial system. Furthermore, while joint stock banks were founded in the 1980s, only one bank was listed by the end of the 1990s (Lardy, 1998, p. 65). Li, Makaew, and Winton (2014) find, however, that Chinese equity markets may have begun to pro- vide more monitoring.

The end of the 1990s saw China’s admission to the WTO after a half- decade of major banking and SOE reform. One important component of this reform was to remove the responsibility of banks to redistribute capital as a social function, divorced from business concerns. A PBoC report from early 1980s laid out a policy of using the Big Four to finance local devel- opment (Shih, 2008, pp. 32–36). These banks were required to lend locally and, combined with the appointment of local government-linked bank managers by local officials, greatly increased political influence over local funding. The Big Four were also used to shift funds from capital-rich to capital-poor Chinese regions (Brandt & Zhu, 2007, pp. 98–103; Cao, Qian, & Weingast, 1999; Hsu, Arner, Wan, & Wang, 2005, pp. 45–46). Combined with SOE reform—which also sought to separate social burdens such as housing, education, and healthcare, and retain under state control only the larger SOEs (Steinfeld, 1998; Zheng & Chen, 2009),4 the possibilities of enhanced monitoring and higher bank profits grew dramatically. In profit terms, the Big Four showed considerable profit and efficiency improve- ment since China’s accession to the WTO in 1998, even as Chinese bank- ing was opening up to more competition (Yin, Yang, & Mehran, 2013). Although monitoring again lagged behind, as monitoring confers political as well as economic power upon financial intermediaries. “Since the finan- cial system… is the last remaining powerful instrument through which the state and party directly influence resource allocation, they are naturally reluctant to give up this power” noted Lardy (1998, p. 221).

The run-up to WTO membership catalyzed the gradual internation- alization of Chinese financial institutions, as well as broader aspects of

4 Summed up as “grasping the large and letting the small go” [抓大放小], the idea was to dramatically shrink the state-owned portion of the economy through downsizing, sell-off of firms, and corporatization, including equity listing and official recognition of all linked companies and interests.

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Chinese finance. Three internationalization processes were tightly linked, financially and politically: globalization of nonfinancial Chinese MNEs, international network expansion of Chinese banks and financial firms (Tokuchi, 2013), and the internationalization of the RMB (Subramanian, 2011). Former Chairman of CITIC Securities International, Ted Tokuchi, summarized this interlinkage in 2013:

A key part of their [the Big Four’s] plans at present is to grow their international banking business through footprints of China’s development strategy and that means by focusing on Africa and Latin America in particular.

Quoted in Selmier (2013, p. 747).

Each of the three processes provided opportunities to enhance moni- toring in domestic Chinese financial intermediation, yet each has yet to fully deliver. Globalization of Chinese MNEs is the most impactful of the three in furthering monitoring. Monitoring is increased through listing overseas and thereby disclosing information, acquiring non-Chinese firms, so reporting to non-Chinese regulators, and using services of foreign banks that monitor Chinese MNEs activities and loan covenants. The internation- alization of the RMB exerts a powerful, although indirect, set of effects. The PBoC implicitly committed itself to manage the Chinese macroeconomy and its banks, through comments such as PBoC Vice Chairman Xiaolian Hu’s (2009, p. 7) that “the Fed seemed to have a let-it-be attitude… until the burst of asset bubbles [in the latest global financial crisis].” The PBoC is also committed through the costs of the RMB becoming a reserve cur- rency, as outlined by Subramanian (2011, pp. 6–8): likelihood of additional currency appreciation through foreign demand; leverage over domestic financial policy obtained through extensive foreign holdings of the RMB; embedded responsibility commensurate with being a lead currency; and the requirement for an open currency. Such Chinese bank internationalization has not yet had a large impact on monitoring simply because, as Chairman Jiang Jianqing of China’s most international bank, ICBC, sadly mused “We are now just an international bank, not yet a real global bank” (quoted in Yang, 2014). Without a large foreign presence, state-owned Chinese banks will not become more scrutinized or pressured toward monitoring by non- Chinese financial intermediaries and governments.

Lardy (1998) estimated that nonperforming loans in the Chinese bank- ing system were roughly 35% and were concentrated more in state-owned banks. While contentious when his book was published, the late 1990s recapitalization of banks proved insufficient, and a second round of reform

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began in the early 2000s (Brandt & Zhu, 2007; Hsu et  al., 2005). Again, this provided opportunities to enhance the delegated monitoring roles of financial intermediaries, and the probability of this opportunity improved as the Big Four considerably upgraded their information systems and credit scoring (Hansakul, 2006). Perhaps underappreciated, the Big Four may be more advanced in delegated monitoring than smaller banks and certainly the informal sector. For instance, Chen, Liu, and Su (2013) find that the Big Four are more likely to allocate loans based on better performance while smaller banks may be swayed through bribery. Increasingly strict loan covenants and even bankruptcy suits by the Big Four are also unusual in Chinese banking. And expansion into SME lending by the Big Four is not only a sign of increased interest in this sector but also that banks with gov- ernment ownership will participate in banking to smaller private firms.

Importantly, in 2003 the China Banking and Regulatory Commission (CBRC) was established, creating an independent, professional regulatory body. Despite this, a significant part of Chinese financial intermediation is still not transparent, and transparency is required for delegated monitoring to work effectively. Jianjun Li estimated in 2005 that informal lending was roughly 28% of amount of formal institutions’ total lending (cited in Tsai, 2009, fn.8, p. 85). Informal lending and smaller banks still dominate SME financing, and here monitoring is especially weak. To understand why this is so, we first turn to banking theory, and then apply this to financial inter- mediation in Wenzhou.

8.3 SME LENDING IN THE CHINESE CONTEXT

Monitoring is conditioned by the two archetypal banking types: transac- tional banking and relationship banking (Allen, 2001; Boot, 2000; Boot & Marinč, 2008). Transactional banking is defined, in part, by that which is not relationship banking: a focus on the hard data-oriented, transac- tion core of banking—pushing to arms-length the relationship which may develop between banker and client. Transactional banking’s essential strategy is to increase the number and efficiency of transactions and so drive down costs, achieving a comparative advantage through speed, vol- ume, and efficiency (see Boot on securitization, 2000: 11–12, also Allen & Santomero, 1997). Information availability is essential to properly function as a bank or financial intermediary whether a transactional- or relation- ship-oriented strategy is pursued. Relationship bankers attempt to capture information that is more difficult to quantify, gathered through numerous

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meetings between banker and client over a long period, resulting in the banker judging the risk and return based on her knowledge of the cli- ent. This tacit knowledge, collected through the social network of the banker, is then infused throughout her bank. In practice, the relationship banker typically also gathers harder data, which she culls from client finan- cial records and other sources. Transactional banking does not, or perhaps more accurately cannot, effectively collect, manage and employ this tacit knowledge and so relies on hard data.

Whether the bank is operating in developed or less-developed, capitalist, communist, or mixed-model economies, theory argues that banks amelio- rate economic inefficiencies by acting as information conduits (Diamond, 1984; Rajan & Winton, 1995; Tanaka & Molnar, 2008). Substantial informa- tion search costs, as well as the costs associated with information capture, storage, usage, and transmission, are the reason for their respective reliance on different kinds of information. The investment required to conduct rela- tionship banking is considered both large and asset-specific to the banking relationship (Berger & Udell, 1992, 2006; Tanaka & Molnar, 2008).

Smaller banks and other financial intermediaries have an advantage in controlling such costs and overseeing their employees, while maximizing returns when engaged in SME lending—termed the “small bank advan- tage” (Berger & Udell, 1992, 2006; Boot & Marinč, 2008, pp. 1190–1191; Zhang, 2002). The “small bank advantage” is viewed as the classic exam- ple of successful relationship banking when the bank’s oversight restrains a banker from becoming too close to her client and over-extending credit, mitigating any soft budget constraints. Soft budget constraints “exist when the strict relationship between expenditure and earnings has been relaxed” (Kornai, 1986). Sometimes the banker does not correlate lending disci- pline to the actual financial condition of the firm, and may continue to extend loans (Qian, 1994). The bank may be unaware of this action, or may encourage it (Bailey et  al., 2011; Selmier, 2016a, 2016b). In China, this is often called “lending new to repay old”5 (Cousin, 2007, p. 88), a problem which has long been linked to SOE lending.

Banking theory holds that smaller banks lend to SMEs because smaller banks’ size enable them to more-efficiently gather “soft data” and better monitor their bankers’ tendencies to over-lend. China leans toward the relationship banking pole by nature of the structure of China’s guanxi- based, social-network, banking system, and stage of financial development (Bailey et  al., 2011; Zhang, 2002). SMEs are also dependent on smaller

5 “借新还旧”—Jie xin hai jiu.

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banks and informal finance (Allen et al., 2005; Guo & Liu, 2002). Chinese SMEs face the same obstacles facing SMEs elsewhere in obtaining capi- tal from banks, plus additional challenges, which push Chinese SMEs to look outside the formal banking channels to what Tsai (2002) refers to as “back-alley banking.” Table 8.2 outlines these obstacles.

First, SMEs’ size and shorter histories often translate into fluctuat- ing demand for capital and lack of banking ties to larger banks. This sig- nificantly increases the rates they must pay (Berger & Udell, 1992, 2006; Cousin, 2007; Zhang, 2002). Second, additional upward pressure on rates is seen because of SMEs’ lack of professionally audited accounting records or credit history, partly due to a lack of collateral and elevated firm fail- ure rates (Lin & Chen, 2012; Tanaka & Molnar, 2008; Zhang, 2002). Third, larger banks’ formal loan approval processes sometimes cannot adjust to SMEs’ seasonal, and often very short term, demand for capital. This pushes Chinese SMEs’ in particular toward fast solutions with less credit scoring, such as folk-lending (Bailey et al., 2011; Fu & Bao, 2011; Guo & Liu, 2002).

Fourth, from a capital supply perspective, larger banks consider these higher risk factors, the lack of incentives to take on risks and small loan sizes, and so have tended to ignore SMEs (Bailey et  al., 2011; Cousin, 2007; Zhang, 2002).6 Fifth, the structure of Chinese banking requires smaller, local financial intermediaries’ to request funds and approval through their supervising banks, further delaying businesses opportunities requiring rapid investment (Lin & Chen 2012, p. 9; also Tanaka & Molnar, 2008). Sixth, after onset of the 2007–08 Global Financial Crisis, China’s central government raised interest rates (Ding, 2012) whilst setting a ceil- ing on rates that could be charged (PBoC, 2012). Structuring this interest rate “corridor” dampened informal financial contracting; this, combined with concerns about SMEs’ overseas markets and better returns available through other investments, caused a decline in folk-lending.

These obstacles were compounded in Wenzhou by two additional, related obstacles (labeled 7 and 8 in Table 8.2): seventh, Wenzhou has perpetually been in capital-deficit and dependent on significant capi- tal flows from the rest of China (Tsai, 2009; Zhang et  al., 2013); Eighth, this is partially due to the unbridled nature of Wenzhou-style business and Wenzhou’s long history as an independent-minded part of China, result- ing in the now famous “Wenzhou Model” (Liu, 1992; Sonobe, Hu, & Otsuka, 2004; finance-specific, see Tsai, 2009, pp. 88–92).

6 However some large banks such as Bank of China have recently established SME Departments to pursue this business, as noted earlier.

Table 8.2 Obstacles to obtaining finance for Chinese SMEs Number Obstacle Notes

Obstacle seen globally by SMEs

1 Size and shorter histories

Leads to lack of banking ties, fluctuating demand for capital, and higher rates paid

2 Lack of professionally audited accounting records

Also lack longer credit histories, collateral, and high failure rates

3 Very short-term requirements

Pushes SMEs to informal, fast lenders

4 Supply-side constraints Bankers lack incentives and do not wish to face higher risks

China-wide obstacle for SMEs

5 Smaller banks must obtain approval from supervising banks

Structure of Chinese banking

6 Post-2008 interest rate channel

Interest rate “corridor” curtailed informal financing

Wenzhou-specific SMEs

7 Perpetually in capital-deficit

Dependent on significant capital inflows, Wenzhou has paid highest rates in China

8 Fallout from the “Wenzhou Model”

High-debt, high-growth, informal finance, SME and non-SOE regional economy

Culled from: Bailey, W., Huang, W., & Yang, Z. S. (2011). Bank loans with Chinese characteristics: Some evidence on inside debt in a state-controlled banking system. The Journal of Financial and Quantitative Analysis, 46(6), 1795–1830; Berger, A. N., & Udell, G. F. (1992). Some empirical evidence on the empirical significance of credit rationing. Journal of Political Economy, 100, 1047–1077; Berger, A. N. & Udell, G. F. (2006). A more complete conceptual framework for SME finance. Journal of Banking & Finance, 30(11), 2945–2966; Cousin, V. (2007). Banking in China. Basingstoke, England; New York: Palgrave Macmillan; Ding, Qi. [丁琪]. (2012). Resolution on folk lending in Wenzhou [解析温州民间借贷]. Technological Development of Enterprise, 31 (4,7) [企业技术开发], 165–166; Fu, X. L., & Bao, Q. H. [付晓亮 & 包清华]. (2011). Theoretical research on application of relationship banking loans in China. [关系型银行贷款理论 及其在我国的应用研究]. Operations and Management, 16《经营管理者: 16期》; Guo, B., & Liu, M.-L. [郭斌 & 刘曼路]. (2002). Private finance and small & medium sized enterprises development: Empirical evidence from Wenzhou Region [民间金融与中小企业发展： 对温州的实证分析]. Economic Study, 21(31), No. 4, 7 [经济研究] 10, 40–46; Lin, G., & Chen, T. [林贵 & 陈婷]. (2012). Risk and prevention of establishing private banks in Wenzhou [温州建立与发展民营银行的风险与防范]. Journal of Wenzhou Vocational &Technical College, 12(1) [温州职业技术学院学报], 8–23; Liu, A. P. L. (1992). The “Wenzhou Model” of development and China’s modernization. Asian Survey, 32(8), 696–711; Selmier, W. T. (2016a). Netizens and private monitoring in Chinese banking. In J. C. Choi, M. R. Powers, & X. T. Zhang (Eds.), Political economy of Chinese finance, Vol. 17 of International Finance Review. Bingley: Emerald Group Publishing Limited; Selmier, W. T. (2016b). Social capital and folk-lending in China’s hottest financial market. Working paper; Tanaka, K., & Molnar, M. (2008). What is different about informal finance? Financing of Private Firms in China. Revue économique, 59(6), 1131–1143; Tsai, K. S. (2009). Beyond banks: The local logic of informal finance and private sector development in China. In J.-J. Li, & S. Hsu (Eds.), Informal finance in China: American and Chinese perspectives (pp. 80–103). Oxford: Oxford University Press; Zhang, J. [张捷]. (2002). Relationship lending to small and medium enterprises and the organizational structure of banks [中小企业的关系型借贷与银行组织结构.]. Economic Research [经济研究], 6.

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8.4 INFORMAL FINANCE IN WENZHOU PRESENTS UNIQUE MONITORING PROBLEMS

8.4.1 Folk-Lending and Related Monitoring Complexities The Wenzhou model was particularly dependent on informal types of financing for a number of reasons. Firstly, Wenzhou was considered geo- graphically undesirable due to its proximity to Taiwan (Tsai, 2009), and a history of regional independence which made Wenzhou seem less easy to govern (Liu, 1992; interviews). Both factors, combined with limited arable land and few natural resources—aside from the Ou River and its trade flows, meant that Wenzhou was capital-deprived, with the national government reticent to site SOEs in Wenzhou (Liu, 1992; Tsai, 2009). Wenzhou people, however, were a natural resource in, and of, themselves, renowned for three characteristics: their much-mentioned reputation for being extremely hard- working (interviews, Wenzhou and Beijing)7; their extremely high risk tol- erance (Lin & Chen, 2012; Liu, 1992; Shi & Ye, 2001)8; and, in the words of a senior local banker, “Wenzhou people love debt.”9

Employing the resources at hand, Wenzhou SMEs and individu- als began pooling capital in the 1980s within small networks, which lent at high interest to local businesses. Wenzhou’s reputation for success- ful SME and regional growth outweighed successive scams and collapses (Shi & Ye, 2001; Tsai, 2009) that dented, but did not destroy, the emerging brand name of the Wenzhou Model. By the 1990s Wenzhou’s multitiered financial network structure had become an important component of the Wenzhou model (Sonobe et al., 2004; Interviews, 2015b).

If Wenzhou SMEs relied solely on smaller banks in which relation- ship banking was practiced, one might expect some buffering of eco- nomic downturns, as suggested in the model proposed by Bolton, Freixas, Gambacorta, and Mistrulli (2013). Economic downturns since the 1980s were, however, often more severe in Wenzhou than in other parts of China, and more severe than these economists might predict. In fact, the higher interest rates charged through informal channels make loan repayment more difficult, often resulting in violent conflicts between the

7 “温州人很勤劳” is a constantly-heard phrase, mentioned in interviews with academics, regulators, and bankers.

8 Mentioned in interviews with two local and two national bankers, several financial aca- demics and a regulator.

9 This banker said “温州人爱贷款.”Seven other interviewees told me this in very similar terms.

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lenders and SME owners (Lin & Chen, 2012). Consequently, the impacts from the global economic downturn beginning in 2007–08 immediately blunted Wenzhou exports as shown in Fig. 8.1 and, by 2011, a recession hit the entire Wenzhou regional economy with a vengeance.

The credit contraction in Wenzhou was so profound that the munici- pal and central governments felt compelled to implement China’s first, and thus far only, “complete financial reform” [jinrong zonghe gaige—金融综 合改革] (PBoC, 2012). In the process of reform, a number of financial intermediaries and holding companies were established and more exten- sive links established between local financial intermediaries and national financial authorities—including the PBoC and the CBRC (Selmier, 2016a). A Local Financial Management Bureau [difang jinrong guanliju— 地方金融管理局] was established to provide on-the-ground oversight. This ongoing profound contraction is largely an outcome of weak mon- itoring. Examining the structure of informal financial intermediation in Wenzhou helps explain how and why delegated monitoring functions are still weak in China.

Wenzhou’s history of financial innovation is famous for its sophis- tication in “folk-lending,” an informal form of financing which trans- lates directly from Chinese as “loans between people” [minjian jiedai—民间借贷]. Folk-lending arrangements are usually structured

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Folk Lending and P2P: Monitoring Maturation in Chinese Financial Contracting 183

between geographically close borrowers and lenders who have a long- established personal relationship and are usually more risk-tolerant, com- pared with formal banks’ lending channels (Ding, 2012; Guo & Liu, 2002; Lin & Chen, 2012). This very informality, however, caused six monitoring problems, as outlined in Table 8.3.

(1) There was no way to know precisely how much capital was involved in the Wenzhou folk-lending market because, until the Wenzhou Private Lending Registration Service Center was established in 2011, there simply was no record of extant lending. (2) The speed at which such loans could be called, or simply not rolled over, was extremely disruptive to SMEs’ ongoing working capital needs. For example, after the export downturn started in 2009, many lenders/capital-providers in the folk- lending channel simply shifted their capital to other profitable investments in coalmining, real estate or elsewhere outside Wenzhou (Yu, 2013), caus- ing a precipitous decline in available capital within Wenzhou.

(3) There was little in the way of hard constraints to bind a borrower/ capital-requirer, so instead of incented to monitor a financial contract for

Table 8.3 Six monitoring problems arising under folk-lending [minjian jiedai—民间借贷] Number Monitoring problem Reason for problem

1 Capital in loan channel unknown

Informality and quasi-legal status make tracking and registration impossible. Wenzhou has created a Center to register minjian jiedai, but reporting is voluntary

2 Imminently callable or nonrollable

Intermediaries have little capital and may call loans as they must pay, or simply not roll the loan

3 No hard constraints Monitoring without teeth is weak or nonexistent monitoring

4 Exit or find another to bail out position rather than monitor

As the borrower/capital-requirer cannot be compelled to pay or change covenants, better moves for the capital-provider are to remain quiet and act on privileged information

5 Low bar to entry into lending channel

Not clear that many lenders/capital- providers have the skill set to properly monitor

6 Unstable network All above-mentioned monitoring problems contribute to this problem

Source: Author’s conception.

The China Business Model184

society’s benefits, capital-providers were motivated to monopolize infor- mation rather than divulge it. Jiang (2009, p. 29) notes:

Most informal financing activities are based only on an oral agreement and lack collateral, while even those having a written contract are weakly protected by the legal system since informal finance is still an underground activity. Therefore, one often finds that moral constraints are the only type of constraint that prevails.

(4) This weak constraint provides an incentive for lenders/capital- providers to not simply hide information, but to exit positions before anyone finds out. Consider the situation wherein no penalty exists for act- ing on nonpublic information. If a counterparty is in trouble, the lender/ capital-provider’s rational response is either to exit the position or attempt to arrange additional loans with other, unknowing, lenders/capital- providers in order to bail herself out.

(5) There is a low bar to becoming a financial intermediary in such informal circumstances. A potential entrant requires only contacts or a bit of capital. Jiang (2009, p. 22) cites an example of an informal intermedi- ary whose very name connotes this potential problem of lack of exper- tise: the Old Lady Bank in Wenzhou, whose banking network members are “middle aged women up to 60 years of age, who have little educa- tion.” Here, a prospective borrower/capital-requirer simply contacted one of the older women in this multivillage network and explained his need. The network would look for available capital to lend. Schumpeter (1939, p. 117) summed up this situation well when he wrote:

… bankers may, at some times and in some countries, fail to be up to the mark corporatively: that is to say, tradition and standards may be absent to such a degree that practically anyone, however lacking in aptitude and training, can drift into the banking business, find customers, and deal with them according to his own ideas. In such countries or times, wildcat banking develops.10

(6) These first five monitoring problems engender a systemic problem made more severe through weak monitoring—considerable network risk in Wenzhou. Financial contracting under folk-lending involves a guaran- tor who either supplies capital and provides assurance for debt payment, or simply provides assurance to the lender/capital-supplier in a separate con- tract. This is known as “carrying guarantee” [担保—danbao]. One senior banker told me “danbao is a China-wide phenomenon, [but] in Wenzhou

10 Emphasis added. Note that part of this quote also cited in Diamond (1984).

Folk Lending and P2P: Monitoring Maturation in Chinese Financial Contracting 185

it is very advanced”. Danbao came to be seen as a separable financial good which could be purchased, lessening or even removing the moral con- straint which came through interpersonal relationship (Selmier, 2016b).

Financial innovation in Wenzhou created more complex, more net- worked syndication arrangements such as baotuan [保团], where a group of individuals pools capital to lend through informal syndication arrange- ment (see Fig. 8.2). The borrower may pay an origination fee and/or a guarantor fee to the baotuan, to one if its members, or to a facilitator who introduces the borrower to the baotuan. Baotuan syndicates enabled financiers to take on investments in large projects in Wenzhou and else- where; one finance academic revealed that some Wenzhou-based baotuan “swooped down” and bought out whole floors or buildings in Shanghai and Beijing.

Network risk also existed in the long chains of folk-lending arrange- ments called lianbao [连保], in which a guarantor to one borrower is a borrower from another, and these arrangements become organically tied together. Selmier (2016b) describes the systemic risk resulting from these complex linkages as “countless spider webs in an old barn, interlinked and difficult to pull apart without destroying all the webs.” Fig. 8.3 shows why those lender/capital-providers tied together in this structure are highly unlikely to know the others. In fact, “no one knew where the risk was in the system” because folk-lending had few public records and no registry of any kind.11

A

B

CD

E

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BORROWER

Capital flow

Obligation (plus fee?)

Figure 8.2 Guarantor group [保团—baotuan]. From Selmier, W. T. (2016). Social capital and folk-lending in China’s hottest financial market.

11 This was mentioned in interviews with two financial academics, two government offi- cials, and two bankers.

The China Business Model186

8.4.2 Wildcat Banking in Wenzhou: The Rise of “P2P” and a New Set of Monitoring Issues Even after the financial crisis hit Wenzhou and folk-lending contracted, the channel still accounted for roughly 20% of total loans disbursed in Wenzhou (PBoC, 2012; Interview with Wenzhou Private Lending Registration Service Center, 2015b). But folk-lending is being eclipsed by a new type of financial intermediary. Part of the credit transmitted through folk-lending channels has now shifted to peer-to-peer online lending platforms [P2P ping tai (P2P平台), or simply P2P]. Growth in the P2P channel exploded in China since 2011, and Wenzhou is one of China’s main P2P centers (Caijing, 2014: numerous interviews, 2014: 2015). Of the roughly 3000 P2Ps known to have existed in China in April 2015, more than 100 were based in Wenzhou (interviews with Local Financial Management Bureau and others). China’s largest P2P, Wenzhou Dai, started in Wenzhou, and several of the larger, and more-successful, P2Ps are based in Wenzhou. “The P2P model fits better to Wenzhou’s cul- ture” according to a senior local banker (interviewed in April, 2015).

While folk-lending arrangements might be characterized as geographi- cally close between those with personal relationships, P2P platforms bring together geographically distant actors without personal relationships. In banking’s simplest terms, folk-lending is more akin to relationship bank- ing while P2P is closer to transactional banking. Another six monitoring problems have arisen with P2P. Some are similar to the previously out- lined problems encountered under folk-lending, but others are not.

Social obligations (plus fee?)

BORROWER

C D

B

A

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Capital flow Financial

obligation

Figure 8.3 Guarantor circle [连保—lianbao]. From Selmier, W. T. (2016). Social capital and folk-lending in China’s hottest financial market.

Folk Lending and P2P: Monitoring Maturation in Chinese Financial Contracting 187

(1) While the possibility of a loan being suddenly called by the inves- tor/capital-provider is lessened, the financial intermediary now has wide discretion over how to monitor the borrower/capital-requirer, how much to report, and the accuracy of such reporting. (2) Independently verifying the information provided through monitoring is now more dif- ficult for the lenders/capital-providers who are now usually geographically distant and so cannot verify projects by looking at them (note Agarwal, Li, Liu, & Zhang, 2015, find that establishing personal guarantee on a loan may help to lessen this problem). (3) The removal of this geographic prox- imity removes the disciplining nature on P2P to which intermediaries and borrower/capital-requirers under folk-lending may be subject. That is to say, the “moral constraints” Jiang mentions are even weaker (Table 8.4).

(4) These weakening moral constraints have led to systemic-level issues under P2P lending, which increase monitoring difficulties. One related problem is what Chen, Hu, Lou, and Yong (2015) analyze as herding behav- ior, in which lenders/capital-providers invest capital by following others.

Table 8.4 Six monitoring problems arising under peer-to-peer online lending platforms (P2P platforms (P2P ping tai, 平台), or simply P2P) Number Monitoring problem Reason for problem

1 Gates on removal of capital mean dependence of P2P for monitoring

P2P platforms may choose to not monitor, monitor but provide only positive information, or release flowery descriptions of borrowers/ capital-requirers’ positions

2 Independent verification of monitored information difficult

Geographically distant lenders/ capital-providers cannot verify projects by looking at them

3 Even weaker moral constraints

Geographically distant P2Ps

4 Systemic weakness due to immaturity, information asymmetry, and “runaways”

Lenders/capital-providers engage in herd behavior while P2P bosses absconding with capital are now commonplace

5 Low bar to entry into lending channel

Not clear that many lenders/capital- providers have the skill set to properly monitor

6 P2Ps act like real banks Chinese P2Ps are taking in capital, then allocating to of borrowers/ capital-requirers

Source: Author’s conception.

The China Business Model188

They attribute this to two possible reasons: immaturity of loan market due to information asymmetry, and a closely linked reason: inexperience on the part of lenders/capital-providers. This is has led to a certain ennui on the part of the investing public: “Runaway P2P bosses are no longer newswor- thy,” as the Economist (2016) quoted from a Jinling Evening News article.12

(5) P2Ps also have very low bars to entry, just as with folk-lending. The skill set required to clear this low bar is different, though. Whereas the potential entrant in folk-lending requires only contacts or a bit of capital, the potential P2P entrant only requires skill in coding an elegant website. Once up and running, the physical location of the P2P is sometime dif- ficult to uncover, leading to confusion as to which government agency is tasked with that P2P’s regulatory responsibility (interviews with Local Finance Management Bureau officials).

(6) Many Chinese P2Ps are acting like real banks. That is, they are taking in capital, then allocating to borrowers/capital-requirers rather than merely acting as transparent conduits connecting investor/lender and borrower/capital-requirer, as American P2P platforms do. However, if Chinese P2Ps were actually banks they should be licensed and regu- lated by the CBRC and subject to capital requirements set by the PBoC. Yet, a CBRC official told me in April 2015: “Since we have not issued bank licenses to any P2P platforms, they cannot be banks.” But the Senior Director of one of Wenzhou’s largest and most profitable P2Ps countered in another interview, “Yes of course we are a bank. Chinese P2P are not like American P2P [in acting as capital conduits].”

Wenzhou P2P are involved in a full range of financing, including to individuals, SMEs, crowd-sourced projects, and recapitalization, and work- out restructurings of bankrupt businesses (interviews). Yet, regulatory responsibilities for Wenzhou-based P2Ps had been pushed onto the Local Financial Management Bureau, which was not sufficiently staffed to han- dle so many P2Ps and their very rapid growth. Interviewees from banking, regulation, and academia all stated that they believed P2Ps were indeed banks; many argued that P2Ps were funding stock market speculators and so partially responsible for the spike in equity prices from late-2014 until summer 2015. P2Ps were not, however, pulled under regulatory juris- diction of the CBRC in summer of 2015, and this regulatory transition remains a work-in-progress. Over the last four decades, financial inter- mediation in China has grown increasingly sophisticated, with impressive

12 One of China’s top newspapers, based in Nanjing.

Folk Lending and P2P: Monitoring Maturation in Chinese Financial Contracting 189

development in “fin tech” (financial technology) channels such as P2P, but with all this sophistication, it is difficult to see delegated monitoring progress if public monitoring of China’s fastest-growing lending channel (Caijing, 2014) is inadequate and poorly coordinated.

8.5 FINAL THOUGHTS: MONITORING AND THE SOFT BUDGET CONSTRAINT

Throughout Chinese SMEs’ rapid growth, questions and problems arose as to informational asymmetry and transparency surrounding their financial state and resulting misunderstanding of their debt obligations. The finan- cial health of weak SMEs was often not known until an SME collapsed. At that point, there would usually be a struggle over what entity was actually responsible for the debts incurred. Sometimes local governments would be the final guarantor, sometimes entrepreneurs and firm owners were held responsible, other times, financial intermediaries were left with the accu- mulated debts. Nearly always, the SME’s workers suffered sudden loss of income, and occasionally loss of ownership shares.

These issues could be partially addressed through enhancing monitor- ing in financial intermediation. Delegated monitoring confers governance, influence, and responsibility upon a financial intermediary. That respon- sibility comes with a price that many delegatees may not wish to pay. Delegating this responsibility for monitoring may make formal financial institutions the targets of additional blame for financial crises, would likely limit margins and increase taxes for informal financial institutions and cap- ital-providing individuals, and bring into view the operations of borrow- ers/capital-requirers who may prefer to keep their financial operations out of view. There has been little motivation on the part of Chinese govern- ments, whether local or national, to give over some governance power to financial intermediaries.

Delegated monitoring is not the mirror image of the soft budget constraint, but their converses are intimately related. We can compare across monitoring, soft budget constraints and the present state of infor- mal finance channels by examining the inherent options of exit, voice, and loyalty available to financial intermediaries. A lender/capital-provider suf- fering under a soft budget constraint is only allowed loyalty. Any financial counsel given is spoken sotto voce, as making public a borrower/capital- requirer’s weakened position is not an option. Exit is also not an option, as the lender/capital-provider is locked into a position as a near-captive

The China Business Model190

capital supplier. Monitoring gives voice to the lender/capital-provider, through both her ex post and ex ante actions regarding the borrower/ capital-requirer. She may also show loyalty, through sound financial coun- sel, or exit the position. Both of these actions actually give voice as well, as observers see the action of the lender/capital-provider, anticipate the implicit signals in her monitoring, and then react. Financial interme- diaries in informal financing channels have two options, loyalty or exit. Monitoring—i.e., using voice—is not required and little is gained from vol- untary monitoring. Loyalty may be given in situations where a lender/cap- ital-provider knows the counterparty quite well and is willing to increase her risk exposure. When the risk exposure seems too large and private information gives an advantage, exit is sometimes an available option.

A debate now rages as to whether government organizations should play an intermediate role in financial contracting, including directing state- owned banks to provide direct financing to SMEs (Ding, 2012; Shi & Ye, 2001), or establishing innovative financial organizations that serve SMEs (Guo & Liu, 2002; Lin & Chen, 2012). Additional government intervention will not strengthen Chinese banking and financial markets, nor would it necessarily benefit society. The next major step in Chinese financial inter- mediation is to empower financial intermediaries to use their asymmetric information advantages by delegating monitoring to them, then hold them to the set of responsibilities which come with that empowerment. This will not only improve financial information flows, but also bind Chinese finan- cial intermediaries into more robust and resilience financial governance.

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