1. INTRODUCTION
The private (informal or underground) lending market is made up of private money lenders, loan sharks, and pawnshops, which provide an additional source of capital for households or entrepreneurs. These financing institutions are not licensed or supervised by a regulatory or supervisory authority, distinguishing them from formal lending institutions. Serving households and small enterprises is a high-risk and high-cost business for banks due to higher transaction costs, unstable income streams, and low capabilities to repay the debt. As a result, lending to these borrowers may incur higher default risks due to the lack of sufficient collateral or credit information. However, the strong demand from these borrowers to gain access to capital has resulted in increased demand in the private lending market, which widens the gap between the formal and informal sectors and pushes up higher interest rates.
This article focuses on the private lending market in China, which not only supplements the formal financial system by serving the lower end of the market, but also accumulates the potential risks further eroding the efficient financial market. The article proceeds as follows: Section 2 describes the on-the-ground reality of the private lending market—a severe economic phenomenon in China—and particularly focuses on the recent runaway crisis caused by serious defaults in the private lending market. Section 3 tries to understand the government’s traditional approach towards private lending through the lens of the Wu Ying case. Sections 4 and 5 focus on two new responses to the runaway crisis caused by the frequent defaults in the private lending market. The government makes an attempt to legitimize and formalize part of the underground lending market through local experimentation in Wenzhou. Meanwhile, the Supreme People’s Court is liberalizing its previously rigid judicial attitude towards contract-based interest rates in private lending. These two responses are important to understand the liberalizing trend in China, switching its financial market from financial repression to financial liberalization. Section 6 offers some analytical interpretations of private lending regulation, namely law and society, and law and finance approaches. A short conclusion ends in Section 7.
2. PRIVATE LENDING’S ON-THE-GROUND REALITY IN CHINA
The private lending market connects China’s army of savers with mostly small borrowers unable to access formal lenders, who may end up paying exorbitant annual interest rates. As private lenders or financing institutions are not viewed as formal banks, the private lending market has not been targeted by the national or international financial regulatory authorities. This, however, does not suggest that the risk is minimal or that there is no systemic risk, which, in the context of banking law, usually refers to substantial losses that are related to the entire banking system given the involvement of savings, interbank loans, and the central bank’s lender of last resort lending. The misperception is that the underground lending market will cause systemic risk and should be regulated as part of the formal banking sector. Technically, the underground lending market does not involve systemic risk due to its disconnection with the central bank’s lender of last resort function. In other words, underground lenders and borrowers are not connected with the formal bank lending. On the other hand, the risk of private lending is mounting in China while the government intensifies its efforts to discipline risky lenders and calm exuberant credit growth, with the purpose of pushing away borrowers from informal or private lenders. Due to the lack of regulatory oversight and the uncertainty of the macroeconomic environment, the private lending market can be the most vulnerable sector in China’s shadow-banking sector and is thus viewed as the largest risk to China’s financial stability.
It is technically difficult to accurately estimate the size of the underground lending market, as most informal lending is executed through private negotiations and contracting. There is no formal reporting or filing system for informal lending. The People’s Bank of China (PBOC), Ministry of Finance or China Banking Regulatory Commission (CBRC) does not release official statistics on informal lending. Occasionally, there are news reports quoting officials’ comments, which may disclose some relevant information, drawing an incomplete picture about the underground lending market.
The underground credit market, which is the least regulated and least transparent subsector in the private/informal lending market, is estimated by the PBOC and private sector analysts at 2 to 4 trillion yuan (US$325 to US$650 billion)Footnote 1 or as much as 7% of total lending.Footnote 2 In some areas, informal lending exceeds that of official banks.Footnote 3 It has been estimated that such informal lending amounts to about US$630 billion (or even US$2.6 trillion)Footnote 4 a year, or the equivalent of about 10% of China’s Gross Domestic Product (GDP),Footnote 5 while the formal lending market offers 135% of GDP as of 2012. Comparatively, the underground lending market in China is smaller than in India (26% of GDP) and Thailand (47% of GDP).Footnote 6 Some sources noted that the size of undergrounding lending in China accounted for 33% of the entire shadow-banking sector in 2011.Footnote 7 Unlike other major sources of funding for shadow banks, assessments of what underground lenders get up to are intelligent guesses at best, as informal lenders are the least transparent of the market players in China’s shadow-banking system.Footnote 8
During the current economic downturn, credit tightening began to hurt China’s non-state small and medium-sized enterprises (SMEs). State-owned banks cut the small amount of private sector lending they provided even as they continued to support the state-owned sector. Many cash-strapped firms were unable to borrow from banks due to the credit clampdown by the government. As a result, some of them have had to turn to China’s underground lending market—which pools money from individuals and firms.
SMEs and farmers are generally poorly served by the larger state-owned banks and frequently have no option but to turn to these informal lending firms. State-owned enterprises (SOEs), however, find it significantly easier to secure funding from the state-owned banks. Large SOEs are able to obtain over 75% of loans from state-owned commercial banksFootnote 9 at a 7.2% interest rate, compared with the one-year benchmark interest rate of 6.56%. Through third-party companies such as financing firms, SOEs can then lend money at higher rates to SMEs.Footnote 10 SMEs have been severely marginalized by the state banking system. In 2013, 23.2% of bank loans, of which 4.7% were short-term working capital loans, were extended to SMEs.Footnote 11 The World Bank’s survey confirmed that, during the period from 2011 to 2013, only 25% of SMEs obtained bank credits and 90% used internal financing.Footnote 12 It is claimed that China’s private sector has missed out on the credit boom over the past eight years—private sector debt has fallen from 48% of total assets in 2008 to 35% in 2015 while the state sector debt rose to 53%.Footnote 13 The general estimation was that 10% of SMEs have access to formal bank loans, while they account for 65% of the workforce and 60% of China’s GDP.Footnote 14
The private lending craze has fuelled an economic bubble and the “runaway episode” in Wenzhou—China’s entrepreneurial capital, a city of about 9 million people on the eastern coast of Zhejiang province. Wenzhou is a city famed for its savvy, risk-taking merchants, and well-known for its strong entrepreneurial activities and underground banking industry. A PBOC survey reported that 60% or so local businesses and 89% of households in Wenzhou had loans from the underground banking in some forms.Footnote 15
The global financial crisis that started in 2008 caused a fall in overseas orders, rising raw material costs, resulting in a firmer yuan. Weak demand and surging labour cost also dragged down many SMEs. The once thriving underground banking system began to fracture, exposing new fault lines in China’s economy. The staggering rates—consisting of the lending rate and deposit rate at more than 15 times China’s benchmark lending rates—have pushed some firms to the limit.
Starting in 2011, the state media reported that nine bosses of small-sized firms in Wenzhou had fled town after realizing that they could not repay their corporate loans. Corporate failures in Wenzhou sparked a series of suicides and runaways of some entrepreneurs who were making their interest payments of as much as 7% a month to informal lenders in order to keep their businesses afloat.Footnote 16 A string of Chinese entrepreneurs have since gone into hiding in an attempt to avoid repaying loans.Footnote 17 During the credit crunch in 2011, many private business owners in Wenzhou were reported to have disappeared, committed suicide, or declared bankruptcy.Footnote 18 Two heavily indebted Wenzhou-based entrepreneurs jumped to their deaths and nearly 100 business owners fled their factories, leaving piles of unpaid loans behind.Footnote 19 This caused a surge in the number of lawsuits concerning private lending disputes in Wenzhou to 19,446 in 2012 from 2,896 in 2007.Footnote 20 Some media outlets even reported that there were more than 80 suicides or bankruptcies by indebted businessmen in a four-month period in late 2011.Footnote 21 The runaway crisis highlighted a credit squeeze on private firms and the dangers of steep interest rates in China’s vast and growing informal lending market.
3. THE WU YING CASE AND TRADITIONAL TIGHTENED-UP APPROACH
Along with the “runaway episode,” there were “illegal fundraising” cases that not only indicate the risky side of underground lending, but also demonstrate the government’s traditional approach eliminating these illegal fundraising activities so as to remove potential risks.
Across the country, borrowers have been arrested for failing to repay loans running into billions of yuan (hundreds of millions of dollars). In Zhejiang province alone, 11 people have been sentenced to death since 2009 on charges of “illegal fundraising.” Among them was a 31-year-old woman, Wu Ying, who once was praised by state media as one of China’s most successful businesswomen. Wu Ying, probably China’s best-known underground lender, was jailed for life in 2012 for raising 770 million yuan (US$120 million) from investors from 2005 to 2007. She was said to have invested in over 700 shops and 20 cars, including four BMWs and one Ferrari. This 31-year-old woman was convicted of illegal fundraising. Wu Ying began her career at 15 working in her aunt’s beauty salon in Zhejiang. She went on to establish a business empire. Her business included the Zhejiang-based Bense Group, which runs hotels, wedding planners, laundry shops, a logistics company, and other investments. Amazingly, in 2006, aged just 25, she was named China’s sixth-richest woman by Hurun Report, a wealth research magazine.
Wu Ying was arrested in February 2007 and was held for two years before she faced charges of embezzling nearly 380 million yuan from 11 people, in what the China Daily described as “one of the country’s biggest financial frauds committed by a woman.” Initially, she was charged with illegal fundraising, which carried a maximum penalty of 15 years in prison and would have been heard at a district-level court. As investigations proceeded, the charges were altered so that she was accused of fundraising fraud when the case eventually came to trial. In spite of her denial that she had cheated anyone and that all the money she had borrowed had been invested rather than used for personal use, she was sentenced in 2009 by the Jinhua City Intermediate Court in Zhejiang Province to death on charges of fraud and “illegal fundraising,” violating the Criminal Law aimed at fighting underground banking, financial improprieties, and loan-sharking.Footnote 22 She was stripped of her political rights and all her possessions were confiscated. She later lodged an appeal within the 10-day period for appealing her sentence. On 7 April 2009, judges from the Zhejiang Higher People’s Court presided over an appeal hearing in the No. 2 courtroom of Jinhua City Intermediate Court. In the appeal, she switched her plea on the lesser charge of “illegally collecting deposits from the public” to guilty.
Since 2007, China has required that all death sentences be reviewed and confirmed by the Supreme People’s Court, which was Wu’s final chance of reprieve. Due to public outcry, in an apparent effort to mollify critics, Wu Ying was resentenced by the Supreme People’s Court to death with a two-year reprieve, which usually is commuted to a long prison term. Technically, she still faces the death penalty, but the two-year reprieve means it will probably be commuted to a life term if she is deemed to have reformed. Public support for the death penalty for non-violent crimes was falling. Apparently, public opinion affected what was coyly called “judicial independence” in the case of Wu Ying.
The case has unleashed a grey area about illegal fundraising and private financing. Private fundraising is illegal but common in China, especially in Zhejiang and other provinces where the private sector is strong. There are two crimes that one could be accused of. One is the crime of fraud in fundraising under Article 192 of the Criminal Law and the other is the crime of illegally taking deposits from the general public under Article 176 of the Criminal Law. The maximum sentence of the second crime is only ten years.
Illegal fundraising is composed of the following key elements: (1) absorbing funds without approval from the relevant government department in accordance with the law; (2) making use of public means of solicitation, such as the media, promotion conferences, leaflets, and text messages on mobile phones; (3) engaging in undertakings to repay the principal and interest or to pay a return in the form of currency, property in kind, or equity within a certain timeframe, or (4) absorbing funds from the general public, namely non-specific targets in society.Footnote 23 Illegal fundraising crime may also be disguised in other forms as long as the above elements are satisfied.Footnote 24 Among these four elements, raising funds from the general public is the most important condition, illustrating the scale of damage the crime can bring to the financial system.
Wu Ying was initially charged with illegally taking deposits from the general public, but those charges later escalated to fraud in fundraising as a private lender. Obviously, the court of first instance, considering the severity of the case, has referred to the first. However, what is unusual is that, if it is a fraud concerning hundreds of millions of yuan, there should be a lot of victims. The indictment said she had raised money illegally from 11 people, with unreasonably high interest rates promised and never delivered. There is no evidence that Wu Ying’s activities caused harm to anyone, except possibly some rich investors. The Criminal Law stipulates that financial deals can be punishable by death if the money involved is “an especially large sum,” which, however, is not explicitly specified.
The fact that no such widespread appeals for compensation appeared in the media suggested that Wu Ying should not be charged with violating Article 192 of the Criminal Law, but rather Article 176. Wu’s lawyer insisted that she did not swindle funds from the public, but raised money from friends and did not use it for illegal purposes or personal indulgence.Footnote 25 The court may have instead placed more emphases on the amounts involved and the prosecutor felt obligated to go beyond the sentencing constraints of Article 176 and purse Wu Ying on the other charges.
Wu Ying’s fundraising activities clearly violated the Criminal Law. However, the law concerning illegal fundraising is itself controversial and criticized not only by the general public, but also academics. The Criminal Law is meant to regulate the financial market that has a substantial impact on the society and to safeguard the financial sector, as the government advocated, in the best interest of financial stability. Accordingly, the criminal liability is meant to be a deterrent towards criminal behaviour. The death sentence, however, may be excessively harsh if its sole purpose is to deter crime, as the impact on the financial sector of this type of “crime” is less severe than crimes that deserve the death penalty. The supreme penalty therefore is meted out with the goal of suppressing informal finance, which benefits the official financial channels.
In China, “illegal fundraising” outlaws various kinds of investment schemes. There are differences between illegal fundraising and private lending, but no distinct boundaries are clearly drawn by the law. The charge has been used to sentence private lenders. The purpose of the Criminal Law and the imposition of criminal liability on illegal fundraising is not only to discourage the informal credit market, but also to protect state-owned banks. The side effect is an apparent attack on the entrepreneurial sector at a grassroots level, which can no longer fund itself through informal means and personal savings.
China’s Ministry of Finance and the State Administration of Foreign Exchange has been cracking down on underground banks since 2002. The Chinese authorities have shut down over 500 underground banks, with over 100 cases involving more than 20 billion yuan in illegal funds.Footnote 26 Leaders, including the ex-Premier Wen Jiabao and other top economic officials, repeatedly promised more credit for small companies.Footnote 27 The government allowed the underground lending market to grow over the past decade, apparently seeing it as necessary to support entrepreneurs.
Zhejiang province alone has about 2.4 million non-state companies with an output valued at more than 1.5 million yuan and abounds with underground banks for cash-strapped small businesses. About 80% of the SMEs in Zhejiang are using underground banking loans to fund their businesses, albeit the fact that the black market interest rates in the province have surged as high as 10% monthly. About 600 billion yuan flows through the province’s underground banking system a year.Footnote 28 In 2011, Wenzhou’s underground lending market amounted to 110 billion yuan, which was 20% of the entire city’s banking loans.Footnote 29
4. REGULATORY RESPONSES TO RUNAWAY CRISIS: WENZHOU PRIVATE LENDING REGULATIONS
In response to Wenzhou’s plight and with fears that Wenzhou’s economic stumble could reverberate throughout the rest of China, the Chinese government in 2012 launched a pilot scheme to funnel more money to private enterprises in Wenzhou. A pilot project was approved by the central government, allowing private lenders in Wenzhou to register as private institutions that can operate with the blessing of the state.
Wenzhou passed the Private Financing Regulations to legalize underground lending that previously led to a local financial crisis. The Wenzhou Private Financing Regulations (passed at the sixth session of the 12th Standing Committee of the Zhejiang Provincial People’s Congress in November 2013) are the first of their kind in China, aimed at turning underground lending into acceptable credit and benefitting SMEs that find it difficult to obtain loans from banks. The Regulations—effective as of 1 March 2014, with seven chapters and 50 clauses—specify regular private financing operations, risk control measures, and legal liabilities.
The Regulations essentially legalize the underground lending market, allowing it to be part of the formal financial institutions. This move reflects efforts by both national and local authorities to increase the transparency of private lending and discourage regulatory arbitrage in the wake of a crisis that broke out in 2011. The financial reform in Wenzhou underscores the central government’s recognition of the plight of small businesses, which have been sidelined in its credit binge in the past few years. It was the first piece of local regulation in China to turn grey-market lending into acceptable credit, to support cash-thirsty SMEs whilst reducing financial risks.
Private financing developed extremely fast following China’s 4 trillion yuan stimulus package in 2009, and became rampant when the country adopted a tightening monetary policy in 2011. SMEs then turned to underground lending to raise money. It is said that 89% of households and 57% of firms in Wenzhou were involved in private financing, with total capital estimated at 110 billion yuan.Footnote 30 In 2012, nearly 26,000 lawsuits relating to private loans were filed in Wenzhou—almost six times the number of suits in 2011—with the aggregate amount in dispute of approximately US$7.5 billion.Footnote 31 Private loan defaults started to soar in 2011, increasing from 0.37% in early 2013 to 4.31% in late 2013.Footnote 32 The Regulations legalize private lending channels for 400,000 local SMEs to get finance in Wenzhou and help individual investors to gain investment returns.
Private lending has a high degree of heterogeneity, opacity, and diversity in terms of business models and lending patterns. Technically, this shadow-banking subsector is hard to monitor or regulate. Circular No. 107 divides the private lending sector into two categories: first, underground financing that is largely unregulated; and, second, petty-loan companies, pawnshops, and financing leasing companies. The regulation of these micro-finance firms needs to be improved. These micro-finance firms are not allowed to take deposits, make shark loans, or collect loans through illegal means.Footnote 33 Petty-loan companies are supposed to use self-owned funds for lending while they can get finance from commercial banks.Footnote 34 Pawnshops and financing leasing companies are not regarded as financial institutions in nature and their business scope is strictly regulated.Footnote 35 In addition, pawnshops must not increase leverage and finance leasing companies must not on-lend bank loans and relevant assets.Footnote 36
The strategy applied by the Private Lending Regulations is to formalize the private lending market by paving the way to convert underground loan companies into local banks servicing SMEs. The key objective of the Private Lending Regulations is to guide the regulation of healthy development of private lending. Bringing private lenders under the regulatory umbrella should help to prevent and dissolve the risks of private lending, curb systemic risks, and promote better allocation of funds in economic and social development.
Unlike the preliminary draft, the Regulations do not specify the ceiling of the rate in private lending. The Regulations make the interest rate provision default rule by stipulating that the private lending rate will be set based on negotiations between the borrower and lender as long as it does not violate national regulations.Footnote 37 This sets a good precedent, by acknowledging the importance of a market-oriented interest rate formation mechanism as well as leaving the government or regulators the ability to override the market when it chooses to do so. Currently, private lending is capped at four times the benchmark official lending rate. Private financing thrived in Wenzhou and many other places in China, such as small firms, often have no access to bank loans and state-dominant banks and so they prefer lending to large SOEs backed by local government credit. Considering that China’s shadow-banking system emerged out of a desire to circumvent tight regulation that restricts the flow of credit, the fact that the Regulations delegate a fair amount of control to the market, rather than the state or regulators, is a positive change.
The local financial management authority is required to monitor, calculate, analyze, manage, supervise, and check private financing.Footnote 38 It is charged with the task of instructing financing institutions to establish management systems to monitor risk control.Footnote 39 It is also granted with fairly broad power to ensure compliance with the risk prevention elements of the Regulations, in particular in terms of its ability to investigate potential violations,Footnote 40 as well as supervise the fulfilment of disclosure obligations.Footnote 41
The local financial management authority has the power to order a staff member of a private financing public service institution, who makes use of the convenience of its position to participate in private financing, or a practitioner of a private fund management enterprise or a private financing information service enterprise making use of convenience of its position to participate in private financing in the enterprise to seek improper interests, to make corrections. It may also give them a warning, confiscate their illegal gains, and fine them no less than 10,000 yuan, but no more than 100,000.Footnote 42
Often, the Regulations and the alike expose the tensions between encouraging growth and limiting instability in finance and credit markets. Clearly, the Regulations seek to legalize formerly underground lending institutions, thereby allowing for regulation, while creating a system of registration, disclosure, and obligations that are meant to improve transparency and discipline—both between the government and private lenders and between lenders and borrowers. The former should make oversight easier while the latter should decrease risky investment and borrowing. With this said, there is much action that the government could take in order to curb the risks. The most glaring deficiency is the failure to liberalize and marketize interest rates—a measure that would likely be the simplest and most effective way of curbing illegal lending. This can effectively increase the use of formal banking and decrease the widespread regulatory arbitrage.
The Regulations in Wenzhou are significant because these rules bring Wenzhou back from the brink and set a good example for other cities and provinces where underground banking is active to follow. The local government may have a better sense of the economic needs and may be privy to local information that the state is not aware of. The local government, at least in China’s context, may be in a better position to monitor and regulate systemic risks involving private financing businesses. The local experimental nature of this type of regulation should not be ignored given China’s unitary regime and centralized-governance model. The Regulations are supposed to embrace underground lending rather than to eliminate it completely, and to mend the inefficiencies of financial institutions in Wenzhou. The solution deployed in Wenzhou’s Private Lending Regulations is to formalize informal lending markets, which is used as a means to provide financial access to the private sector and inject more competition into the closed financial market. The Regulations are likely to play an active role in standardizing private lending. However, it is far from a comprehensive solution. The Regulations try to address many issues in relation to underground lending, but not many of the issues that caused the popularity of underground lending. It is unlikely to totally solve the problems such as small firms, which face financing difficulties. A shift in government policy for commercial banks would go a long way towards decreasing the need for underground lending. Clearly, deeper financial reform is necessary.
5. FOUR-TIMEs INTEREST RATE RULE AND INTERCOMPANY LENDING REGULATIONS
Private lending and borrowing activities among individuals and firms are not just subject to financial regulation. In principle, in absence of the parties’ agreement, the court may refer to the interest rate for the late repayment of loans charged by financing institutions as fixed by the People’s Bank of China (PBOC). The court may adjust that interest rate in accordance with any adjustments made by the PBOC from time to time.Footnote 43 Since the promulgation of the Contract Law, Chinese courts are more consistent in calculating interest rates by reference to the lending rate of the PBOC. As opposed to the United Nations Convention on Contracts for the International Sale of Goods (CISG), the Contract Law does not use interest as a remedy to recover the amount of damages caused by the breach, including loss of profit. Under the CISG, interest is recoverable independently from damages. As the PRC is a party to the CISG, the CISG is a source of law in China, and may apply when domestic laws contradict the CISG.
The Supreme People’s Court issued the second piece of judicial interpretation in relation to the Contract Law in February 2009. This piece of judicial interpretation came into force on 13 May 2009. Article 2 provides that, in addition to the primary debts, the obligator/debtor shall bear the interest and the expenses to realize the obligee’s/creditor’s rights. Chinese courts accordingly have the authority to award interest on prejudgment debts. The interpretation explicitly provides an obligation to pay interest independently from penalties or damages, without regard to fault or proof of loss. It is reasonable to assume that interest on damages for non-performance of non-monetary obligations may be recovered. However, the judicial interpretation still fails to address the method of calculating the interest to be awarded. Lending rates in excess of four times the benchmark interest rate is illegal.
On 6 August 2015, the Supreme Court of the People’s Republic of China issued the Regulations on Application of Laws to Certain Issues For Hearing of Private Lending Cases (Fa Shi (2015) No. 18) (the Private Lending Regulations), which came into effect on 1 September 2015. The Private Lending Regulations are introduced at a time when the increasing financing needs of SMEs cannot be fully satisfied by the banking system, and alternative financing solutions (including funding provided by an online peer-to-peer network, which is also covered by the Regulations) are being developed.
The Private Lending Regulations provide a much-needed legal framework for regulation of the increasing onshore lending activities undertaken by non-bank entities and present new opportunities and structuring options for both investors and lenders. The Private Lending Regulations apply to lending activities between natural persons, corporations, and other organizations, but exclude loans made by financial institutions.Footnote 44 In this section, the focus is placed on the provisions of the Private Lending Regulations, which change the legal regime on intercompany loans, and how such change may impact the way financing transactions involving PRC companies are structured.
Prior to the Private Lending Regulations coming into force, the making of intercompany loans directly between PRC companies was not allowed. Article 61 of the General Principles for Lending, promulgated by the PBOC in 1996, prohibits any direct or de facto intercompany loan. The PRC Supreme People’s Court confirmed, in a reply letter dated 23 September 1996, that any intercompany loan agreement should be null and void. In view of these legal restrictions, a PRC company wishing to borrow from, or lend to, another PRC company would need to enter into an entrustment loan arrangement with a domestic bank, where the domestic bank acts as the funding conduit between the two PRC companies and charges a fee.
The position is changed under the Private Lending Regulations, which made clear that, subject to limited exceptions, an intercompany loan agreement entered into for production or operating purposes is valid and will be recognized by the courts.Footnote 45 That said, the validity of an intercompany loan agreement can still be challenged if the lender (not being a financial institution) regularly carries out lending business, or if money-lending activities have become its main income source of income, as, in such cases, the lender’s entry into an intercompany loan agreement may not be for production or operating purposes. This suggests that a non-financial-institution lender can only lend money on an ad hoc basis.
Under the Private Lending Regulations, interest, default interests, and other fees can be charged. As a rule of thumb, any interest rate on an intercompany loan, not exceeding 24% per annum, will be upheld by the courts.Footnote 46 The detailed rules are as follows: where the interest rate agreed upon by the borrower and the lender exceeds the annual interest rate of 36%, the agreed interest on the excessive part shall be null and void. If the borrower requests the lender’s return of the paid interest on the part exceeding the annual interest rate of 36%, the court will support such a request.Footnote 47
6. UNDERSTANDING PRIVATE LENDING AND ITS REGULATION IN CHINA’S CONTEXT: MULTIPLE ANALYTICAL APPROACHES
The “runaway episode” and “illegal fundraising” criminal cases, and the more recent local experiments in Wenzhou and the Supreme People’s Court’s judicial relaxation of private lending interest rates, present a dynamic picture of China’s underground lending market and regulatory and policy responses by the regulators and judiciary. This dynamic picture may be understood through a number of analytical lenses discussed in this section.
6.1 A Law and Society Approach
Entrepreneurs and private firms face barriers in accessing credit. This is an enduring structural feature in both advanced and emerging economies.Footnote 48 Research concludes that SMEs are financially more constrained than large companies, in both developed and developing countries.Footnote 49 Serving small enterprises can be a high-risk, high-cost business for banks; as such, borrowers have neither stable revenue streams nor repayment capabilities. Small, short-term, and unsecured loans do not economically justify the extension of credit from formal banks to SMEs. Borrowers usually do not have sufficient collateral assets and credit information, increasing not only the default risk of lending to them, but also the transaction costs for banks. Small enterprises, unable to meet the lending criteria set out by banks, may prefer informal lending as the loan approval process is much more straightforward. The difficulty in financing for SMEs is more severe in China. SMEs are more limited to financial resources than large companies in ChinaFootnote 50 as well as their counterparts in other Asian countries. The World Bank’s survey shows that, on average, Chinese SMEs receive 12% of their working capital from bank loans, compared to 21% in Malaysia, 24% in Indonesia, 26% in Korea, and 28% in Philippines.Footnote 51
In the Chinese context, this structural bias against SME financing not only has an economic logic, but also reveals political priority. Compared to SMEs, SOEs and larger firms usually have stronger connections with the government, which provide an implicit guarantee or subsidy to the bank credit. The logic development of limited access to the formal lending market is the increasing reliance on underground lending markets by SMEs. Financial exclusion worsens the equilibrium between demand and supply of financial resources. Commercial bank branches and ATMs per 100,000 adults are two key measures of financial outreach, evidencing a lack of access to formal finance. In China, there are only eight commercial bank branches per 100,000 adults, lower than an average of 19 worldwide and 35 in G7 countries, and 38 ATMs per 100,000 adults, lower than an average of 43 worldwide and 135 in G7.Footnote 52 China has a small micro-finance penetration rate compared with other Asian countries, evidenced by the number of active borrowers from micro-finance institution. In 2011, China only recorded 0.57 million active borrowers, far less than 26.49 million borrowers in India, and 20.88 million in Bangladesh, only slightly more than 0.46 million borrowers in Indonesia.Footnote 53
Most underground lending businesses are not truly illegal or prohibited. In jurisdictions where there is an interest rate cap, underground lending offering a higher interest rate above the cap is then prohibited. A closed financial market imposing restrictions on market entry also disallows underground lending, which operates outside of the formal banking sector without regulatory approval and regulatory oversight. These happen to be the restrictions in China. Lack of access to credit is identified as one of the major constraints for entrepreneurial activities in developing economiesFootnote 54 and an obstacle to economic growth and development in the long term. Empirical work confirms a correlation between the lack of credit access and poverty.Footnote 55 Higher interest rates, heightened costs of borrowing, and coercive measures for debt collections lead to larger household debt and massive social disruption. Therefore, social risks and impacts become the main concerns over the informal lending market. In China’s context, financial resources tend to flow from the high-efficiency private sector to low-efficiency state-owned one, the consequence of which is a further misallocation of capital and increasing of economic risks. While it has been well recognized that private lending is necessary to revitalize economic development,Footnote 56 an excessive number of underground lending markets impedes a country’s regulatory efficacy, thus making containing risks more difficult.
6.2 Competing Financial Growth Models: Financial Repression vs. Financial Liberalization
Stronger or more favourable protection of the state-owned banking sector helps the government secures less expensive sources of funding and to steer domestic savings to politically favoured investment projects or industrial sectors. This is a clear example of financial repression, which is used through coercive power, in the form of policy, law, or regulations to bolster myriad government policies.Footnote 57 Financial repression is composed of a package of political-legal policies, measures, and rules, which shift the benefits of consumer capital from the individual to the state, thereby ensuring lower costs of financing. These measures are put in place to provide SOEs or policy-biased industries with subsidized credit. Without financial repression and contingent cheaper funding, the mushrooming public debt and low-efficient state-owned sectors may deteriorate faster. The by-products of financial repression include a weaker private sector, a monopolistic banking sector, and an unhealthy consumer finance system. Consequently, the financial system is not market-based, as the banks are unable to price loans properly and are heavily influenced by the government’s visible hands.
Financial repression is a shadow taxation redistributing capital and financial resources through policies instead of the market itself. Without an invisible hand, credit is misallocated,Footnote 58 increasing the instability and uncertainty of the financial systems.Footnote 59 Financial repression is invisible to financial consumers, even though it has the same effect on consumers as direct taxation. Financial consumers, for instance, have to pay higher transaction costs due to the limited supply of credits.
Financial repression, as a financial market development model or governance framework, was once popular among developed countries after World War II when these countries tried to secure cheaper funding to reduce war debts.Footnote 60 Nowadays, financial repression is more often seen in developing countries, while most developed countries have switched their financial development strategy towards financial market liberalization or liberalized financial system.Footnote 61 There are various forms of financial repression.Footnote 62 Developed countries may practise a light form of financial repression by imposing some restrictions on the players in the financial market. After the latest financial crisis, there has been a revival of financial repression in the developed countries where the governments used explicit or implicit caps on interest rates, tighter regulation on cross-border capital movements, and more directed lending to government by captive domestic investors. These measures are put in place to reduce debt rollover risks and curb rising interest expenditures. Developing countries, on the other hand, often practise financial repression heavily.Footnote 63 Typical measures include the market entry restriction, cross-border capital flow restriction, deposit interest cap, compulsory purchase of government bonds, and favourable policies towards a monopolistic position of banks or SOEs in the lending market.
China is characterized as a highly financially repressive regime,Footnote 64 imposing controls on credit, interest rate, exchange rate, capital flow, and market entry. Credit controls require state-owned lenders to grant loans to borrowers based on imposed quotas or favoured policies with the aim of achieving broader economic, social, and political objectives. As quotas or policies, other than economic criteria, are used or relied on to allocate credit, formal lenders are more likely to accumulate non-performing loans and suffer from undesired economic outcomes. In China, credit controls are reflected in policy lending, which often pursue policy goals instead of economic returns. Interest rate controls in China are formulated in the form of a ceiling on the deposit rate, the purpose of which is to limit the cost of borrowing. Banks, however, charge higher lending rates, which guarantee their profit margin and in turn reduce competition in the financial market. As the benchmark interest rate set by the central bank guides and determines both deposit and lending rates, the pricing of credit is less transparent and does not reflect the market price.
Through the suppression of interest rates below market rates, depositors’ savings are transferred through the banks to subsidize SOEs (including state-owned banks) and some policy-favoured industries.Footnote 65 This explains the Big Five’s (the Big Four plus the Bank of Communications) extraordinarily high profitability during the latest financial crisis. The Big Five’s combined profit rose to 674 billion yuan (US$108 billion) in 2011 from 121 billion yuan (US$19.4 billion) in 2005.Footnote 66 The economic contribution made by the private sector and SOE sector is in a stark contrast. Privately owned companies account for 70% of total employment on the mainland and 60% of China’s GDP.Footnote 67 By contrast, SOEs account for two-fifths of GDP and employ one-tenth of China’s workforce.Footnote 68 Reliant on state support and inexpensive capital, the SOEs have far lower returns on equity than private enterprises. Since the onset of the global financial crisis, SOEs (excluding banks) have delivered virtually no earnings growth, while the private sector profit growth was in double digits,Footnote 69 at an average rate of 18%. The average return on assets for SOEs was at about 4.6% in 2014, compared with 9.1% for private businesses.Footnote 70 Comparatively speaking, the state sector is merely two-thirds as profitable as their private sector counterparts.Footnote 71 SOEs apparently remain a drag on growth due to the mismatch between their earnings and cost of capital,Footnote 72 indicating that SOEs are inefficient in terms of capital allocation and utility.
In a financially repressed regime, the financial sector is not designed to serve consumers’ needs. Rather, the financial sector, in particular the banking sector, is utilized as a political-legal tool for the government to pursue broader political, economic, and policy goals at the expense of financial consumers. Although financial repression preserves China’s fast-paced economic growth and social harmony, it makes financial market liberalization and reform more difficult, due to the current supplementary institutional structures supporting the heavily financially repressed regime. Structural changes are likely to cause severe financial losses and encounter the prohibitively high switching costs due to path dependency. In addition, financial market liberalization may be blocked by some fractions such as the laggard SOE sector, which are beneficiaries of financial repression. Both commercial law and banking regulation should be crafted to reduce the number of legal restrictions necessary to regulate private enterprises and allow greater financial and entrepreneurial freedom.
6.3 A Law and Finance Approach
Although our understanding of the relationship between law and finance is claimed to remain at a theoretical infant stage,Footnote 73 the dominant view in the law and finance literature is that informal financial institutions play a complementary role to the formal financial system. The informal financial system cannot replace the formal financial system due to their incompatible monitoring and enforcement mechanisms. China has been often singled out as a counter-example to the law and finance literature’s focus on formal financial system and its contribution to the economic development.Footnote 74 As confirmed by empirical work, it is alternative financing and governance mechanisms that strongly support China’s fast-growing private sector firms’ albeit weaker legal protection and poorer access to finance.Footnote 75 The large underground lending market in China is one of such informal financing sources and involves several hundred billion dollars in bank deposits.Footnote 76 However, economically, as empirical findings also confirm, firms that rely on informal external financing do not grow faster or have higher productivity growth than firms that are bank financed.Footnote 77 This may explain that formal financing, as empirical research has confirmed, plays a larger role in enhancing productivity and economic growth.Footnote 78 It is not clear whether this market segmentation reflects the superiority of bank lending over informal lending. The underlying rationale may be that the banks take the best credits and attract the best-quality borrowers and then leave the rest to the informal lending sector. Another way of explaining the superiority of formal lending is the instability and unsustainability of underground lending, which is prone to boom and bust and is little regulated. On balance, the informal/underground lending contributes less to the overall economic growth. This may suggest that informal financing is not an effective substitute to formal financing channels in promoting economic growth.
The inefficacy of private lending in replacing formal lending may lie in the law and finance paradox.Footnote 79 First, informal lending, in contrast to formal lending, is positioned in the lower level of the financial market hierarchy. The investor protection law is less formal and effective due to informal lending contracts. Second, there is a lack of a formal role of the law in generating stronger credible commitments and regulating financial instability in connection with private lending. As explained in the beginning, private lending may be conducted through a weaker form of contracts. Law and legal enforcement mechanisms are correspondingly designed in a weaker form. Third, there is a stronger inherent tension between the full enforcement of contractual commitments in private lending and the self-destruction of the financial market. While the enforcement of private lending contracts is effective, the regulatory space is shrinking and the regulatory effectiveness has eroded as a consequence. The law and finance paradox appears to end up in a dilemma. The informal financing market, as part of the least regulated shadow-banking sector, involves various risks.
Nevertheless, the risks mitigate to the place where the government is least equipped to deal with it.Footnote 80 If SOEs and other large firms absorb the lower-cost regulated credit, then this deprives banks from developing the underwriting skills and statistical data in the SME market that are needed to help distinguish creditworthy SMEs from the others. Granted that information costs are higher for SMEs than for SOEs and larger firms, lenders still can protect themselves with initial parameters that they may adjust as better data become available. For instance, if one sector has on average much higher default rates than other small businesses, loans are unlikely to be granted to this sector in the first place. At the very least, the Wenzhou pilot scheme could be used to gain underwriting experience and loan-level data.Footnote 81 Also, it may be that a small amount of counselling (e.g. as to develop a realistic business plan) can help SMEs to be creditworthy. However, that only works if they have not been confined to an informal market with ruinous interest rates and fees. In this context, the idea of Stanton’s law was that the large formal sector—by absorbing all of the low-cost credit and probably all of the institutions with underwriting skills—drove even potentially creditworthy SMEs into a market where the risks were so high (high borrowing cost and informal lenders that were totally unequipped to run a sound lending business) that the borrowers were generally doomed to fail.
7. TENTATIVE CONCLUSIONS
Availability of finance is of great importance for SMEs and poor households, in the sense that credit can strengthen their capability to produce, innovate, and expand their small businesses, thus boosting productivity and increasing income. In the long run (as evidenced by the empirical cross-country studies), the availability of credit is likely to protect SMEs from financial vulnerability and to stimulate overall economic and social development.Footnote 82 The power of credit lies in the inherent force to distribute income opportunities more evenly and effectively among various constituents in the community. The significance of equal access to finance has been well recognized. Securing access to finance is perceived as a catalyst for attainability of the Millennium Development GoalsFootnote 83 and has been closed associated with the WTO Doha round of negotiation on international trade liberalization.Footnote 84
A vibrant private (underground) lending market in China is a natural market response to China’s interventionist approach towards not only banking regulation, but also macroeconomic policy. The overly protected and subsidized formal lending sector correlates with, leads to, and even increases dysfunction in the informal lending sector. As a counter-reaction, some market-based legislative and regulatory approaches have been offered by the government (via regulatory agencies) to mitigating the negative aspects of informal lending practices. Unlike the conventional containment strategy, which focused solely on balancing payments deficits or removing the underground lending market, these reformative policies are put in place to address the concern over the lack of access to formal finance. Partially formalizing the underground lending market in Wenzhou through legislative moves, allowing private investors to set up commercial banks and liberalizing interest rates, target the lack of access to formal finance. While these policy moves are important and will remedy some negative effects of underground lending, the extent of the problem, the role of government, and the range of sophistication in the financial systems may affect the efficacy of these solutions.
Without macro policies, the negative impacts on private firms could potentially cause deeper economic distresses and unexpected political unrest. The policy should place more emphases on the supply side of the financial market by offering more formal funding. Some market economy approaches can help strengthen the supply side. Microfinancing can be one solution, as it brings broad access to credit. Some good examples of this are Building Resources Across Communities and Grameen Bank in Bangladesh.Footnote 85 To make microcredit firms work, government support or public funding is a must. In a larger context, China needs to transform its financial market from a repressed one to a liberalized one. With credit controls and interest rate controls in place, the state-owned sector, large firms, favoured industries, and well-connected clients are more likely to secure more formal bank lending, at more favourable terms and conditions, namely at a lower interest rate. By contrast, small firms and start-up firms will have to pay higher interest rates or be subject to less favourable terms in the lending transactions. The equilibrium can be adjusted or rebalanced through the relaxation of financial controls and increasing of market competition. The broader policy implication is that informal financing should not be used as an ultimate solution to the financing gap problem that the private sector faces in China. Further, in a wider context, China’s imbalanced economy must be rebalanced through culling non-performing SOEs and nurturing smaller but more profitable companies in the private sector.
In the short term, in order to get a handle on debt without disrupting economic stability and societal harmony, China needs to continue to practice its opaque financial repression as the preferred approach to minimize side effects of its slowing economy, instead of a sudden switch to a financial market liberalization strategy. Nevertheless, in the long run, China needs a long-term comprehensive strategy to reform its credit and capital market, shifting the focus of debt relief from the serving of debt to fostering the economic development. To this end, reforming China’s financially repressed regime, which is not compatible with a modern consumer finance industry, is a must. Empirical work has unveiled a linkage behind the economic development that the more concentrated financial resources tend to be in a national economy, the higher the country’s level of poverty.Footnote 86 Access to finance can be used as a device to improve the imbalanced governance structure, which favours some constituents over others. Widening the channels to funding can be achieved through the opening-up and strengthening of the capital markets or the reform of the existing financial market by eroding the power of the incumbent elite groups.Footnote 87 Deeper financial market reform requires an effective institutional structure, which China does not currently possess. A top-down reform is needed to have a liberalized and bottom-up consumer-oriented financial market and financial regulatory regime, which present citizens with not only more economic benefits, but also economic and political rights.
