China’s Bubble Metastasizes: Fraud, Corruption And Reckless Speculation Cropping Up Everywhere

Bankruptcies Rock Loan Guarantors

In China, loan guarantors are going bust at a sharp pace. Many more bankruptcies are on the way. The setup is quite reminiscent of the implosion of credit insurers Ambac and MBIA during the US housing bust.

The South China Post reports Bankruptcies Rock Loan Guarantors.

Mainland loan guarantors have found themselves ensnared in the woes of the underground banking sector following a fresh wave of bankruptcies around the country.

Creaking under the weight of bad debts, hundreds of guarantee groups would be unable to bear even more, although their services are critical for the economic system and the millions of small firms that provide the majority of the mainland’s jobs.

“It is by all means a risky business,” said Wang Xiao, a Zhejiang entrepreneur who invests in a loan guarantee business. “An increasing number of loan defaults will soon force us to close down the business.”

In Wenzhou, nearly 90 per cent of loan guarantors have failed since the start of the credit crisis arising from the underground banking system, according to the media.

“It could become the last straw that breaks the camel’s back,” said Yan Yipan, the head of law firm Zhejiang Panyuan, which mainly deals with cases related to financing. “Without the loan guarantee services, it will be more difficult for small companies to do business.”

Rampant loan-shark schemes in Wenzhou resulted in the collapse of the city’s economy, with dozens of underground banking operators and investors either committing suicide or fleeing the country.

In Guangdong, the financial authorities said more than 30 loan guarantors had failed so far this year, while in Sichuan, the provincial government revoked 12 loan guarantee licences.

Anatomy of China’s Credit Bubble

I picked up the above reference from Macro Business Australia in its report on the Anatomy of China’s Credit Bubble.

The credit guarantee system is very large because small and medium businesses cannot obtain bank credit. This demand brings in many investors looking to earn high rates of return lending to small and medium businesses. Given the way the firms are set up and run, with many firms thrown together by people with lots of cash to invest and little to no experience, to say nothing of those individuals using these companies as a way to defraud banks, the potential for crisis when credit growth in the economy slows is obvious.

Today, we have a very fresh example: the company at the center of the Qingdao port scandal, Dezheng. The story below is a result of Dezheng’s fraud, but keep in mind that Wu Xiaoling has fingered credit guarantee companies as part of the cause of the crisis, Wu Xiaoling: Qingdao Port Scandal Fault of Banks Relying on Credit Guarantees.

Credit guarantees played a role in fraudulent borrowing. These borrowers then open their own credit guarantee firms and either aid others in fraudulent borrowing, or use the credit guarantee firm as a way to earn a high rate of interest on their fraudulently obtained money. Much of this credit may be tied up in the real estate market. Low income borrowers can borrow their down payment from a credit guarantee firm. Real estate speculators can obtain capital through credit guarantee firms.

Legitimate companies in need of financing may also have borrowed, such as glass or furniture companies strapped for cash due to the slowdown in the real estate market. This is why the Chinese press sometimes refers to “stranded capital.” Since real estate developers aren’t paying their bills on time, their suppliers can’t pay their bills, and this exposes credit guarantee companies to losses in the best of cases, and jail time in the worst of cases where fraud is involved.

At its most simple, this is the story of a credit bubble. Lenders all around the world chase high profit, high interest loans when the credit bubble inflates. Credit growth and a growing economy create a temporarily low risk environment where losses are limited. Poorly managed firms ignore or miscalculate the risk of the inevitable bust and when credit finally tightens, firms that didn’t get out ahead of time find that only a few bad loans can wipe out years of profits.

In China, these credit guarantee firms are networked. A city or industry could have several or dozens of companies all with interlocking guarantees. Dozens more companies are involved because they obtained credit through one of the guarantee firms. Dozens more are involved because they made private loans at high rates of interest to the credit guarantee firms. Failure of one or two key firms in a city or industry can freeze credit overnight as creditors try to figure out who owes what to whom. This is a nightmare even if no fraud is involved. Toss in fraud and now credit is completely frozen by court order, company bosses suddenly disappear and yet more tertiary companies are involved because companies they transact with cannot move their funds.

Finally, the risk to the banks is not small. At the end of the day, credit guarantee companies are the thin veneer between Chinese banks and a mountain of potential bad loans.

Beijing Residents Use Credit Guarantors to Speculate on Real Estate

Also consider Beijing Residents Use Consumer Credit to Speculate on Baoding Real Estate; Yet Another Source of Bad Debt.

It works like this: a customer needs to spend 0.5% of an items cost, and then the credit company agrees to pay the rest. The shop creates a real invoice to give to the bank, and the credit guaranty company is responsible for transferring the money from the dealer to the customer.

Customers can receive loans for up to 9 years, but they need to be able to repay the loan during each loan period, usually 1 year. If they cannot pay the loan back, the credit guaranty firm charges 3.5% monthly interest. The customer borrows again from the bank, but they have to pay back the credit guaranty firm.

Of course, this way of doing business threatens the quality of loans on the bank’s books. In 2013, the NPL ratio for consumer credit was not only on the high side, but it is increasing rapidly. Since these consumer loans can go for as long as 10 years, the extent of bad debt has yet to be fully exposed.

Works Fine Until

Massive speculation works fine as long as home prices rise. Speculators can unload the property down the road to the next greater fool.

But when the pool of greater fools runs out, or prices tumble for a lengthy duration, the party is over.

We appear to be at that stage now.

Corruption Cases on the Rise

The LA Times reports In China, Corruption Cases Keep Cropping Up

Reports of corrupt Chinese officials seem to be a dime a dozen these days, and it’s easy for readers to get blasé about such news. So this week, the Beijing Youth Daily provided its audience with a helpful info-graphic to highlight the case of Wei Pengyuan.

Wei, deputy director of the coal division of the National Energy Administration, was found with 100 million renminbi — $16 million — at his home, the financial news publication Caixin reported this week, citing unnamed investigators.

Since the 100-renminbi note is the largest-denomination bill in circulation, that means that Wei’s alleged stash presented a bit of a storage problem. Such a hoard, if stacked in one tall tower, would reach 328 feet high, the Youth Daily said. Laid out end to end, the haul would stretch 96 miles — the length of Beijing’s Third Ring Road and Fifth Ring Road combined.

Investigators had to bring in 16 cash-counting machines to tally the money, Caixin said; four of the devices — which can process 1,000 bills per minute — burned out in the process.

How exactly Wei kept his cash wasn’t disclosed, but other officials with large piles of money have gotten creative. In recent years, Chinese media have reported on a provincial party secretary found with 25 million renminbi in safe deposit boxes; a former provincial construction chief who hid 20 million renminbi in a hollow tree trunk, a toilet and a rice field; and an ex-highway bureau boss who kept 2.8 million renminbi in a trash dump.

President Xi Jinping has vowed to crack down on graft both at high levels (“tigers”) and at the grass-roots (“flies”), and the cases just keep rolling in at a mind-numbing pace. In the first three months of this year, prosecutors investigated 8,222 cases  — up 24% compared with the same period last year, the Supreme People’s Procuratorate said this week.

More than 10,800 officials were involved, up almost 20%, and “major cases” made up 82% of the total, the state-run China Daily newspaper reported.

Perhaps no case is as highly anticipated as that of Zhou Yongkang, the nation’s former top domestic security official and ex-overseer of the national oil industry. The government has yet to make any official announcement about Zhou, but he has not been seen in public since last October and speculation is rife that formal corruption charges are in the offing.

In recent months, scores of his relatives, friends and associates — perhaps as many as 300 people, by some accounts — have been detained or questioned.

In March, a Reuters investigation reported that authorities had seized $14.5 billion worth of assets from Zhou’s family and associates.

Beginning of Tidal Wave?

Earlier today I commented on the recent flood of all-cash buyers investing in California real estate.

Lawrence Yun, Chief Economist for the National Association of Realtors says the “share of money arriving from China is likely to keep growing” and this is the “Just the Beginning of a Tidal Wave” of buying.

Questions for Yun

  1. Are credit guarantees, fraud, and capital flight at the beginning stage as well?
  2. Are you totally oblivious to what is happening or are you simply doing your job as chief proponent of the NAR’s perpetual “Never a Better Time to Buy” thesis?

Mike “Mish” Shedlock