Why local officials are in a hurry to invest their capital

PUBLISHED : Saturday, 08 May, 2010, 12:00am
UPDATED : Saturday, 08 May, 2010, 12:00am

You have heard that Beijing has become nervous and ordered banks to investigate the 7.5 trillion yuan (HK$8.5 trillion) they have loaned to financial entities backed by local governments. So what's happening on the ground?

The story of one investment banker may offer a clue. He works on listing small private manufacturers with turnover of no more than 1 billion yuan.

The IPO market has always been a sure win. But our investment banker's job is not easy because his deals are not big and his clients are not sexy.

It used to take months of marketing, courting and waiting before he could get some pre-IPO investors for his clients. You would think that the falling stock market would be hell for him. But it is the opposite. His life could not be better. Ever since the May holiday, money has been pouring in.

'I got a call from a government financial entity in northern China the other day,' our investment banker said. 'He wanted to send in 30 million yuan to one of my clients. But it will be some months before my client becomes a shareholding company.'

Mind you, the starting point of a listing is to get the company restructured into a shareholding company. It will be another two years before it can apply for a listing. That is a long way to go.

But that did not bother the government entity's investment arm. Instead of waiting, it wanted the 30 million yuan to come in immediately as debt and be converted into shares upon the establishment of the shareholding company.

And the conversion price that determines how big a stake 30 million yuan will buy? Well, it was never discussed until the 30 million arrived in the account of the investment banker's client.

This scenario is not just happening in the north. The investment banker is seeing the same hunger to invest in the southwest.

Ever since March, his subordinates have courted the investment officer of the financial arm of a local government. They were looking for a pre-IPO investment of 10 to 20 million yuan for a client.

But every conversation was lukewarm. In early April, they offered a plant visit.

'I am quite busy at the moment,' said the investment officer for the local government. 'Let's touch base after the May holiday.' It did not sound hopeful.

Yet on the first working day after the holiday, the investment officer rang twice, asking to meet the client. When told it would not be possible until two weeks later, the officer said: 'That will be too late. Can I talk to the banker in charge instead?'

So he spent an hour on the phone with our investment banker, in a bid to understand the client. Before hanging up, the banker said: 'Let's fix a date to visit the plant and meet the management.'

The officer replied: 'That will not be necessary.'

In less than two days, a memo from the financial arm landed on our investment banker's table, offering to invest 20 million yuan in his client. The price? Well, the financial arm was happy to pay 8 yuan a share when the banker was asking for 2 yuan a share.

Our banker can go on and on with such reports. The question is, why the hunger to invest the money and why the change over the holiday?

It can't be the stock market. The Shanghai Composite Index has fallen 14 per cent in the past month. Bargain hunting? But that does not explain the 'grab it at whatever cost' mood.

Let's imagine you are the chief of a government-backed funding entity and try to figure out the answer.

The past year or so has been like heaven. Encouraged by Beijing's investment spree, banks have been showering you with money.

All you need to begin with is a piece of land as collateral. With the bubbling property market, that can easily fetch a decent valuation. With that you get the loan, kick more farmers off the land, then get more loans on that land, and so on. It has the beauty of a ponzi scheme but not the nasty name.

The financial arms of major cities have seen their borrowings balloon. Chongqing's debt has soared to 200 per cent of its annual revenue.

Small municipalities are going even stronger. The district government of Hongwei in Liaoning has secured 2.3 billion yuan from banks. That is 12 times the city's annual revenue.

The country's tally of bank loans to local government entities soared from 6 trillion yuan to 7.5 trillion yuan in the past four months.

There is a good chance that most of these loans have not been drawn down, or at least not yet used in the infrastructure or development projects for which they were designated.

Now, the big guy in Beijing is getting really uncomfortable with the size of all the loans. Orders were issued in mid-April for bankers to figure out the whereabouts of all their loans.

So, any day the bankers will arrive at your door step. The first thing they will do is to take back whatever money remains in your account. That's the quickest way to reduce their exposure to local government financial arms.

You are not going to let that happen. Instead you want to turn that money into assets.

You have to spend the money as soon as possible before the bankers grab it. But where to put it?

The share market is not an option. That's because stocks are as good as cash and the banker will press you to sell the stocks. In fact, you should take your earlier investments in the stock market and put the money somewhere else.

Equity investments in yet-to-list manufacturers will be a good deal. The bank can't grab it. Under the current bad-debt classification system, the bank won't seize the title even if you haven't made any repayment for two years.

By the end of the two years, the economy and politics will be in another cycle and you are safe. Besides, the bank will be happy to see the investment because they can tell Beijing the money has been put into brick-and-mortar businesses.

And let's don't forget the nice upside you are likely to enjoy with your investment in the potential IPO candidate. The fact is that IPO fever rarely subsides and your return is really not that dependent on a company's quality. This is a classic example of: When Beijing sees a problem, local governments come up with a 'solution'.