Paying the price in Wenzhou's underground banking system

Wenzhou is in the midst of a banking nuclear winter, the fallout from underground lending

PUBLISHED : Monday, 15 October, 2012, 12:00am
UPDATED : Monday, 15 October, 2012, 8:39am

Mischief comes by the pound and goes by the ounce - and businesspeople in Wenzhou, the mainland's entrepreneurial heartland, learned the lesson of this old proverb the hard way.

The "mischief" in their case, was created by the rise and fall of a deeply entrenched underground banking system in the Zhejiang city, one of the country's most affluent.

Dozens of Wenzhou entrepreneurs have either committed suicide or fled the country as illegal shadow banks have collapsed and Beijing's monetary tightening has taken hold.

And now few survivors are willing to return to the alternative banking system for more.

As a result, Beijing's decision earlier this year to legalise underground banks and make Wenzhou a pilot city for the reform has failed to reinvigorate the private lending business.

"Locals are scared and no one wants to take any more risks," Wang Yuzhu, owner of a car-parts business, said.

"People are worried that things could get even worse."

Non-performing loans (NPLs) at commercial banks operating in Wenzhou provide a vivid snapshot of the plight confronting the former boom town.

The bad loan ratio hit 3 per cent at the end of August, the highest level in a decade, according to the state-owned China Securities Journal, after rising for 12 consecutive months.

But there is worse to come, analysts say. They predict that the ratio of bad debt to total loan portfolios could exceed 7 per cent in the coming months.

"If the ratio were to top 7 per cent, it could signal a very serious problem," Orient Securities analyst Jin Lin said. "The damage to the nation's banking system, including big state-owned lenders, will be bigger than expected."

A 7 per-cent NPL ratio in Wenzhou translates into about 50 billion yuan (HK$61.45 billion) in bad debts.

It's a long way from the boom years. Wenzhou entrepreneurs were regarded as the nation's trailblazers in developing their privately owned businesses during the past two decades.

Their enterprising spirit and high appetite for risk paid huge dividends for many who struck it rich by speculating on property or ploughing massive investment into manufacturing facilities and coal mines.

In the early 2000s, underground banks began to thrive as locals - who refer to the shadow lenders as "private lending businesses" - borrowed money to replenish their businesses and investments.

Initially the lenders brought benefits to thousands of small firms that used the loans to fund their export-oriented manufacturing businesses as overseas demand rose.

But in 2006 the shadow banks spun out of control as borrowers raised loans to gamble on the stock market in the hope of getting rich overnight.

The underground lenders' high deposit rates drew massive flows of cash into the system and some local entrepreneurs went so far as to borrow from the formal banking sector to deposit the money in the shadow banks in their chase for the higher returns.

As the business environment worsened from 2008 onwards, thousands of Wenzhou entrepreneurs quit the ailing manufacturing sector to focus on profiting from private lending.

"Most of the people were comfortable with the handsome returns they raked in from the loan-sharking schemes," lubricants businessman Qi Qingfa said.

"Every Wenzhou resident was a fan of the finance business at that time."

Then last year a series of scandals erupted in Wenzhou as some of the shadow banks became insolvent, leaving thousands of locals to pick up the pieces.

Economists warned that the ripple effect would eventually spread to the commercial banks given that hundreds of billions of yuan in loans had flowed through the underground system.

According to the chief executive of a financial advisory firm working with commercial banks to solve the bad-loan problem, the city government has stepped in to help contain growth in the debts. But it is too late?

Most of the banks gave borrowers a grace period last year to repay their overdue debts, the chief executive said.

"The original purpose of the grace period, normally six months, was to let the borrowers earn money from their own businesses, so they could use the money to repay the loans," the source said.

"But the bad economic conditions at home and abroad made it difficult for their businesses to generate profits."

Now the local economy remains deep in a hole and could get worse, Wenzhou businesspeople say.

In March, the State Council announced it would begin a trial run of financial reform in Wenzhou, aiming to legalise the underground lending business with better supervision and oversight.

Local businesses and individuals are now encouraged to set up small-loan firms and register them with the regulators.

However, acceptance of the reform opportunity has not taken off amid the present sluggish demand for loans.

"People have realised that Wenzhou has to regain its strength in manufacturing. But it doesn't seem easy to go back to manufacturing now that demand is weak," Wenzhou businesswoman Lin Ye said.

"Everyone is now asking how long the 'nuclear winter' will last."