When people talk about China's financial market, they naturally refer to the capital market such as stock trading, or the banking sector like personal savings or commercial lending. After all, this is the more visible mainstream market.
But a lesser-known territory has been catching the attention of investors for a few years: the microfinance market - financial services for entrepreneurs, small businesses and individuals who lack access to traditional banking services.
In China, microfinance products range from consumer loans to commercial lending. As in other nations, this segment has become a necessity rather than a choice. The growth of China's microfinance market is fuelled by an unbalanced financial ecosystem and the central government's strict control of interest rates, which has resulted in banks deserting this market. Subsequently, new operators have arisen to fill the space, including microcredit and guarantee companies, peer-to-peer lenders, as well as underground banks.
It is not news that many enterprises and individuals struggle to secure loans from banks, especially those who lack collateral. Chinese banks in general prefer lending money to large corporations as it is in line with government policy. As one official put it, a branch manager will not lose his job owing to the default on payments of a state-owned enterprise, but he most certainly will be held liable if a small or medium-sized enterprise is unable to pay, let alone default on payments on unsecured personal loans.
Nevertheless, the central government has already issued new policies to encourage banks to increase lending to the "underprivileged". But the change is slow and the banks are happy earning a handsome spread of 3per cent without taking much risk.
According to the Boston Consulting Group's 2011 report, "The Dragon Wants to Spend", at 7 trillion yuan (HK$8.6 trillion), China's consumer loan market is already one of the largest lending markets in Asia, despite its infancy. The group predicts that the market will grow to three times its size by 2015.
In 2009, China's consumer loan market was around 20 per cent of gross domestic product, compared with Hong Kong's 56 per cent and America's 90 per cent. Even though 80per cent of the Chinese figure are mortgages, it is clear that the growth potential is colossal.
Among 4,600 microcredit companies in operation, the total outstanding loan is around 500 billion yuan. Microcredit companies fall under the jurisdiction of the local financial bureau, but there are strict rules. Regardless of some of the constraints, the number of such companies is growing at 20 per cent per annum. Overseas competition is also entering China as 100 per cent foreign ownership is allowed.
Setting up a microcredit company is one thing, managing it is another. For most, the clientele is SMEs with large ticket sizes of loans; governance is relatively simple, as there are few clients to manage. According to government sources, with an average interest rate of 16per cent, some 90per cent of microcredit companies are profitable.
It is also common that many microcredit businesses operate like convenience stores, with few staff and no systems in place. The downside is the concentrated default risk from borrowers, especially involving bridging loans which bear relatively high risks.
For the retail client segment, such as consumer finance, it is a different ball game. Retail business is about scale. With the right operating model and credit policy, risk mitigation is sustainable even with an enormous customer base. In addition, proper checks and balances through good governance, business intelligence and standardised processes can lower unit costs, detect fraudulent loans and speed up approval cycles.
Person-to-person lending, another form of microfinance, has also experienced exponential growth since 2006, when CreditEase, a Beijing-based lender, imported the idea into China. Underground banks all over the country provide personal lending with ultra-high annual interest rates, some at over 50 per cent The total size of this market is estimated at an astounding 2 trillion yuan.
The major requirement for microcredit companies is capital. China's banking regulator's recent deregulation efforts allow microcredit companies to convert into rural banks. Larger debt ratios that allow lower funding costs for lending firms are also likely to happen.
With a return on equity as low as 10 per cent for some microcredit companies, it is clearly not sustainable. Since tax incentives are given to the capital market, it is only rational to call for such inducements for the microfinance trade.
More product offerings in the microfinance industry, such as consumer finance, would be healthy. And outsourcing services may become the future of microcredit companies, as a facility to banks.
The microfinance market will continue to expand and adjust. Superior governance, advanced technology and trained talent will separate the winner from the rest. For shareholders and investors, this is a plausible financial venture that shows promising growth and returns.
As for overseas investors eyeing China, this is one of the very few avenues that allow foreign competitors to enter China as wholly owned financial institutions, with a relatively low entry barrier and investment.
Greg Au-Yeung is chief information officer of VantAsia (formerly AIG) Finance in China