What's ailing China? Explanations aren't hard to come by: slowing growth, bloated and inefficient state-owned enterprises, and a ferocious anti-corruption campaign that seems to take precedence over needed economic reforms.
Yet for all that, there is probably no bigger, more detrimental, disruptive or overlooked problem in China's economy than the high cost of borrowing money. Real interest rates on collateralized loans for most companies -- especially in the private sector, where most of the best Chinese companies can be found -- are rarely below 10%. They are usually at least 15% and are not uncommonly over 20%. Nowhere else are so many good companies diced up for chum and fed to the loan sharks.
Full and on time
Logic would suggest that the high rates price in some of the world's highest loan default rates. However, this is not the case. The official percentage of bad loans in the Chinese banking sector is 1%, less than half the rate in the U.S., Japan or Germany -- all countries, incidentally, where companies can borrow money for 2-4% a year.
You could be forgiven for thinking that China is a place where lenders are drowning in a sea of bad credit. After all, major English-language business publications are replete with articles suggesting China's banking system is in the early days of a bad-loan crisis of earth-shattering proportions. A few Chinese companies borrowing money from overseas, including Hong Kong-listed property developer Kaisa Group Holdings, have come close to default or restructured their debts. But overall, Chinese borrowers pay back loans in full and on time.
A combination of sky-high real interest rates and near-zero defaults makes China probably the single most profitable place on a risk-adjusted basis to lend money in the world. It is also one of the most exclusive: The sometimes obscene profits earned from lending pretty much stay on the mainland. Foreign investors are effectively shut out.
The big-time pools of investment capital -- American university endowments, insurance companies, and pension and sovereign wealth funds -- must salivate at the interest rates being paid in China by creditworthy borrowers. They would consider it a triumph to put some of their billions to work lending to earn a 7% return. However, they are kept out of China's lucrative lending market through a web of regulations, including controls on exchanging dollars for yuan, as well as licensing procedures.
This is starting to change. But it takes clever structuring to get around the thicket of regulations originally put in place to protect the interests of China's state-owned banking system. As an investment banker in China with a niche in this area, I spend more of my time on debt deals than just about anything else. The aim is to give Chinese borrowers lower rates and better terms, while giving lenders outside China access to the high yields found there.
China's high-yield debt market is enormous. The country's big banks, trust companies and securities houses have packaged over $2.5 trillion in corporate and municipal debt, securitized it, and sold it to institutional and retail investors in China. These so-called shadow-banking loans have become the favorite low-risk and high fixed-return investment in China.
Overpriced loans waste capital in epic proportions. Total loans outstanding in China, both from banks and the shadow-banking sector, are now in excess of 100 trillion yuan ($16 trillion), or about double outstanding U.S. commercial loans. The high price of much of that lending amounts to a colossal tax on Chinese business, reducing profitability, and distorting investment and rational long-term planning.
A Chinese company with its assets in China but a parent company based in Hong Kong or the Cayman Islands can borrow for 5% or less, as Alibaba Group Holding did recently. The same company with the same assets, but without that offshore shell at the top, may pay triple that rate. So why don't all Chinese companies set up an offshore parent? Because this was made illegal by Chinese regulators in 2008.
Chinese loans are not only expensive, they are just about all short-term in duration -- one year or less in the overwhelming majority of cases. Banks and the shadow-lending system won't lend for longer.
The loans get called every year, meaning borrowers really only have use of the money for eight to nine months. The remainder is spent hoarding money to pay back principal. The remarkable thing is that China still has such a dynamic, fast-growing economy, shackled as it is to one of the world's most overpriced and rigid credit systems.
It is now taking longer and longer to renew one-year loans. It used to take a few days to process the paperwork. Now, two months or more is not uncommon. As a result, many Chinese companies have nowhere else to turn except illegal moneylenders to tide them over after repaying last year's loan while waiting for this year's to be dispersed. The cost of this so-called bridge lending? Anywhere from 3% a month.
Again, we're talking here not only about small, poorly capitalized and struggling borrowers, but also some of the titans of Chinese business: private-sector companies with revenues well in excess of 1 billion yuan, solid cash flows and net income. Chinese policymakers are now beginning to wake up to the problem that you can't build long-term prosperity where long-term lending is unavailable.
The same goes for a banking system that wants to lend only against fixed assets, not cash flow or receivables. China says it wants to build a sleek new economy based on services, but nobody seems to have told the banks. They won't go near companies in the service sector, unless of course they own and can pledge as collateral a large tract of land and a few thousand square feet of factory space.
Chinese companies no longer find it easy to absorb the cost of their high-yield debt. Companies, along with the overall Chinese economy, are no longer growing at such a furious pace. Margins are squeezed. Interest costs are now swallowing up a dangerously high percentage of profits at many companies.
Not surprisingly, in China there is probably no better business to be in than banking. Chinese banks, almost all of which are state-owned, made $292 billion in profits in 2013 -- one-third of the total for the entire global banking industry. The government is trying to force a little more competition into the market, and has issued licenses for several new private banks, including affiliates of Tencent Holdings and Alibaba, two of China's biggest Internet companies.
Lending in China is a market rigged to transfer an ever-larger chunk of corporate profits to a domestic rentier class. High interest rates sap China's economy of dynamism and make entrepreneurial risk-taking far less attractive. Those looking for signs China's economy is moving more in the direction of the market should look to a single touchstone: Is foreign capital being more warmly welcomed in China as a way to help lower the usurious cost of borrowing?
Peter Fuhrman is the founder, chairman and chief executive of China First Capital, an investment bank based in Shenzhen, China.