And they thought they were just getting started: fintech companies in China are going to suffer mass consolidation in 2016 as the state sector takes over what has been a private-sector trend, according to J Capital Research.
In a January 4 report, the Hong Kong-based JCap predicted that falling returns on investments, new regulation and the lack of sustainable business models would force a sharp decline among China’s fintech players. This in turn is a harbinger of tough times for the country’s e-commerce players, including giants Alibaba, Baidu and Tencent.
State-owned banks, on the other hand, will be able to reassert dominance over all aspects of Chinese finance.
J Capital is an independent research firm whose co-founders, Anne Stevenson-Yang and Tim Murray, have produced a number of reports bearish on China's economy and provide advice on how to short its market.
Many investors are still excited about China fintech's prospects. Ant Financial, Alibaba's financial affiliate which runs Alipay, has recently returned to private markets to raise more capital, possibly instead of pursuing an IPO for now, as market conditions deteriorate amid a long queue of large 'unicorn' tech companies.
The canary in the coal mine involves payment companies, according to the report. Alipay generated 0.14% of revenue against total transaction volume in 2014, against 3.4% for US rival PayPal, JCap calculates. Alipay, founded in 2004, is only the biggest of many payment services in China, which are tied to companies in everything from e-commerce to steel manufacturing.
These payment companies generated revenue from the float on vast amounts of collateral held up in their systems by purchasers, which were invested in high-yielding deposits or bonds. While foreign payments companies compete on the basis of encryption, security and convenience to users, Chinese firms became aggregators and deployers of capital. This business model is coming a cropper, as the US raises interest rates, capital inflows to China turn to outflows, and the People’s Bank of China continues to slash interest rates.
These payment companies channeled money away from banks into money-market funds, trusts or other shadow-banking vehicles, from which they could create securitisation vehicles to be sold back to banks.
Regulators encouraged this activity because it was seen as helping finance the small private companies ignored by banks, and because it was integral in raising money to invest in the country’s insatiable appetite for new fixed assets. Now that these private-sector payment companies are no longer profitable, the PBoC is releasing regulations tightening the noose and sending lending back into the arms of the banks.
JCap’s report calls this the unwinding of a Ponzi scheme. “If there is an element of Chinese exceptionalism in this story,” the report said, “it is the scale and sustainability of this massive misallocation of capital and wealth destruction, as well as the happy stories that spread around the world about it.”
JCap further argues that e-commerce companies’ profits increasingly have been derived by managing customer money through these bank-like services, rather than actually selling useful goods or services. Alibaba, Tencent, JD.com and Baidu are just the biggest, best known names in a huge sector of such companies.
Those revenues came from plowing captive capital into funds that returned high spreads; selling financial services to this captive capital; and using the captive capital to make investments to support the core business. All three lines of revenue are under threat.
“It’s very likely that China’s e-commerce companies, far from representing the rise of consumption in China, are creatures of China’s Era of Capital and will fall like stars,” the JCap report said.
These high returns also supported the rise of thousands of peer-to-peer lenders, but JCap said lending to SMEs and individuals was not profitable without scale. The same factors upsetting payment services are driving P2P lenders to the wall.
The PBoC has issued new regulations turning the screws, JCap says; in effect, the government used the private sector to innovate new forms of lending, and is now driving them out of business so that state-owned banks and payment companies can take over.
Fintech companies in China enjoyed a decade of easily aggregated capital, heady returns in high-interest rate bearing vehicles, capital inflows thanks to a strong currency, and little regulation. Now capital is hard to come by, returns are collapsing, the renminbi is weakening (driving capital out of the country), and, giving the screw a final turn, the government has turned hostile.
The report interprets these regulations by stating: “The intentions are not to create a healthier and safer environment for third-party service providers to prosper and grow. Rather they are to curtail their activities sharply if not make their very survival dependent on select and extra-legal tolerance by regulators.”