China's credit guarantee agencies plagued by related party lending

Shanghai Industrial Economic Assurance Company''s Liu Yihe explains the intricacies of risk management in China.

The loan guarantee agencies are part of a system where business entities can offer to guarantee a loan for an SME, or even a listed company, from a bank. How successful has it been? And by checking on the credit worthiness of a company, aren't you essentially doing the work of the banks?

Liu: The system of how to finance the small business sector in the private and public sectors has been a long time coming, and it's encountering many problems. Although the problem of how to encourage financing for small to medium companies was first mooted in 1992, only in 1997 did the government set up a high level committee to look at the problem. That finally resulted in some achievements, and a network of around 2500 SME guarantee companies now exists across the country spread amongst the counties and districts.

Most of them, at least originally, were run by the Ministry of Finance, although some have state owned enterprise shareholders, and an even smaller minority are private. For example, we were set up in 1999 by the MOF, but our principal shareholder is now Shanghai Indusial Economic Assurance Company.

Actually, our longer-term aim is to become something to a credit rating company, with the difference that we take on the risk of bond we rate. (Our business model is that we take get paid a management fee in the form of a percentage of the amount we guarantee.)

As for doing the work of the banks, it's more accurate to say we repeat it. The banks do their own work. The important difference is that by forcing the company to find a guarantor, they are diffusing the risk away from themselves. Needless to say, the risk still stays in the system, it's just concentrated away from the bank.

Actually we work closely with the banks and they often refer clients onto us. What we consider a little outrageous is that the banks don't pay us for the service we provide - all the expense falls onto the client.

How profitable an industry is this to be in?

If you do your homework right, it can be profitable. But at the moment there are too many companies offering the service. We are lobbying for a situation where only two to three companies are allowed to provide the guarantee service, a little like the system with the US credit rating agencies. In fact, Bank of Shanghai already has a short list of the companies it will accept guarantees from. We're on that list. That should encourage a more dispassionate assessment, since it prevents friendly companies scratching each others' backs and guaranteeing each others' loans. It will also alter our relationships to the banks. At the moment we're considered the junior partners.

What problems is the credit guarantee system facing?

The system has been plagued by connected party lending. Essentially, the decision about who would receive a loan guarantee was decided by a local government entity in favour of related firms. So it was complete unrelated to the fundamentals of the business. That means, I estimate, that about 20% of the loans which these state owned agencies have guaranteed are in default. So not only did the right companies probably get their financing, the banks didn't end up being protected, raising the number of non-performing loans. The banks have begun to wise up though: they now ask for 10% of the guaranteed loan from the guarantee company. That way, if the agency goes belly up it get some of the money back.

So you are the ones that have to go in and claim and auction the assets if a company goes bankrupt.

Yes. And as I'm sure you know the legal process can be long and arduous: usually at least one year before we get the assets on the auctioneer's block.

When you say SME, does that then not mean private firms?

No. The decision to encourage SMEs is not confined to private firms, but to all SMEs. But in fact, definition is a bit of problem. Attempts have been made to define small firms as having fewer than 50 employees and a registered capital of Rmb 5 million, or Rmb 50 million in sales. No real attempt has been made to define 'medium' sized companies. It's confusing because some smaller listed companies have sales figures which are not far off the definition for 'small' companies, so the definition isn't stuck to very rigidly. The lack of definition is one weakness in the system and prevents accurate targeting of the needy. Some companies don't why they have been rejected or accepted, for example. It also means you can't punish an agency for lending to the wrong kind of firm.

Indeed, despite our mandate, we often turn down entrepreneurs who really need working capital financing. I've had to turn down some really excellent people, but it was simply too risky. I think it's time for the government to support SMEs via risk capital funds, not for us. It should be the government's duty to explicitly underwrite the risk of the of the SME area. Or, simply give them grants out of the taxes they pay the government!

Do you estimate there is a great demand for your service, given the difficulty in obtaining official financing?

That's a funny question. A couple of years ago, I went down the Shanghai development zone and carried out a thorough canvassing of the primarily high tech companies resident there. Of the more than one hundred companies there, we eventually found just two that were interested in dealing with us. The others had private investment, or most frequently, they were invested in by other firms in the same business.

You mention that some of the agencies are facing serious defaults. What's lies ahead for them?

If you look at the statistics in Shanghai, of the around 37 credit guarantee companies, a high proportion are showing reduced registered capital - it's being used to pay off defaulting loans. In many case, you are also seeing the government shareholders trying to get out by selling or just transferring their stake to state owned companies or even private persons.

Are danbao agencies the only way you can get a loan guarantee?

No. The banks don't really mind who the guarantee is from. And that's part of the problem. Companies often don't want to pay us the 1% to 3% management fee for a guarantee. Listed companies often vouch for each other. Some big groups will even deliberately set up a credit vouching subsidiary and vouch for the holding company. But as mentioned, that's changing, as the Bank of Shanghai's policy shows.

What's the future of credit guarantee agencies?

In some ways prospects are good for the right companies. That's because with the sinking stock market, companies are under stress. Incautious guarantees are being found and adding huge liabilities to the companies. That's been a theme of this year's corporate results: unexpectedly large liabilities from guarantees. So companies are unwilling to vouch for each other and coming to the likes of us for a guarantee.

What are the restrictions on providing guarantees?

You are allowed to guarantee up to four times your registered capital. However, we are the biggest in Shanghai and considered qualified to guarantee ten times the amount of our registered capital.

How do assess the credit of a company?

They have to correspond to a list of our conditions. Their ownership background is completely unimportant. I look especially at cash flow for the last two years - ie the ability to repay debt instantly!

Can you adapt your fee to adapt to the risk of your risks?

We are capped at 3% of the loan amount. Notice that already makes the price of capital quite expensive for companies. A one-year loan is over 5% from the bank so if you add another 3% from us that really raises the cost of capital.

What kinds of companies do you look to lend at?

As mentioned, we are currently very interested in looking at guaranteeing bonds by listed companies. We think that's a very safe we to earn our fee. We often don't dare to lend to private companies, unfortunately, however good they are, mainly because they are small. Rather, we look rather to lend to large companies which already have plentiful assets, especially land. Machinery is often too specialized to resell in the case of a default. In fact, we are most reluctant to guarantee small loans for small companies. We'd rather lend Rmb 10 million than Rmb 100,000.

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