Chinese financial innovation, brought by entrepreneurs, is disrupting the Chinese financial services industry in a good way

Giles. W. Chance / Expert on Chinese economy and business, Visiting Professor of Tuck School of Business at Dartmouth College, Guanghua School of Management at Peking University / 2016-03-07

The first steps in these financial innovations appeared to bring more bad than good, and the state sector said ‘I told you so.’ But P2P platforms like that of Yirendai, which links small borrowers with small lenders online, provide an important channel for the diversion of China’s huge savings pool into economically sound and productive uses.

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On December 18th 2015, Yirendai, a Chinese micro-financing* company owned by Beijing-based Credit-Ease, completed an initial public offering (IPO) on the NASDAQ stock market in New York, raising US$75 million in new capital. In its IPO prospectus, Yirendai stated that it had executed RMB 8.8 billion worth of micro-finance lending and borrowing between March 2012 and the end of September 2015. Yirendai is an example of a new kind of financial company in China, which focuses on competing with China’s state-owned banks to provide Chinese savers with better investment returns than they would receive on a bank deposit. These higher returns are possible because Yirendai (and its competitors in China) match savers with individuals and smaller companies who need capital, or simply want to borrow to improve their lifestyle, and whose incomes enable them to pay higher interest rates. The online matching of a private lender with a private borrower is known as P2P. Private entrepreneurs have led this Chinese P2P revolution, which has found a huge market both with Chinese savers seeking better returns, and borrowers, who through the lack of a banking service are now able to convert their monthly cash flow into credit.

Since 2010, more than 2,000 P2P internet platforms have emerged in China offering a range of wealth management products online. China’s banking sector, led by the big state-owned banks ICBC, CCB, BOC and ABC, have complained to the Chinese Government that these private internet lending clubs should be closed down because the high rates they offer to savers are based on risky lending. They say that the private lenders are able to make large profits because they don’t have to maintain expensive bank branches. Are these criticisms justified? Are the new financial companies dangerous for the Chinese investor? Does this financial innovation have any significance for the health of the Chinese economy?

In the 1990’s, China’s banks acted as cash machines for China’s state-owned economy. Government-owned and operated, their business consisted of making loans to, and receiving deposits from Chinese state-owned enterprises. The small Chinese saver lent his money to the bank, which provided safety and paid him a small return. After the Chinese economic boom of the mid-1990’s, annual Chinese price inflation soared to over 20%. As the cost of living rose, interest rates failed to keep pace, and many Chinese families saw the spending power of their savings shrink. In 1995, China’s Prime Minister ZhuRonji took drastic action to reduce price inflation by cutting credit to slow the economy. China’s banks saw many of their boom-time loans turn bad, as their customers, consisting of companies and local governments in China, stopped making repayments as their losses grew. In 1998 the Government was forced to carry out a thorough restructuring of the Chinese banking sector. Trillions of RMB of bad loans were removed from the books of the Chinese banks, which were recapitalized and, from 2005, listed on the stock market in Hong Kong to introduce foreign investors as shareholders and upgrade the banks’ management.

This bank overhaul process significantly improved the structure and management of the Chinese banks. But after the stock market listing of the big five banks (including the Bank of Communications in Shanghai), the Chinese government continued to hold around 75% of their equity, and the banks continued to operate much as they had before—taking deposits from, and making loans to the government-owned sector in China. Because many of their state-owned customers continued to lose money, the big Chinese banks continued to incur losses on their loan books, even after their restructuring. The spreads between the rates they received on their loans and the rather low interest rates they paid their depositors were much larger than the interest spreads that their international competitors like Citibank or HSBC enjoyed. But these large banking spreads continue to be necessary today in order for Chinese banks to go on financing China’s largely unprofitable state-owned sector. If the Chinese banks paid fully competitive rates to depositors, their spreads would fall and they would suffer severe financial problems. Effectively, Chinese households continue to subsidize the Chinese state-owned sector via the Chinese state-owned banking system.

It was left to China’s private entrepreneurs to come up a solution that could satisfy China’s army of savers while providing much-needed finance to undercapitalized small Chinese companies. The first to do this around 2005 were from Wenzhou, a coastal city famous for its entrepreneurs. But when their badly-designed savings products ran into trouble, the central government clamped down. One Wenzhou entrepreneur, Wu Ying, was sentenced to death by a court in Zhejiang after she had raised RMB 700 million from friends and relatives to use in micro-finance lending. After a national outcry, her death sentence was commuted.

The Wenzhou experience with shadow banking, although not very successful due to poor product design and execution, did show there was a huge unmet demand amongst Chinese households for financial savings products that offered high rates of return. Local governments, short of funds since a 1994 reorganization transferred much of their tax revenues to Beijing, saw an opportunity here to balance their books. They set up trust companies separated from their ordinary activities and offered wealth management products backed by the local government and administered by a leading Chinese bank. This gave the products the same sense of security as a bank deposit. The funds that flowed in from savers who were attracted by the high interest rates and apparent security on offer were used to meeting local government funding gaps and investing in projects sponsored by local governments that provided local employment and economic activity, but often little or no economic return. After2011, the economy slowed and many of these projects turned sour. Many of the trust companies became insolvent. Since 2013, the Chinese government has intervened to resolve these problems by prohibiting new local government trust companies and encouraging the large banks to buy bonds issued by local governments to plug their losses.

The first steps in these financial innovations appeared to bring more bad than good, and the state sector said ‘I told you so.’ But P2P platforms like that of Yirendai, which links small borrowers with small lenders online, provide an important channel for the diversion of China’s huge savings pool into economically sound and productive uses. If the borrowers are carefully analyzed, then the P2P service can provide a genuine opportunity to savers.

These platforms address the huge Chinese SME market, which generates almost all of China’s new jobs and most of the country’s economic growth, but has remained outside China’s financial system because of the focus of China’s banks on large and medium-size state-owned companies. The new focus of the Chinese government under President Xi on market solutions, highlighted in the 2013 Third Plenum, has meant that Chinese P2P platforms are now being encouraged as an important private-led development in China’s capital markets. After sending a team of researchers from the Ministry of Finance to investigate how P2P platforms worked and were regulated in London, guidelines for Chinese P2P regulation were published in December 2015 by the Chinese banking regulator. These state that the platforms are not banks, and cannot use their own capital to lend to borrowers. Instead, they should act only as intermediaries by providing a convenient online service to match investors with suitable projects. The P2P platforms must not borrow money, must disclose their aggregate loan information and performance to the public, and must register themselves with the local financial authorities. Here, the Chinese government is acting as a referee, not as a business owner, and is leaving the borrowing and lending decisions to the individual customer, as it should. Getting the government out of ownership and into governing is a prime objective of the Xi Government.

The success of e-commerce has stimulated the development of related financial products. By the end of 2015, Alipay and Tenpay jointly occupied about 90% of the fast-growing market for making payments online, either by computer or mobile phone (with Lakala, LianLian Pay, JD Wallet and a range of other payment services making up the balance). In Q3 2015, Chinese online payments grew by 64% over 2014 to a total of RMB 433 trillion, of which mobile payments made up RMB 18.2 trillion.

Alibaba’s leadership of the Chinese online payment market originated from its successful online retail site Taobao, which accounted at the end of 2015 for 83% of Alibaba’s total revenue. Although Taobao was set up back in 2003 as a competitor to the US auction site EBay, it did not start to become a success until six or seven years later, when online payment through Alibaba’s payment service Alipay became secure and convenient enough to attract Chinese retail buyers in large numbers. Starting in 2012, Alipay users were encouraged to deposit funds with Alibaba with the high interest rates offered by Alipay for each day that funds were left on deposit. Today, Alipay generates significant profits through its money operations, although these are not available to the public because Alipay became a company privately owned by PRC nationals in 2011 in order to obtain a business license.

Since 2000, private enterprise has driven the emergence of China’s internet companies into areas of the economy underserved by China’s big state companies. These private Chinese companies have produced market-driven financial innovations, like P2P micro-finance, which have already disrupted and developed China’s financial services market. In 2015, Chinese P2P platforms transacted the equivalent of US$150 billion, and household saving via P2P rose by 4 times.

There is no shortage ofyoung Chinese entrepreneur risk-takers. Vibrant Chinese venture capital and private equity industries now provide ample early stage finance and support to these entrepreneurs at a lowcost, drivinginnovation in China’s financial sector. The much-needed development of China’s capital market will follow, bringing huge benefits to China’s economy in terms of consumer satisfaction and economic growth. China is benefiting from a revolution of private enterprise.

*‘Micro-financing’ refers to households and small companies, or SME’s (small and medium-size enterprises).