Private sector financing: the grey elephant in the room

Like many industries, finance belongs to the grey zone of China’s domestic private economy. Government attitudes towards private financing have twisted and turned since its economic reform, but no definitive law or regulation was passed.

One potential reason for delay is that private financing has never caused any significant problems. Lack of regulatory clarity has always caused high interest rates and occasional scams in the private sector. However, its impact has generally being positive on economic growth, and its problems were local and containable.

Recently, a combination of factors has seen private financing unexpectedly soaring in actual lending and profile, leading to inflation risks that are both real and current. Unfortunately, lack of regulation means the government has no formal ways of controlling it. Looking back on history, this is precisely when the government would be taking arbitrary administrative measures in order to achieve its policy goals.

Private credit and run-away inflation

Supply of private capital in China always had limited choices of destinations. The two largest destinations have been domestic shares and property. In 2010, both markets suffered setbacks: stocks due to global economic woes and property due to local regulatory uncertainty. The result is large and available domestic credit pool at the right prices.

Meanwhile inflationary pressure is building up ominously, due QE II in the US and the excessive domestic stimulation package during the GFC. In response, the government has lifted interest rate and issued orders for banks to curtail lending.

Increasingly available private credit and fast diminishing public financing played out like two ends of a see-saw: where banks refused to lend, private credit unions supplemented. As a result, monetary tightening has failed to control inflation so far. The starkest example is how property developers have survived government’s effective freeze of public credit and extreme policy uncertainty, all without reducing housing price.

Prosecution of private lenders?

Controlling inflation is a top imperative in China: economic and political stability rests on it. With so much at stake and no institutionalized method of dealing with it, the authorities may take drastic measures.

The economic reform in China has always been dogged by abrupt government “back-flips” (to be 100% accurate, they are not really “back-flips” since no law was passed and no official sanction declared in the first place; things were just allowed to happen). Interventions are always strong-armed, often crude and sometimes take leverage of criminal prosecutions to achieve absolutely non-criminal policy objectives.

For example, in the early days of reform when private commerce were outlawed in the letter of law but encouraged in spirit, authorities turned a blind eye for years before pouncing on WenZhou entrepreneurs. The crackdown was less motivated by communist ideals than by private sector competition threatening survival of public enterprises, which the government sought to strengthen.

During the 90s and again early 2000s, lack of legal clarity over ownership and control of “communal enterprises” led to the prosecution of many entrepreneurs when they sought to privatize their companies or cash-in their shares.

So if history is anything to go by, given the macro-economic woes caused by private finances right now and the inflation beast the government has to slay, I will tread very softly as a private lender.