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Informal Financing: An Issue for New Understanding

Jun 02,2003

Zhang Chenghui

Research Report No 162, 2002

I. Present Status and Problems of Informal Financing in China

Informal financing activity refers to informally organized public financial activity outside the governance of the supervision authorities. The informal financial activities discussed in this article only include investment and financing processes where the surplus social capitals are transferred directly into the hands of entrepreneurs for production investment.

Informal financing activities have developed vigorously in recent years. One of the main reasons why these activities unauthorized by the supervision departments are so vigorous is that the development of the private economy has created huge capital demand. As a significant part of information financing activities is particularly aimed at serving the private economy and filling up the vacancy of the supply and demand market, such activities have received considerable local government support.

1. The role of private enterprises in Chinese economy and their financing difficulties

Since the reform and opening up, China’s private economy has developed rapidly. By 2001, household industrial and commercial enterprises registered in Mainland China reached 24.33 million, and private enterprises reached about 2.03 million. The private enterprises produced a total of RMB1.9637 trillion of output, which took up over 20 percent of the total GDP of that year. Meanwhile, the total value of their annual social retails of consumer goods amounted to RMB1.7744 trillion, which took up 47 percent of the total value of consumer retails of that year. In addition, they absorbed 1.42 million workers laid-off by the state-owned enterprises, which took up 63 percent of total such workers re-employed in the year. Their total number of employees reached 74.74 million, accounting for over 31 percent of the total urban employees.1 These statistics demonstrate that private economy has long grown out of its "supplementary" status and become a major force in national economic and social development.

Despite the rapid development of the private economy in recent years, however, the financing difficulty that has always affected the development of the private economy has never been solved. Due to the traditional way of thinking inherited from the planned economic system and structural problems in the formal financial system, neither the capital market nor the fund market has ever provided sufficient financing opportunities for private enterprises. Based on investigation in typical cases, about 80 percent of the enterprises regard financing difficulty as their major development obstacle, and over 90 percent of household and private enterprises depend entirely on their own fundraising to establish their enterprises. In the financing structure of the private enterprises (except listed companies), their own capital takes up 65 percent, private loans and commercial credits take up 25 percent, bank loans only take up 10 percent, and funds raised in the formal financial markets is almost zero.

2. Main ways of informal financing activities

As the small and medium-sized private enterprises can hardly satisfy their capital demand through formal channels, informal financing activities have remained vigorous in areas with developed private economy and have become a major source of capital for the establishment and operation of the private enterprises. Despite efforts of the supervision department that time and again severely restricted various types of private financing activities and strictly banned "illegal fundraising" activities, private financing activities still continued. In general, they mainly take the following ways:

The first is private borrowing. Despite severe restrictions of the financial supervisory department, private borrowing market has never ceased its activities but has become a major way of informal financing activities. As private loans have basically maintained an interest rate double higher than that of bank lending, many urban residents invested their funds into this market and thus guaranteed the source of capital of private financial activities. Second is payment delay. Large-sized enterprises delay their payments for goods purchased from small-sized enterprises, downstream enterprises delay their payments for upstream enterprises, enterprises delay payment to one another, and some enterprises even depend on payments in arrears for working capital. Third is private fundraising. This is done at the time of enterprise establishment, when enterprises raise funds privately from their employees as part of their stock capital. Fourth is to obtain funds from pawns through pawnshops. Fifth is enterprise mutual guarantee and debt-stock swap. In this way, the guaranteed enterprise uses its enterprise stock equity as counter-guaranty and mortgages it to the guaranty party. When the guaranteed party is unable to repay its debts and needs the guaranty party to do so, the creditor’s right of the latter in the former is turned into stock ownership rights. Along with the development of private financing activities, significant number of underground (or semi-underground) private banks and middlemen have come into being and become the backbone of the private financial market.

3. The problems of informal financing activities

With insufficient standards, informal financing inevitably incurs many problems. They are most obvious in the following areas:

First, the financing costs are too high. The small and medium-sized enterprises already suffer from weak business strength, but they have to pay interests for informal financing at a double rate than that of the formal financing, and thus increase their business risks. With an incomplete guaranty system, the guaranty costs are also very high. The present status of China’s capital market reveals that the cost for listing is very high whether an enterprise gets directly listed, or through purchasing the majority shares of a listed company and merging into it after complex operations. Therefore, the medium- and small-sized enterprises cannot afford to try.

Second, a non-standard and high-risk investment market has already taken form. In the short-term capital market, due to high investment risks, many private loans depend on blood ties or regional relations. The transactions usually fail without relatives, employment or business relations. In the capital market, as the shares of non-listed companies can hardly circulate, many underground transactions took place, leading to the emergence of many stock mongers. In fact, underground stock transactions used to prevail in Xi’an, Chengdu, Hainan, Jinan and Shanghai. In one certain province, the incomes from stock ownership trustee of only 50 enterprises delisted from the stock exchange amounted to RMB 30 million in one year, which equalled to an annual transaction of 500-600 million shares. Although such underground transactions satisfied the actual demand of equity circulation by certain degree, they also created lots of "primary share frauds". Some companies joined together to bank on and tied up the investment of numerous individual investors.

Third, it has affected enterprise credit standing. The financing method of depending on payments in arrears for working capital does not only intensify the problem of chain-debts in society, but also deteriorate the competition environment and credit status. According to some enterprises, the payments in arrears vary from several months to over one year. Based on relevant analysis, inter-enterprise payments in arrears in developed market economies take up about 0.25-0.5 percent of their total amount of trade. In China, however, the ratio is over 5 percent.

Fourth, some lawless people have exploited underground private banks and pawnshops to issue usury for huge profits. There have been events in which monthly interest rates exceeded 30 percent, with some loans grown from the size of "ant" into that of "elephant", and the borrowers been ruined, which seriously affected social stability.

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1Data from the All-China Federation of Industry and Commerce.