On July 16th, 2010 Dr. Peter Navarro gave an interview to Yahoo Finance where he discussed China’s Shark Loan Phenomenon. He examined the "shark loan" industry in China, and its possible effects on the Chinese real estate market, its possible global ramifications and why investors should be concerned.
The interviewer seemed surprised and shocked by the large scale of ponzi finance that is rampant in China’s real estate market but it didn’t come as any surprise to readers of Israel’s Financial Expert. I was the first source outside of China to report on this subject (Check me on this, simply Google “China Shark Loan”)
My research was based on sources inside China (not any government officials, simply ordinary Chinese residents), the Chinese press and Chinese internet forums . At my come as a surprise, but the Chinese press has been reporting on these developments for a while now, and stories about these schemes are all around discussion forums inside China but yet no news source outside of China has picked up on this crucial development. All they had to do is Google “Shark Loan” in Mandarin and they would have found plenty of stories and adds of such operations!
This is what I wrote on June 17th, 2010, in a special report titled The Secret Engine behind China’s Housing Bubble- the Ponzi Shark Loan Finance:
This is how this ponzi scheme works:
Local governmental officials that are demanded from the government to produce double digit GDP growth numbers give real estate developers permits to build housing projects in return for bribes. They also get bribes in return for allowing the shark loan companies to operate under their jurisdiction. Some of them are active partners in shark loan businesses. For example, a party secretary of legal affairs, that controls the public security bureau, which is a court and prosecutor division of government in Yongkang city, in Zhe Jiang province tired to run abroad using a passport in 2009 after he found out he can’t repay 60million Yuan. Every scheme has a ring leader whose job is to collect money from all the participants in the ponzi scheme. When some of these ponzi schemes blow up, the party leaders always get bailed out first, and some even ask local business owners to lend them money, and then bail out their own personal fund. After that the ring leader turns himself in and gets protection from the local government.
Most of the funds that are collected in this classic ponzi finance go to local land purchases and real estate development. Part of the funds is used in order to pay back the rolling loan. The short term interest rate in this black market is very high and ranges between 20%-150% annual rate. The sources of the ponzi funds are diverse, as ordinary citizens, banks with corrupted bank officials, and state enterprises play the game.
So what is China’s Shark Loan Phenomenon and how does it Work?
China’s shark loan finance industry which has grown massively in the last 2 years has characteristics of a classic ponzi scheme, since it demands larger and larger funds to flow into the industry in order for the system to prevent a collapse of the scheme, where investors will lose most, if not all of their money.
However, it is different than a classic ponzi scheme like the one that was run by Barny Madoff since in this case really money is being made. The real estate developers involved are making a profit by selling housing units at inflated prices, unlike Barny Madoff who simply redistributed the funds of his new clients to his old one claiming they were profits that derived from his investments.
The shark loan industry is an underground industry, although the Chinese government knows about these activities and many local Chinese officials participate in these schemes. They either invest in these kind of funds or take bribes in return for ignoring the operations of the shark loans. The funds come from various sources. It can be low interest rate loans from the banks, cash from state owned enterprises, and private savings of local investors. The shark loan operator then lends the money out to real estate developers or other domestic private firms.
The shark loan are being made in order to exchange the housing units at ever faster pace, in order to maintain the appreciation of housing prices, and in order to private firms with fund to pay back maturing bank loans. Unlike in the Western banking system, the common lending practice of Chinese banks has a maturity of one year, and so the borrowers need to renew the loans every year if the old loans are to be paid. So many private firms that can’t pay back their loans are forced to borrow from shark loan operators at extreme high interest rates with very short durations.
After they obtain the loan from the shark loan operator they then turn to the bank, repay the old loan and get a new loan for the next year.
It should be clear that a stagnation or fall of Chinese housing prices will cause these schemes to collapse at a very short period of time. In fact, there have been already reports in the Chinese press about a collapse of a few. One of them is the Tang long scheme.
In fact, during the financial crisis in 2008, many real estate companies were failing in China, and a large number of ponzi schemes did collapse, causing riots in some cities. In Il Shui, the whole city was rioting since many households couldn’t get the principal back after the local loan shark companies couldn’t pay interest anymore due to the real estate price slump.
(You can see some YouTube videos HERE)
Ordinary Chinese have pledged their houses to get low interest loans from the banks, and then lent the money to local shark loan companies at high interest rates. They are promised a 20-150% annual interest rate return. The loans are of course much shorter than one year, and their duration ranges between 1-3 months. So investors in these schemes are receiving 7% percent and more for loans of 3 month duration, and they are doing so with their lifetime savings!
After receiving the money, the shark loan operator lends it to real estate developers, speculators, or some SME which has to pay back the bank. The latter is a very common practice, given the dire situation of many SME exporters due to razor thin profit margins combined with rising labor costs. Furthermore, in recent years, many SME’s totally stopped their old business of exporting since the high return of real estate drove more and more of them into this historical bubble.
Why are these Ponzi Schemes so dangerous for China’s economy and social stability?
During the 1950’s the CCP had an economic development plan. It was called “the created great leap forward”. At that time, every household was obligated to produce a fixed amount of iron in order to industrialize the country. So the Chinese farmer built furnace to produce iron, and melted farming tools in order to do so. It was one of the biggest misallocations of capital in human history. China’s central economic planners forced people to spend more time and resources on this economic activity than was necessary. As a result, they spent less time on farming, which caused the great famine later during which 30 million civilians died.
You may ask what the economic policies of China’s 20th century communist regime have to do with its 21st century economic miracle. Well, the connection between the two cases is simple fact that China has once again tied up the majority of its resources in to one single economic activity. All the countries funds are tied to real estate, and liquidity is drying up. The deposits in every major bank in China bank are down, and the A share keeps dropping. In China, the A market is a barometer to the confidence of the residents in the power of the regime. They once believed that the regime will never let it fall. But it has been falling since August 2009 and it is the worst performing major stock market in the world. They now believe that the government will prevent real estate prices from falling significantly like they did in the United States and more than 80% of China’s residential financial wealth is tied up in the real estate market.
What will happen when this bubble collapses? I have no doubt that the government will try to help again. But even the CCP has its limits. A collapse in Chinese housing prices will signal a collapse in the confidence of the Chinese residents in the ability of the government to provide them with an ever improving standard of living. A financial crisis, with massive unemployment could become a threat to China’s semi communist regime. That could be the big black swan of this decade.
If you wish to know more about China’s Shark Loan Ponzi Finance, with full translation of Stories from the Chinese press please visit China’s Shark Loan Finance Section at Israel’s Financial Expert.
