Trade Resources Policy & Opinion China Must Make Sure That Talent and Bright Ideas Are Matched with Access to Credit

China Must Make Sure That Talent and Bright Ideas Are Matched with Access to Credit

Judging by the designer shoes this young Chinese entrepreneur is sporting, his business, a cozy Italian restaurant in an upscale Shanghai neighborhood, must be doing rather well. The new car parked outside reinforces that observation.

On closer inspection, however, the eatery is almost always empty. At 8pm on a Friday night, the 30-year-old and a few of his friends have puffed up a cloud of cigarette smoke on the second floor as they sample the restaurant's stock of imported beer. He might shut the place down. It was fun while it lasted. In all honesty, he says, it was an experiment funded by his father.

Unfortunately, this is a familiar pattern. Many of China's startups and small businesses rely on informal family financing. The country lacks robust credit institutions that calculate the risk associated with lending to the entrepreneurial class. A monopoly by state-owned enterprises over bank loans has squeezed out businesspeople without savings, pushing them into a shadow market for credit that is threatening the country's financial stability.

In order to keep growing, the country must make sure that talent and bright ideas are matched with access to credit. As in many developed nations, it's the entrepreneurial class that will make money then spend it, driving economic development. China is badly in need of innovation but relying on innovation spawned only by the rich seems a risky bet.

“That would depend on just the wealth of the families, not the quality of ideas,” former US Federal Reserve governor Randall Kroszner said this month at a talk in Shanghai.

Credit scores for all

Innovation and strong domestic consumption in countries such as the US has been driven by a middle class with ample access to credit, noted Kroszner, who is now a professor at University of Chicago's Booth School of Business. The Silicon Valley boom in the 1990s and the entrepreneurs behind it came overwhelmingly from the working class and often relied on access to credit to fund their ideas. Microsoft's Bill Gates is a poster child for that cause.

An essential building block in this process is the development of a competitive credit scoring system, one that can assess the risk of those looking to borrow and then allocate capital efficiently. China is developing a system, yet like so many other aspects of the financial market, this too is under the thumb of the central government.

The People's Bank of China opened the country's first credit scoring agency, the Credit Reference Center, just seven years ago, according to its official website. The bank had been keeping track of some personal and business credit records before then but those operations were shrouded in mystery. Individuals had no right to look at their records and even state banks had trouble accessing the highly fragmented information.

The center now holds records for about 800 million people, or about 60% of the population. In late 2009, the central bank laid down guidelines for how the system will be used to score credit. Banks can access personal credit reports for customers applying for loans, much like banks in developed financial markets do.

The primary difference between China and markets such as the US is the lack of private assessment and competition in credit scoring. Between the People's Bank and the state lenders under it, a Chinese citizen's access to credit is completely determined by the government. Or, as one Chinese newspaper put it in 2009, “the bank is the one and only ruler of [credit] records.”

“In order to make those financing decisions, you need a competitive system,” Kroszner said. “Steps are being taken in that direction in some of the regulatory reforms but I think there's much greater urgency than what they have received so far.”

Private enterprise has done most of this work in the US. Companies such as Fair Issac Corporation and Equifax compete to provide the data on individual credit histories. The market in collecting and processing the records itself is a multibillion-dollar industry as banks pay top dollar to understand the risks associated with borrowers.

It goes without saying that the Chinese government has kept these international companies out.

System failure

Stomping out competition in the formal market has naturally given life to a gray area – one that's grown so rapidly during the past four years that it threatens to destabilize China.

In Wenzhou, Zhejiang province, a hotbed of entrepreneurship in the country, a shadow banking sector has thrived on the demand for quick access to capital. Ignored by the big state banks, regional businesspeople look to informal lenders that often collect upwards of an annual 30% on loans.

According to a study by the China Academy of Social Sciences, the country's top government think tank, outstanding loans in the shadow banking sector were worth up to 40% of China's GDP at the end of 2012. Waves of informal defaults have already led to suicides among factory owners in the region. Another slew of defaults on the estimated US$3.35 trillion in gray loans could cause the greatest domestic financial distress China has seen in decades.

The government has come down hard on shadow bankers, even dishing out the death penalty to some of the biggest lenders. Yet strict laws will not stem these problems. They are, after all, symptoms of a closed and tightly controlled credit system that have excluded capital-hungry businesses.

Policymakers must now move to tackle the root of these difficulties instead of sidestepping them. Introducing competition in the market for credit would put many shadow bankers instantly out of business. Perhaps more importantly, it will tap a new wellspring of innovation for Chinese growth.

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China Must Match Bank Loans with Innovation
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