Private Lending in China: Practice, Law, and Regulation of Shadow Banking and Alternative Finance [1 ed.] 1138331651, 9781138331655

Table of contents :
Dedication
Contents
List of figures and tables
List of legislations
Preface
1 Introduction
2 Private lending market: historical evolution and operating mechanism
3 The private lending crisis: cause, effect, and risk
4 The legal framework of private lending
5 Regulating private lending: rationale and practice
6 The future of private lending
7 Conclusion
Index

Citation preview

Private Lending in China

This book explores China’s private lending market from historical, economic, l­ egal, and regulatory perspectives. Private lending refers to moneylending agreements between business borrowers and their debt investors without the involvement of banks. In China, it remains difficult for private entrepreneurs to obtain sufficient loans from state-owned banks. Thus, private lending has been a vital alternative financing channel for over 80 million businesses which are reliant on private funds as their major source of operating capital. The market volume of private financing stands at 5 trillion yuan ($783bn), making it one of the largest shadow banking systems in the world. Despite the wide popularity and systemic importance of private lending activities, they have remained outside of the official regulatory framework, leading to extra financial risks. In 2011, China’s private lending sector encountered a severe financial crisis as thousands of business borrowers failed to repay debts and fell into bankruptcy. Lots of bosses who found it impossible to liquidate debts ran away to hide from creditors. The financial turmoil has caused substantial monetary losses for investors across the country, which triggered social unrest and undermined financial stability. This book is a timely work intended to demystify China’s private lending market by investigating its historical development, operating mechanism, and special characteristics. It evaluates the causes and effects of the latest financial crisis by considering a number of real cases relating to helpless investors and runaway bosses. It conducts an in-depth doctrinal analysis of Chinese laws and regulations regarding private lending transactions. It also examines China’s ongoing financial reform to bring underground lending activities under official supervision. Finally, the book points out future development paths for the private lending market. It offers suggestions for global policymakers devising an effective regulatory framework for shadow banking. It appeals to researchers, lecturers, and students in several fields, including law, business, finance, political economy, public policy, and China study. Lerong Lu is Lecturer in Law at the University of Bristol. Prior to this, he was Teaching Fellow at the Dickson Poon School of Law, King’s College London. Dr Lu holds a Doctor of Philosophy in Law and a Master of Laws from the University of Leeds. He obtained his Bachelor of Laws and Bachelor of Economics degrees from the East China University of Political Science and Law. Dr Lu’s research interests lie in international financial law and regulation, and he has published extensively in the fields of shadow banking and fintech. Dr Lu is a qualified attorney-at-law in the People’s Republic of China.

Routledge Research in Finance and Banking Law

Law and Finance after the Financial Crisis The Untold Stories of the UK Financial Market Abdul Karim Aldohni Microfinance and Financial Inclusion The challenge of regulating alternative forms of finance Eugenia Macchiavello Law and Regulation of Mobile Payment Systems Issues arising ‘post’ financial inclusion in Kenya Joy Malala Management and Regulation of Pension Scheme Australia: A Cautionary Tale Nicholas Morris The Regulation and Supervision of Banks The post crisis Regulatory Responses of the EU Chen Chen Hu Regulation and Supervision of the OTC Derivatives Market Ligia Catherine Arias-Barrera Value Added Tax Fraud Marius-Cristian Frunza Private Lending in China Practice, Law, and Regulation of Shadow Banking and Alternative Finance Lerong Lu For more information about this series, please visit: www.routledge.com/ Rout le dge -Re s e a rch-i n-Fi na nc e -a nd-Ba n k i ng-Law/ b ook- s er ie s / FINANCIALLAW

Private Lending in China Practice, Law, and Regulation of Shadow Banking and Alternative Finance

Lerong Lu

First published 2019 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 52 Vanderbilt Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2019 Lerong Lu The right of Lerong Lu to be identified as author of this work has been asserted by him in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data A catalog record has been requested for this book. ISBN: 978-1-138-33165-5 (hbk) ISBN: 978-0-429-44717-4 (ebk) Typeset in Times New Roman by codeMantra

This book is dedicated to my parents. 谨以此书献给我的父母。

Contents

List of figures and tables ix List of legislations xi Preface xiii 1 Introduction 1 2 Private lending market: historical evolution and operating mechanism 17 3 The private lending crisis: cause, effect, and risk 44 4 The legal framework of private lending 76 5 Regulating private lending: rationale and practice 107 6 The future of private lending 135 7 Conclusion 161 Index 173

List of figures and tables

Figures 1.1 2.1 3.1 3.2 3.3 4.1 5.1 6.1 6.2

The basic structure of private lending 5 China’s GDP, 1978–2016 (Unit: CNY 100 million) 25 China’s annual GDP growth rate (2005–2017) 46 The business model of Xiamen Rongdian financing guarantee company 62 The structure of a large lending chain 68 The number of private lending cases received by Chinese courts 90 The dual-level credit system 108 Annual investment return of P2P loans 143 The number of P2P lending platforms in China 145

Tables 2.1 Selected Examples of the Classification Standard for Chinese Businesses 26 2.2 Ownership Structure of Big Four Chinese Banks 28 2.3 Main Components of the Shadow Banking System in China 33 4.1 A Summary of the Validity of Private Lending Agreements by Different Entities 82 4.2 Private Lending Cases (First Instance) Received by Xiamen Courts 91 5.1 Wenzhou Private Financing Index (19 April 2018) 130 6.1 The Timeline of Interest Rate Liberalisation in China 156

List of legislations

Ministry of Justice, “The Opinions of Ministry of Justice on Providing Notarisation for Private Lending Contracts” (SIFATONG 1992 No.074) People’s Bank of China, “The Notice of Cracking Down Underground Money House and Usury Activities” (YINFA 2012 No.30) People’s Bank of China, “The Reply of PBOC on Issues Concerning Lending between Enterprises” (16 March 1998, YINTIAOFA 1998 No.13) PRC Civil Procedure Law 2012 PRC Commercial Bank Law 1995 PRC Contract Law 1999 PRC Criminal Law 1997 PRC Deposit Insurance Regulation 2014 PRC Enterprise Bankruptcy Law 2006 PRC General Principles of Civil Law 1987 PRC Guarantee Law 1995 PRC Organic Law of the People’s Courts 1979 PRC Property Law 2007 State Council, “Regulation on the Supervision and Administration of Financing Guarantee Companies” (2017 Order No.683) State Council, “The Overall Scheme of Financial Reform Pilot Zone in Wenzhou, Zhejiang Province” (YINFA 2012 No.188) Supreme People’ Court, “The Reply of SPC on What Standards Shall Be Used When Calculating Liquidated Damages of Overdue Loan Payment” (FASHI 1999 No.8) Supreme People’s Court, “Notice of the Supreme People’s Court on Legally and Properly Hearing Cases of Private Lending Disputes to Promote Economic Development and Maintain Social Stability” (FA 2011 No.336)

xii  List of legislations Supreme People’s Court, “Provisions of the Supreme People’s Court on Several Issues Concerning the Application of Law in the Trial of Private Lending Cases” (FASHI 2015 No.18) Supreme People’s Court, “Reply to How to Deal with Borrowers’ Defaults When Falling Due in Enterprise Lending Agreements” (FAFU 1996 No.15) Supreme People’s Court, “Some Opinions Concerning the Hearing of Private Lending Cases by People’s Courts” (13 August 1991, FAMINFA 1991 No.21) Supreme People’s Court, “The Explanations Concerning Trials of Joint Operation Contract Disputes” (FAJINGFA 1990 No.27) Supreme People’s Court, “The Reply of the SPC on How to Determine the Validity of Lending Activities between Residence and Enterprise” (FASHI 1999 No.3) Wenzhou Private Financing Regulation (2014) Wenzhou Private Financing Regulation Implementation Rules (2014) Zhejiang Provincial Government, “Implement Rules for the Wenzhou Financial Reform Pilot Zone” (23 November 2012)

Preface

This book provides an in-depth and holistic analysis regarding China’s private lending market, one of the largest shadow banking systems in the world. Private lending refers to moneylending agreements between business borrowers and their debt investors without the involvement of banks. Over the past four decades, China has gradually abandoned a centrally planned economy and established a socialist market economy. The revival of Adam Smith’s free-market ideology has led to the proliferation of private enterprises and rapid economic growth. In 2010, China became the second-largest economy in the world. Now, it has a large number of world-class corporations, like Huawei, Baidu, Alibaba, Tencent, DJI, and Lenovo. Clearly, the economic successes of Chinese entrepreneurs are well known. However, how private businesses are being financed remains a secret. In fact, it is difficult for private enterprises to borrow sufficient funds from state-owned banks, which grant most of their loans to other state-owned corporations. Therefore, 80 million private businesses in the country have been heavily reliant on private lending as their major source of operating funds. Private financing has become the most popular alternative financing vehicle for entrepreneurs in modern China. Its market volume amounts to 5 trillion yuan ($783 billion). Although the enormous private lending market is operating in parallel to the official banking industry, it is almost unregulated by financial authorities. In 2011, the shadow banking system encountered a series of credit crises when numerous business borrowers failed to repay private debts amidst China’s economic slowdown after the global financial crisis. The default waves caused investors significant financial losses and led to the collapse of multiple large investment schemes across the country. Many bosses chose to run away to evade debts and abandoned their businesses and employees. The financial crisis has sparked widespread social unrest and undermined China’s financial stability. Against this background, this book studies China’s private lending market from historical, economic, legal, and regulatory perspectives. It investigates the historical development, operating mechanism, and special characteristics of private lending activities. It evaluates the causes and effects of the latest financial crisis by considering a number of real cases relating to helpless

xiv Preface investors and runaway bosses. It conducts a thorough doctrinal analysis of Chinese laws and regulations regarding private lending transactions. It examines China’s ongoing financial reform to bring underground lending activities under official supervision and to provide more financing resources for private businesses. It also explores potential development paths for China’s private lending market in the context of the fintech revolution and financial liberalisation. The book offers valuable suggestions for global policymakers devising an effective regulatory framework over shadow banking activities. It appeals to researchers, lecturers, and students in several fields, including law, business, finance, political economy, public policy, and China study. This paragraph explains what inspired the author to write this book: I was born and raised in Xiamen, a commercial city on China’s south-east coast. Xiamen has a population of 4 million and a prosperous private sector, and the city has been regarded as the regional financial centre in South Fujian. I have personally witnessed the private lending investment bubble in Xiamen over the past decade, and the following bubble burst in 2011. Private lending has been a common method of business finance for local entrepreneurs. Local residents are crazy about loaning their savings to business owners to earn eye-catching interest incomes as the annual rate is often over 20 per cent. Take my father as an example. He has been practising law for over 30 years and is a senior partner at a local law firm. As a lawyer himself, my father used to be very sceptical about private lending investments owing to their risky and semi-legitimate nature. However, in 2010, when one of his friends invited him to join a private lending investment scheme and promised an attractive return (3 per cent monthly return), my father could not resist the temptation to make quick money and invested most of his savings into the scheme. After lending out the money, he did enjoy good interest returns, which were paid on time for several months. Nonetheless, when the private lending crisis hit Xiamen in 2011, the moneylender who looked after my father’s money suddenly ceased to pay interest. My father started to realise that it was nearly impossible to recover the principal because the moneylender had suffered substantial losses due to numerous debtors defaulting. Finally, my father ended up losing all of his savings in this investment. In Xiamen, there are thousands of investors like my father who experienced tremendous financial losses during the lending crisis. As a result, many investors hired lawyers and filed lawsuits against debtors to claim back their money. In the early 2010s, over 17,000 private lending-related civil cases were heard by courts in Xiamen, involving monetary claims worth billions of yuan. Due to the surging lending disputes, lots of investors asked my father to be their attorney to launch the civil litigations. Therefore, his law firm had good business after the private lending crisis. Ironically, my father, who had been a victim of the private lending investment bubble, somehow benefited from the crisis. Clearly, what happened in my hometown provoked my interest in researching China’s mysterious private lending market.

Preface  xv I would like to extend my gratitude to the following individuals. My special thanks go to Professor Andrew Campbell and Dr Sarah Brown for their guidance, support, and patience from 2012 to 2017, when I was an LLM student and then a doctoral candidate at the School of Law, University of Leeds. I am extremely grateful to my parents, Mr Lu Yuanzheng and Mrs Ye Bin, and my wife, Dr Hong Jialan, for their endless love, encouragement, and support. I thank the editors at Routledge for their enormous help during the publication process of this book. I also thank the editors at Sweet & Maxwell and Carswell for their permission to reproduce the following two articles in this book: • •

Lu L, ‘Shadow Banking for Cash-Strapped Entrepreneurs: A Study of Private Lending Agreements Under Chinese Contract Law’ (2018) Journal of Business Law, Issue 3, pp. 215–228. Lu L, ‘Private Banks in China: Origin, Challenges and Regulatory Implications’ (2016) Banking and Finance Law Review, Vol. 31(3), pp. 585–599. Lerong Lu London, May 2018

1 Introduction

1.1  Research background In the late 1970s, China started to launch a series of market-oriented e­ conomic reforms guided by the “reform and opening-up” policy.1 It has gradually abandoned the planned economy model that had been ­i mplemented over the previous 30 years. The market discipline, or the “invisible hand” described by Adam Smith, has been brought back to China. The “socialist market economy” has been established where private businesses play a greater role in resource allocation and economic production.2 As the state is giving way to the market, China has witnessed the rapid growth of private capitalism over the past four decades. Entrepreneurs started to run businesses and pursue personal wealth, contributing to a rising private sector as well as to economic expansion. From 1978 to 2012, the Chinese economy experienced an average annual gross domestic product (GDP) growth of 9.8 per cent.3 In 2010, China surpassed Japan as the second-largest economy in the world, just next to the United States.4 Clearly, China’s economic development can be largely attributed to the reviving of the private sector, consisting of 10 million businesses that accounted for 60 per cent of China’s GDP in 2012.5 Private enterprises have made significant contributions in terms of producing various products and services for domestic and global consumers, creating hundreds of millions

1 In December 1978, the economic reform was initiated by Deng Xiaoping in the 3rd Plenary Session of the 11th Central Committee of the Communist Party of China. Deng has been viewed as the architect of China’s economic reform. See Linda Yueh, China’s Growth: The Making of an Economic Superpower (Oxford University Press 2013) at 19. 2 The Economist, “China’s Reforms: The Second Long March” (11 December 2008) at 30. 3 Jianhong Zhu, “35 Years, Chinese Economy Keep Rising”, People’s Daily (21 November 2013) at 4. 4 Mure Dickie and Jonathan Soble, “China Displaces Japan as Second Biggest Economy”, Financial Times (15 February 2011) at 9. 5 People, “Private Economy Account for 60% of GDP, Registered Private Enterprises Exceed 10 Million” (3 February 2013), available at http://finance.people.com.cn/n/2013/0203/ c1004-20414645.html, accessed 1 May 2018.

2 Introduction of job opportunities in Chinese cities and rural areas as well as contributing to a large percentage of the country’s tax revenue. The majority of private businesses are small and medium-sized enterprises (SMEs), representing 99 per cent of the total business population in China.6 In 2015, SMEs generated 60 per cent of the national GDP, 50 per cent of the state’s tax ­income, and 80 per cent of jobs in urban areas.7 The proliferation of ­private ­capitalism has accumulated a large amount of private wealth. According to the Hurun Rich List 2016, China had 594 billionaires, outnumbering 535 billionaires in the United States.8 A number of Chinese businesses have become global leaders in their respective fields, such as Lenovo, Huawei, ­Alibaba, Tencent, Baidu, Wanda, Fosun, and HNA Group. Contrary to the well-known success story of Chinese entrepreneurs, how their businesses are being financed remains a secret. In fact, they have been facing financing difficulties for a long time since private businesses have limited access to China’s banking sector. This has been described as a major obstacle, impeding the growth of Chinese businesses, particularly SMEs, and the overall economy.9 The financing dilemma of private entrepreneurs, to a large extent, results from the state monopoly in the financial ­industry. Despite the multiplying of private businesses, the state is still ­exerting tight control over industries of strategic importance, such as banking, telecommunications, petroleum, and railway. Most Chinese banks have strong government backgrounds and have been heavily influenced by the official lending policies.10 As a result, state lenders prefer to grant loans to other state-owned companies and local government infrastructure projects. When making loans to private businesses, Chinese banks favour large companies which can offer adequate collaterals and valid guarantees. SMEs are considered less secure, so they have little chance of borrowing funds from banks. The rejection rate for loan applications is 72 per cent for businesses with no more than 500 employees.11 The conflict between the rising private sectors and the inadequate financing resources has been a fundamental challenge to the Chinese economy. Accordingly, entrepreneurs needing funds are forced to seek alternative financing outside the banking sector. Meanwhile, members of the Chinese 6 Yijiang Wang, “The Reason to Save SMEs at First”, Business Review (February 2009) at 40. 7 Lucy Hornby and Gabriel Wildau, “Beijing Tries to Extend Credit Lines in the Countryside”, Financial Times (7 August 2015) at 2. 8 BBC News, “China Tops US in Numbers of Billionaires” (13 October 2016), available at www.bbc.co.uk/news/business-37640156, accessed 1 May 2018. 9 Emma Dong and Simon Rabinovitch, “China’s Lending Laboratory”, Financial Times (23 May 2012) at 11. 10 Violaine Cousin, Banking in China (2nd Edition, Palgrave MacMillan 2011) at 56. 11 Ye Huang, “What Cause SME Financing Difficulty?” People (25 August 2014), available at http://finance.people.com.cn/bank/n/2014/0825/c202331-25528320.html, accessed 1 May 2018.

Introduction  3 population have accumulated significant private wealth during the economic boom and are searching for investments that could bring satisfactory returns. In 2014, the total investable assets held by Chinese individuals amounted to CNY 112 trillion.12 Therefore, the abundant private savings and capital in the society have supplied sufficient funds to the private lending market, in which private entrepreneurs can borrow credit to finance their business ventures. Private lending denotes moneylending and borrowing activities occurring outside the state banking system. Such shadow banking businesses are almost unregulated by financial authorities. According to one estimate, the size of the informal lending market in China was around CNY 4 trillion or 8 per cent of the official lending scale.13 Despite the lack of regulation and its semi-legal status, private financing has evolved into a massive and sophisticated industry in China. In the past, the government turned a blind eye to underground financing for most market participants indeed benefited from shadow banking activities. Private entrepreneurs, through borrowing money from the private lending market, obtained adequate capital to grow their businesses. Investors also earned decent returns. However, things have changed, owing to the global financial crisis as well as the slowing down of China’s economic growth. The double-­digit GDP growth rate suddenly fell to a rate of just over 6 per cent.14 The economic slowdown triggered a “private lending crisis” in 2011. It has been described as the “Chinese-style subprime crisis”.15 Lots of private businesses, particularly traditional manufacturers and exporters, fell into insolvency owing to the fierce competition and decline in sales.16 During the credit crunch, a large number of private entrepreneurs were unable to pay off private debts, so they tried to hide, run away, or even commit suicide. The rising defaults in the private lending market caused significant financial losses for millions of investors who are either professional lenders or ordinary households. Worse still, some investors had borrowed money from their relatives, friends, and business partners in order to use the leverage to multiply investment returns. When business borrowers failed to liquidate debts, the entire private lending market collapsed like a domino. It caused severe financial crises and undermined the financial and social stability.

12 China Merchants Bank and Bain & Company, China Private Wealth Report (2015) at 5, available at http://images.cmbchina.com/cmbcms/201506/b7ee1bf8-47fa-4ba7-ba997545a62f6ca1.pdf, accessed 1 May 2018. 13 Rahul Jacob, Ping Zhou and Simon Rabinovitch, “Chinese SMEs Rely on Shadow ­Financing”, Financial Times (19 October 2011) at 2. 14 Tom Mitchell and Yuan Yang, “China’s Growth Adds to Fears on Debt Levels”, Financial Times (20 October 2016) at 4. 15 Simon Rabinovitch, “Lending Loses Its Lustre for China’s Rich”, Financial Times (5 ­O ctober 2011) at 22. 16 Julie Ball, “China Set to Reform Illicit Private Finance Market”, BBC News (20 April 2012), available at www.bbc.co.uk/news/business-17746171, accessed 1 May 2018.

4 Introduction In response to the financial tsunami, the Chinese authorities launched a new round of financial reforms. They have been exploring effective methods to regulate the private lending market and to increase credit support for private businesses. For example, the State Council set up a pilot reform zone in Wenzhou in 2012 which has been testing an official regulatory ­regime for private financing. The financial reform has also encouraged ­private ­i nvestors to establish banks and other financial institutions, like small-loan ­c ompanies, to improve SMEs’ access to finance.17 In recent years, the Chinese economy has entered into a new development phase dubbed the “new normal”.18 It has featured a moderate growth rate as well as the change of the growth engine from manufacturing and construction towards service and innovation. It is high time that the country established a multilevel financing system which includes the banking industry, securities markets, and the private lending market to support the further growth of private businesses. In addition, the formalisation and regulation of private lending activities have echoed China’s ongoing “supply-side reform”, which aims to let the market produce products and services which are really needed by the society.19 Evidently, the financial industry, including the private lending market, is supposed to provide enough financing resources for private businesses in need of funds. In order to achieve these reform objectives, China has to find an effective method to legalise, regulate, and supervise private lending activities. The new regulatory framework has to curb excessive financial risks associated with underground financing, maintain financial stability, and boost the availability of finance for private enterprises.

1.2  Key concepts in the book This section introduces some key concepts in this book, including private lending, informal finance, shadow banking, and financial regulation. Private lending has been perceived as a vital element of the informal finance sector. Nonetheless, China’s private lending activities are distinctive from the informal finance industries in other countries. The private lending ­market exists in parallel with an advanced banking industry, and it serves a wide range of clients, which even include public companies. In addition, the private lending market belongs to China’s shadow banking system as it qualifies as non-bank credit intermediaries and meets most criteria regarding shadow banking.

17 PRC State Council, The Overall Scheme of Financial Reform Pilot Zone in Wenzhou, ­Zhejiang Province (2012). 18 Martin Wolf, “China’s Struggle for A New Normal”, Financial Times (23 March 2016) at 13. 19 Tom Mitchell, “Beijing Struggles to Meet Needs of Middle-Class Consumers”, Financial Times (20 January 2016) at 7.

Introduction  5 1.2.1  Private lending The financial services industry can be broadly divided into banking, ­securities, and insurance. Outside mainstream financial institutions and markets, there exists a hidden world of informal finance which has been largely underexplored by scholars. Private lending, clearly, forms part of China’s informal financial sector. It refers to moneylending agreements between a business borrower and its debt investors. Millions of private businesses, having limited access to the state-dominated banking sector, rely on private financing methods to borrow funds. Accordingly, private lending agreements have become one of the most popular commercial contracts in China, and the private lending market has been an important and indispensable alternative finance channel for entrepreneurs. This book studies ­private lending as an alternative business finance method. It is different from traditional small-sum and not-for-profit moneylending activities that happen among relatives, friends, colleagues, and other acquaintances. By this definition, individuals and corporates borrow private loans for the purpose of business operation. At the same time, moneylenders and investors lend out their money in exchange for future financial returns in the form of interest. Despite the popularity of private lending, it lacks a clear definition and legitimate status. The term “private lending” is often interchangeable with similar concepts, such as private financing, informal finance, and shadow banking, as they all refer to non-bank financing activities (Figure 1.1). The basic structure in any private lending agreement involves at least two parties: lenders and borrowers. Borrowers mainly refer to entrepreneurs who run their own businesses, most of which are SMEs. Private lending is crucial to the funding of such businesses. Lenders could be any individuals or businesses in the society who have spare capital or savings and would like to invest their money in the borrowers’ businesses through private ­financing. In practice, the sources of funding for lenders are diverse. Some use their own funds to extend loans to borrowers. Some obtain bank loans and then relend the funds to other capital-starved entrepreneurs at a higher price. In some cases, professional moneylenders even attract funds from the public. They make profits by borrowing at lower interest rates and then making loans at higher interest rates. The lending venture can be extremely

Figure 1.1  T  he basic structure of private lending.

6 Introduction lucrative if moneylenders pool together a large amount of money. These moneylenders are creditors on the one side and debtors on the other side as they owe money to their own investors. The deposit-taking model leads to extra financial risks and is a source of systemic risks. Apart from lenders and borrowers, there are some third parties engaging in private lending transactions. For instance, lending brokers introduce lenders and borrowers to enter into lending agreements and charge fees over their matching service. Sometimes lenders will ask the brokers to provide a guarantee for the future payment of interest and principal. In addition, any individuals and businesses can be guarantors in private loan arrangements. There are also professional guarantee companies providing tailored guarantee services. Lenders, borrowers, and third parties, including brokers and guarantors, together form private lending agreements. The potential financial risks can be found in several aspects. The sources of funding for moneylenders are diversified, and in practice, the self-owned capital takes up only a small ­proportion of the funding pool of professional moneylenders. Moneylending businesses operate at a low reserve as most funds are derived from the public, and this has increased the negative impacts of potential defaults. If lots of borrowers simultaneously default on loans owed to moneylenders, moneylenders will default on their own investors for they do not have ­adequate capital reserves. When massive defaults happen or when a large number of investors withdraw funds at the same time, the market liquidity will quickly drain, and moneylenders will fall into insolvency. As a result, the entire private lending market will probably collapse if several major moneylenders become bankrupt. In this scenario, thousands of investors who have deposited their savings into lending schemes will suffer significant financial losses as their money is not protected by the authorities. The only legitimate remedy for investors is to file lawsuits against debtors to claim back the funds. The civil litigations can be time-consuming and costly, and have a limited effect on recovering money in the end. Furthermore, a s­ ignificant proportion of moneylenders’ capital has come from Chinese banks. Thus, if the default crisis arrives in the private lending market, banks will also be affected and will witness increasing bad loans. The interconnectedness between banking and shadow banking results in systemic risks. In addition, when a financial crisis is coming, guarantors bear a joint liability with debtors to pay off principals and interest. Nonetheless, many business owners have formed an alliance to provide guarantees for each other in order to increase the chance of securing external loans. Thus, the failure of one business in the group is likely to drag other healthy businesses who serve as guarantors into insolvency. This also creates systemic risks. 1.2.2  Informal finance Informal finance encompasses a wide range of non-bank financing activities conducted through family, friends, local money houses, and other financial

Introduction  7 20

associations. Informal financial activities are subject to limited supervision from financial authorities owing to their underground and opaque nature. They provide a large amount of credit for individuals and businesses who are excluded from the formal financial system. In the 1960s, economists started to research informal finance in developing countries, with a focus on what role non-bank financial institutions play in economic and social progress. Clifford Geertz suggested that it is necessary for developing countries to possess a middle ground between having no credit and saving institutions, and having a modern banking system.21 The middle ground is comprised of multiple informal financial activities and institutions, such as Rotating Savings and Credit Associations (ROSCAs), pawnshops, and private lending.22 In the 1990s, informal financial activities in China were categorised into six groups: he hui (the Chinese version of ROSCAs), private lending, qian zhuang (money houses), pawn brokering, money collection, and rural cooperative funds.23 Informal finance is rooted in local personal networks where lenders, borrowers, and brokers are known to each other. Lending parties who are acquaintances can negotiate the terms and conditions of private lending agreements in a flexible manner. Informal finance supports the economic growth of developing countries without a mature banking sector by allowing individuals to access credit to purchase large-amount goods or to run businesses. Edward Shaw and Ronald McKinnon invented the financial repression theory to explain the cause of informal finance.24 The governments of some developing countries have adopted an interventionist approach to govern the financial industry, including the control of banking interest rates and the state ownership of financial institutions. In doing so, they can direct financing resources to certain state-backed sectors and reduce the financing costs of government debts. Financial repression, therefore, gives rise to the financing difficulties of the private sector, so private businesses have to use informal finance to obtain working capital. Moreover, the prevalence of informal finance can be attributed to its advantage in solving information asymmetry.25 Banks refuse to

20 Sara Hsu, “Introduction” in Jianjun Li and Sara Hsu (eds), Informal Finance in China: American and Chinese Perspectives (Oxford University Press 2009) at 3. 21 Clifford Geertz, “The Rotating Credit Association: A ‘Middle Rung’ in Development” (1962) 10 Economic Development and Cultural Change 241 at 263. 22 ROSCA refers to a type of financial organisation based in the local community where members regularly contribute money to a pool and then take turns using the money for personal consumption or economic production. 23 Xuzhao Jiang, The Research of Informal Finance in China (Shandong People’s Publishing House Press 1996) at 54. 24 See Edward S. Shaw, Financial Deepening in Economic Development (Oxford University Press 1973); and Ronald I. McKinnon, Money and Capital in Economic Development (Brookings Institution 1973). 25 Yifu Lin and Xifang Sun, “Information, Informal Finance, and SME Financing” (2006) 1 Frontiers of Economics in China 69 at 72.

8 Introduction extend loans to SMEs because they are unable to get sufficient information concerning borrowers’ real financial situations. In contrast, informal lenders can make use of social networks to acquire the information of borrowers relating to business operation, asset amount, l­ iability, and cash flow. In this ­r espect, the long-lasting ­problem of ­i nformation asymmetry can partly be mitigated by the information a­ dvantage of informal lenders. It is widely agreed that informal finance, by serving the lower end of the financial market, plays a complementary role in the financial system.26 ­I nformal finance supplies small-amount and short-term loans to financially excluded individuals, such as rural residents and small business owners. Its popularity results from the underdevelopment of the formal financial industry. Accordingly, the private lending market in China, to some extent, fits into the definition of informal finance. However, private financing in China also challenges the conventional view about informal finance in ­s everal ­a spects. For example, according to Geertz’s theory, the existence of informal finance is mainly due to the absence of formal credit and saving institutions. This contradicts China’s reality as its private lending market has been growing fast in parallel with a well-established banking system. As we know, the primary function of Chinese banks is to fund state-owned enterprises. Therefore, despite having some of the largest banks in the world, China still needs a private lending sector to satisfy the financing needs of private enterprises. In addition, the prevalence of private lending in China is contrary to the conservative assumption that informal finance serves the lower end of financial markets. In practice, private financing has been widely employed by most Chinese businesses, irrespective of their size. Businesses at the higher end of the SME ­spectrum have strong demands for alternative financing.27 Even some public companies exploit the private lending market to raise funds. For example, Mr Ding Hui, the chairman and chief executive officer of Nuoqi, which is a Hong Kong-listed fashion retailer, borrowed private loans worth CNY 1.5 billion to finance the expansion of his clothing empire.28 Evidently, China’s private lending activities refute the traditional idea that informal finance has been used by marginalised borrowers and that it only involves a small sum of money.

26 Meghana Ayyagari, Asli Demirgüç-Kunt and Vojislav Maksimovic, Formal Versus Informal Finance: Evidence From China (World Bank Research Report, March 2007) at 2. 27 Luke Deer, Jackson Mi and Yuxin Yu, The Rise of Peer-to-Peer Lending in China: An Overview and Survey Case Study (Association of Chartered Certified Accountants, October 2015) at 8, available at http://www.accaglobal.com/content/dam/ACCA_Global/Technical/manage/ ea-china-p2p-lending.pdf, accessed 1 May 2018. 28 Shanshan Wang, “Nuoqi Collapsed as Chairman Absconded: A Curse for IPO”, China Economic Weekly (18 August 2014), available at http://www.ceweekly.cn/2014/0818/90303. shtml, accessed 1 May 2018.

Introduction  9 1.2.3  Shadow banking The term “shadow banking system” refers to financial institutions which act like banks but are not supervised as banks.29 Shadow banking has been considered a major cause for the global financial crisis, and the topic has attracted lots of media attention and academic discussion in recent years. ­Financial regulators have been investigating the nature of shadow banking and the appropriate approach to supervising it. In 2007, the concept of shadow banking was first proposed by Paul McCulley, an economist who defined it as “the whole alphabet soup of levered up non-bank investment conduits, vehicles and structures”.30 The Financial Stability Board (FSB) made an official definition of shadow banking as “the credit intermediation involving entities and activities outside the regular banking system”.31 Regarding how to identify shadow banking activities, the FSB recommends that financial regulators cast the net wide enough to catch all possible non-bank credit intermediation, and then narrow down the scope by looking at additional shadow banking features, such as maturity and liquidity transformation, leverage, flawed credit risk transfer, and regulatory arbitrage.32 The origin of shadow banking systems in Western countries resulted from the shift of banking models from originate-to-hold to originate-to-­ distribute.33 Traditionally, banks take deposits and then use the received funds to extend loans. Banks will hold the loans as primary assets on their balance sheets until the relevant maturity dates. Nowadays, banks are no longer relying on deposit-taking as their sole source of funding. They ­originate loans with the purpose of selling them to other investors ­i mmediately. This involves the securitisation process where banks pack loans into securities, like mortgage-backed securities (MBS) and collateralised debt obligations (CDO).34 These securities are advertised and sold to potential investors around the world, who bring cash to banks, so they can make new loans. Securitisation, however, has extended the conventional credit chain where there used to be only banks, depositors, and ­borrowers. At present, numerous retail and institutional investors take part in the credit transformation process, which spreads credit risks to the entire

29 Laura E. Kodres, What Is Shadow Banking? (IMF Finance & Development, June 2013), available at http://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm, accessed 1 May 2018. 3 0 Paul McCulley, Teton Reflections (PIMCO Global Central Bank Focus, September 2007) at 2. 31 FSB, Shadow Banking: Scoping the Issues (12 April 2011) at 2. 32 Ibid., at 3. 33 Vitaly M. Bord and João A. C. Santos, The Rise of the Originate-to-Distribute Model and the Role of Banks in Financial Intermediation (Federal Reserve Bank of New York Economic Policy Review, July 2012). 34 Zoltan Pozsar et al., Shadow Banking (Federal Reserve Bank of New York Staff Reports No. 458, Revised February 2012).

10 Introduction financial system. The off-balance sheet operation evades regulatory rules which were initially made to supervise the originate-to-hold model, giving rise to ­regulatory arbitrage. However, the Chinese shadow banking system is distinctive from its Western counterparts. As stated, the term was invented to describe the problem of over-securitisation in the United States. In China, the term has been used to describe quasi-banking activities outside the formal banking sector since there are limited innovative structured vehicles in its securities markets. In the past, most credit in China’s financial system did come from banks, but now credit is provided by a wide range of non-bank financiers, including trust companies, leasing companies, credit guarantee companies, money market funds, and the private lending market.35 All these elements constitute China’s vast shadow banking sector, which works as an alternative to bank loans. Market observers indicate that China just borrowed the concept of the “shadow banking system” to describe the prosperous social ­financing system operating alongside its official banking system.36 Therefore, shadow banking in China refers to non-bank financing, which clearly covers the private lending market discussed in this book. Bank loans used to represent 90 per cent of total credit in the country a decade ago, but the figure has fallen sharply, to 50 per cent, in recent years.37 Clearly, the reduced 40 per cent goes to non-bank lending. China’s shadow banking system has been one of the largest in the world for its scale was estimated to be CNY 22.8 trillion or 44 per cent of its GDP.38 1.2.4  Financial regulation The term “regulation” should be broadly conceived. Regulation has an ambiguous meaning, and it can be understood in several ways, from the making and implementation of rules by a certain authority (the narrow ­definition) to any social and economic influences exerted by the state on people’s ­behaviours (the broad definition).39 In this book, regulation refers to the official control over private lending activities, which includes the ­creation of policies, legislations, and other quasi-legal tools as well as the dynamic ­process of monitoring and supervising the private lending market by official authorities. It is worth mentioning that although some discussions 35 The Economist, “Battling the Darkness: Shadow Banking in China” (10 May 2014) at 71. 36 Keguan Luo, “What Is the Chinese-Style Shadow Banking?” Security Times (24 September 2012) A10. 37 Jingwei Zhang, “The Legalisation of Private Lending Can Release the Risk of Shadow Banking”, Xinhua (18 February 2014), available at http://news.xinhuanet.com/­fortune/ 2014-02/18/c_126149597.htm, accessed 1 May 2018. 38 Dong Tao and Weishen Deng, China: Shadow Banking – Road to Heightened Risks (Credit Suisse Economic Research February 2013) at 2. 39 Robert Baldwin, Martin Cave and Martin Lodge, Understanding Regulation: Theory, Strategy, and Practice (2nd Edition, Oxford University Press 2012) at 3.

Introduction  11 concerning personal and corporate insolvency will be inevitable when it comes to the private lending crisis, this book does not intend to fully analyse China’s insolvency laws and regulations, i.e. People’s Republic of China (PRC) Enterprise Bankruptcy Law 2006. In addition, this book focusses on the practical aspect of financial regulation rather than the theoretical examination. Nonetheless, some important regulatory principles, such as the public interest theory, will be mentioned where necessary.

1.3  Research objective, originality, and methodology This book aims to study China’s private lending market from historical, ­economic, legal, and regulatory perspectives. It attempts to do the following: • • • • •

To conduct an inquiry into the nature, causes, and characteristics of the private lending market; To investigate the 2011 private lending crisis, including its causes, ­effects, and economic problems; To evaluate the current legal framework governing private lending activities; To find an effective approach of legalising and regulating the private lending market by examining China’s pilot financial reforms; and To explore future development paths for the private financing industry, in particular, online peer-to-peer (P2P) lending and private banks.

Recent times have witnessed an increasing amount of literature discussing financial law and regulation in China. Most existing works concentrate on China’s banking sector and capital markets.40 When it comes to private lending, shadow banking, and alternative finance, limited research has been conducted so far. There are limited publications focussing on the economic analysis of private financing.41 The legal and regulatory aspects of private lending activities have been largely unexplored by scholars. This book intends to fill this gap in the existing literature for it probes into China’s ­private lending crisis in 2011 for the first time and comprehensively analyses legal and regulatory issues regarding private financing. The originality of this book is self-evident. Apart from that, the private lending market has been viewed as a vital component of China’s shadow banking system, so this book engages in the heated global discussions on the topic of shadow

40 For example, see Violaine Cousin, Banking in China (2nd Edition, Palgrave ­MacMillan 2011); Robin Huang, Securities and Capital Markets Law in China (Oxford University Press 2014); and Jing Bian, China’s Securities Market: Towards Efficient Regulation (­Routledge 2016). 41 For example, see Xuzhao Jiang, The Research of Informal Finance in China (Shandong People’s Publishing House 1996); and Jianjun Li and Sara Hsu (eds), Informal Finance in China: American and Chinese Perspectives (Oxford University Press 2009).

12 Introduction banking. In addition, it has some practical implications. The financial industry in China is developing at an unprecedented speed, and its regulatory regime has been facing multiple challenges. It is clear that the financial reforms need theoretical support, so this book provides valuable suggestions for policymakers in China and beyond. Finally, it will be useful for legal practitioners who advise clients with business interests in China. The study of financial law and regulation is inherently interdisciplinary. This book contains both economic and legal analyses for it examines how the private lending market works and how it is being regulated by law. The discussions involve some fundamental economic principles. For instance, the book uses the supply and demand theory to explain the prevalence of private lending activities in China. It also employs the doctrinal legal method to assess existing Chinese policies, laws, and regulations with regard to private lending. Doctrinal research is the process of identifying and scrutinising the contents of law, and it lies at the heart of most works of academic lawyers.42 Through the examination of current legislation, the author attempts to evaluate the effectiveness and adequacy of the existing legal framework. Despite the limited literature on private lending, the author has collected, assessed, and synthesised most publicly available materials, including but not limited to journal articles, monographs, newspapers, magazines, policies, statutes, regulatory rules, court reports, and research reports. This book refers to numerous news articles from China’s official media, such as Xinhua, People’s Daily, and Global Times, as well as reputable English financial media, such as Financial Times, The Wall Street Journal, The Economist, and Bloomberg. In addition, historical analysis can be found in this book as it reviews the history of lending and banking in China, and predicts the future development paths for private financing.

1.4  Structure of the book The remainder of this book contains six chapters. Chapter 2, entitled “­Private lending market: historical evolution and operating mechanism”, elaborates on the background knowledge concerning the private lending market, including its historical development, operating mechanism, and main characteristics. Private lending activities have emerged under China’s special economic and political environments, so any discussions about private financing would be incomplete without assessing the country’s financial history and social reality. The chapter offers a historical review of lending and banking activities in three time periods: in ancient and imperial China (pre-1912), in the Republic of China period (1912–1949), and in the first 30  years of the People’s Republic of China (1949–1978). Then it examines

42 Terry Hutchinson, “Doctrinal Research” in Dawn Watkins and Mandy Burton (eds), Research Methods in Law (Routledge 2013) at 9.

Introduction  13 the revival and development of private financing activities in contemporary China (1978–present), especially their function in bridging the financing gap of private businesses. It also pays close attention to China’s unique shadow banking system, which includes trust loans, entrusted loan, and private lending. Finally, it summarises the key characteristics of private financing practices. This chapter lays a sound foundation for further analyses about private lending in this book. Chapter 3, entitled “The private lending crisis: cause, effect, and risk”, attempts to investigate the causes and effects of China’s private lending crisis in 2011, which broke the win-win situation in the underground lending market. It offers insight into financial risks and economic problems associated with the Chinese shadow banking system. First, it examines the main factors that led to the crisis, including the macroeconomic condition, the overheated speculation, and the tightened credit policy. It reveals how highcost private loans have become a heavy debt burden for private enterprises, giving rise to default waves in the economic downturn. Next, it probes the effects of the shadow banking crisis on both lending and borrowing sides. The chapter conducts detailed case studies concerning insolvent businesses, runaway bosses, fraudulent lending schemes, and helpless investors who lost most of their savings. It also uncovers economic problems, financial risks, and regulatory deficiencies that were exposed during the crisis, such as the complex lending structure, the illegal deposit-taking model, the ineffective interest rate cap, the lack of a personal insolvency regime, and the inadequacy of investor protection. These problems clearly justify the regulatory reform in the future. Chapter 4, entitled “The legal framework of private lending”, evaluates the existing legal framework governing private lending activities in China. All policies, laws, regulations, and judicial interpretations with regards to private lending will be studied. At first, the chapter considers the changing official attitudes towards private lending activities from the 1990s to the present time, which have been playing an important role in determining the legitimacy of private financing and shaping laws and policy agendas in this area. After that, it emphasises the doctrinal analysis of Chinese laws relating to private lending in three areas: civil laws (mainly contract), criminal liabilities, and interest rate regulations. It also studies two criminal cases regarding Mr Zeng Chengjie and Ms Wu Ying, who committed the crime of fraudulent fundraising. This chapter attempts to understand how relevant laws and regulations are being interpreted and applied by China’s judicial system. It tries to find out whether the current legal framework is sufficient, efficient, and effective in dealing with the rising civil disputes and illegal fundraising cases after the private lending crisis. Chapter 5, entitled “Regulating private lending: rationale and practice”, explores China’s recent financial reforms to address market failures and financial risks during the private lending crisis and to provide more financing resources for private entrepreneurs. It begins with some discussions about

14 Introduction the logic of solving the private lending puzzle in China, a paramount issue for policymakers, economists, lawyers, and social scientists. It then scrutinises the rationale for regulating the private lending market by taking into account some regulatory theories and China’s practical needs. The following section studies the pilot financial reform in Wenzhou aiming to bring underground financing activities under official supervision and to build a multilevel financing system for SMEs. It evaluates the effectiveness of the reform’s general strategy and details its approaches. The chapter pays special attention to the Wenzhou Private Financing Regulation, which invented a regulatory system over private financing that is based on loan registration, as well as the Wenzhou Private Financing Interest Index, which tracks the interest rate level of private financing activities and promotes market efficiency and transparency. Chapter 6, entitled “The future of private lending”, explores the potential development paths of China’s private lending market and shadow banking system. It argues that the future of private lending lies in the digitalisation, formalisation, and institutionalisation of underground moneylending ­activities. There are two major options for upgrading the private lending market. First, the ongoing fintech revolution allows moneylenders to utilise information technologies to transform their traditional lending businesses into online P2P lending marketplaces. P2P lending is considered the online version of private lending, which brings substantial benefits for both borrowers and lenders. Online P2P lending is also easier for financial regulators to monitor and supervise. The chapter discusses how P2P lending works, its advantages compared with bank lending, and its recent development in China. Second, it is high time for Chinese authorities to deepen financial reform and open the banking sector up to private investors. The financial liberalisation will inject more competition into the banking industry. Consequently, more market-driven banking institutions will allocate adequate credit to private businesses. The chapter studies China’s recent move to ­establish some privately owned banks and relevant regulatory responses. Chapter 7 concludes the book by summarising the main findings and making a final statement. It points out the contribution of this book and offers recommendations for China’s policymakers regarding how to regulate the private lending market and tackle the shadow banking problem. It also offers some suggestions for other researchers who wish to continue research in this area.

Bibliography Ayyagari M., Demirgüç-Kunt A. and Maksimovic V. (2007), Formal Versus Informal Finance: Evidence from China, World Bank Research Report. Baldwin R., Cave M. and Lodge M. (2012), Understanding Regulation: Theory, Strategy, and Practice, 2nd Edition, Oxford University Press. Ball J. (2012), “China Set to Reform Illicit Private Finance Market”, BBC News, 20 April .

Introduction  15 BBC News (2016), “China Tops US in Numbers of Billionaires”, 13 October . Bian J. (2016), China’s Securities Market: Towards Efficient Regulation, Routledge. Bord V.M. and Santos J.A.C. (2012), The Rise of the Originate-to-Distribute Model and the Role of Banks in Financial Intermediation, Federal Reserve Bank of New York Economic Policy Review, July 2012. China Merchants Bank and Bain & Company (2015), China Private Wealth ­Report . Cousin V. (2011), Banking in China, 2nd Edition, Palgrave Macmillan. Deer L., Mi J. and Yu Y. (2015), The Rise of Peer-to-Peer Lending in China: An ­Overview and Survey Case Study, Association of Chartered Certified ­Accountants, October 2015 . Dickie M. and Soble J. (2011), “China Displaces Japan as Second Biggest ­Economy”, Financial Times, 15 February. Dong E. and Rabinovitch S. (2012), “China’s Lending Laboratory”, Financial Times, 23 May. FSB (2011), Shadow Banking: Scoping the Issues, 12 April. Geertz C. (1962), “The Rotating Credit Association: A ‘Middle Rung’ in ­Development” 10 Economic Development and Cultural Change 241. Hornby L. and Wildau G. (2015), “Beijing Tries to Extend Credit Lines in the ­Countryside”, Financial Times, 7 August. Huang R. (2014), Securities and Capital Markets Law in China, Oxford University Press. Huang Y. (2014), “What Cause SME Financing Difficulty?” People, 25 August . Jacob R., Zhou P. and Rabinovitch S. (2011), “Chinese SMEs Rely on Shadow ­Financing”, Financial Times, 19 October. Jiang X. (1996), The Research of Informal Finance in China, Shandong People’s ­P ublishing House. Kodres L.E. (2013), What Is Shadow Banking? IMF Finance & Development, June 2013 . Li J. and Hsu S. (eds.) (2009), Informal Finance in China: American and Chinese ­Perspectives, Oxford University Press. Lin Y. and Sun X. (2006), “Information, Informal Finance, and SME Financing” 1 Frontiers of Economics in China 69. Luo K. (2012), “What Is the Chinese-Style Shadow Banking?” Security Times, 24 September. McCulley P. (2007), Teton Reflections, PIMCO Global Central Bank Focus, ­September 2007. McKinnon R.I. (1973), Money and Capital in Economic Development, Brookings Institution. Mitchell T. (2016), “Beijing Struggles to Meet Needs of Middle-Class Consumers”, Financial Times, 20 January. Mitchell T. and Yang Y. (2016), “China’s Growth Adds to Fears on Debt Levels”, Financial Times, 20 October. People (2013), “Private Economy Account for 60% of GDP, Registered P ­ rivate ­Enterprises Exceed 10 Million”, 3 February .

16 Introduction Pozsar Z. et al. (2012), Shadow Banking, Federal Reserve Bank of New York, Staff Reports No. 458, February 2012. PRC State Council (2012), The Overall Scheme of Financial Reform Pilot Zone in Wenzhou, Zhejiang Province. Rabinovitch S. (2011), “Lending Loses Its Lustre for China’s Rich”, Financial Times, 5 October. Shaw E.S. (1973), Financial Deepening in Economic Development, Oxford University Press. Tao D. and Deng W. (2013), China: Shadow Banking – Road to Heightened Risks, Credit Suisse Economic Research, February 2013. The Economist (2008), “China’s Reforms: The Second Long March”, 11 December. The Economist (2014), “Battling the Darkness: Shadow Banking in China”, 10 May. Wang Y. (2009), “The Reason to Save SMEs at First”, Business Review, February 2009. Wang S. (2014), “Nuoqi Collapsed as Chairman Absconded: A Curse for IPO”, China Economic Weekly, 18 August . Watkins D. and Burton M. (eds.) (2013), Research Methods in Law, Routledge. Wolf M. (2016), “China’s Struggle for A New Normal”, Financial Times, 23 March. Yueh L. (2013), China’s Growth: The Making of an Economic Superpower, Oxford University Press. Zhang J. (2014), “The Legalisation of Private Lending Can Release the Risk of Shadow Banking”, Xinhua, 18 February . Zhu J. (2013), “35 Years, Chinese Economy Keep Rising”, People’s Daily, 21 November.

2 Private lending market Historical evolution and operating mechanism

2.1 Introduction Private lending, one of the most primitive financing activities in the human history, has regained its popularity in modern China. The chapter introduces background knowledge regarding the private lending market, including its historical development, operating mechanism, and main characteristics. ­Section 2.2 provides a brief review of the Chinese financial history in three time periods: ancient and imperial China (pre-1912), the R ­ epublic of China era (1912–1949), and the first 30 years of the People’s Republic of China (1949–1978). Section 2.3 examines the revival and latest developments of ­private lending activities in contemporary China (1978–present). It employs the supply and demand theory to explain the formation of the private ­lending market by considering the financing demands from private enterprises and the supply of funds from cash-rich investors. Section 2.4 i­ nvestigates ­China’s shadow banking system in detail by looking into its major components, such as trust lending, entrusted lending, and private lending. It also scrutinises whether China’s private financing activities possess shadow banking f­ eatures defined by the Financial Stability Board (FSB). Section 2.5 then summarises key characteristics of private financing transactions.

2.2  A brief history of lending in China The financial industry plays a central role in any commodity economies.1 Most modern financial activities in China, whether banking or private l­ending, can find their origins in the country’s 5,000-year history. Therefore, the research on private lending will begin with a study of Chinese lending history. 2.2.1  Credit, lending, and banking in ancient and imperial China (pre-1912) The Chinese civilisation has a prolonged history, including the history of finance and lending. The practice of moneylending between individuals was 1 Zhengping Chen, A Brief History of Finance in China (Paths International 2014) at 1.

18  Private lending market recorded as early as the Western Zhou Dynasty (1046–771 BC). At that time, moneylending contracts were referred to as Fu Bie, documented in Rites of Zhou, which is a book on the official political and ritual systems of the Zhou Dynasty.2 Fu literally means the written form of a lending contract, including the object of debt as well as rights and obligations of the lender and borrower. Bie means splitting the paper contract into two parts to be held by the lender and borrower separately. If lending parties had any disputes regarding the contract, they could report the case to the officials, who would handle the case and make a judgement based on what was written on two parts of Fu Bie provided by both parties. The existence of Fu Bie suggests that moneylending was a common practice in ancient China as the ruling class already devised the standard form of lending contracts and a special dispute-resolution mechanism. At the end of the Eastern Zhou Dynasty, Qing Shi Huang, the first ­emperor of China, united a number of independent kingdoms by force in 221 BC, which marked the beginning of imperial China.3 After the u ­ nification, the agriculture-dominated economy enjoyed steady growth for a long time in a politically stable environment. During the Han Dynasty (206 BC–220 AD), owing to the rapid development of a commodity economy, private ­lending activities and usury were prevalent in the society.4 A lot of businessmen in need of funds borrowed credit from rich individuals like landlords and ­government officials, who became moneylenders, earning interest on the money they lent out. To cope with the mounting problem of usury, the imperial government of Han passed a piece of regulation capping the annual interest rate of private lending at 20 per cent. This was considered the first statute about private lending in Chinese history. Lenders who charged ­interest above the limit would constitute the criminal offence of Qu Xi Guo Lv, which literally means charging interest over the law.5 By the Tang Dynasty (618–907 AD), the private lending market had ­become mature, with mortgage lending and pawnbroking being witnessed. Various professional lending institutions were established at that time. For example, as Buddhism was introduced to China and gained popularity ­during the Tang Dynasty, Buddhist monks often engaged in private ­lending businesses.6 Buddhist temples, as religious shrines receiving donations from the public, played an extra role in being financial institutions which made loans to individuals who intended to borrow money. When the time came

2 Huihui Wen, “Fubie and Zhiji: Two Major Forms of Contracts in the Pre-Qin Period” (2004) 12 Shixue Yuekan (History Monthly) at 20. 3 Ray Huang, China: A Macro History (Routledge 1997) at 12. 4 Qin Hui, “The Classic Lending Relationship in Han Dynasty” (1990) 3 China Economic ­History Research, available at www.hprc.org.cn/pdf/ZJSY199003011.pdf, accessed 1 May 2018. 5 Ibid. 6 Tonghua Luo, The Research of Private Lending in Tang Dynasty (Taiwan Commercial Press 2005) at 81.

Private lending market  19 to the Song Dynasty (960–1279 AD), Jiao Zi, as the oldest paper note in the world, had been circulating in the South-West Sichuan region.7 Jiao Zi was originally designed as a certificate of deposit for it was inconvenient for businessmen to carry heavy metals like gold and silver when travelling. Therefore, many of them deposited metal currencies at Jiao Zi Pu (Shop of Jiao Zi) in exchange for a paper certificate and afterwards withdrew the same number of medals from Jiao Zi Pu’s other branches at the travel destination. Gradually, some merchants found it easier to make payments by Jiao Zi directly instead of frequently depositing and withdrawing medals. As a result, Jiao Zi had become a de facto currency widely accepted by society, and Jiao Zi Pu might have been the earliest financing institution to take deposits, make loans, and issue notes. The Qing Dynasty (1644–1912 AD), the last imperial dynasty in Chinese history, saw the institutionalisation of professional lending activities as Piao Hao and Qian Zhuang emerged as the initial forms of modern banking.8 Piao Hao originated from North China’s Shanxi Province, and it functioned in a similar fashion as Jiao Zi Pu. Nevertheless, the system of Piao Hao was much more advanced as they collectively formed a national banking network. It enabled merchants to transfer large amounts of silver money across different towns and provinces. Besides, Piao Hao issued cashable notes to businessmen and individuals who could exchange the notes into precious metals, or vice versa, at any of Piao Hao’s branches. On the other hand, Qian Zhuang’s commercial banking business had limited geographical presence in South China. Following the Opium Wars in the mid-19th century, some European banks in particular British banks entered into China and established local branches to serve the booming trading businesses between two continents. It was the first time that modern banking was introduced to China. For example, the Hong Kong and Shanghai Banking Corporation (HSBC) was one of several Western banks that began to offer trade financing services in China in the 19th century.9 In 1865, HSBC was founded in Hong Kong, and it had soon become the largest foreign lender in China. Clearly, foreign banks exerted control over foreign trade financing and international remittance businesses. In addition, some foreign lenders formed a close partnership with local financial institutions like Qian Zhuang and took part in commercial banking businesses like deposit-taking and loan-making. Moneylending activities can be found throughout the history of ancient and imperial China as they have been crucial to the formation and

7 John S. Bowman, Columbia Chronologies of Asian History and Culture (Columbia University Press 2000) at 105. 8 See Chengming Wu, “The Evolution of Piaohao and Qianzhuang, and the Emergence of Private Banks”, in Dixin Xu and Chengming Wu (eds), The History of Chinese Capitalism, Volume 2 (People’s Publisher 1990), Chapter 4, Section 5. 9 HSBC, The History of HSBC, available at www.hsbc.com/about-hsbc/company-history/ hsbc-history, accessed 1 May 2018.

20  Private lending market development of the commodity economy and private capitalism. Moneylenders and ancient financial institutions channelled spare capital in the society to those needing money to survive or run businesses. Fu Bie not only demonstrated the existence of lending contracts in the remote past but also revealed the wisdom of Chinese ancestors in solving lending disputes. The criminal offence of Qu Xi Guo Lv exhibited the ruler’s determination to crack down usury and the awareness of protecting vulnerable debtors, even 2,000 years ago. Furthermore, the lending history uncovers the trend of financial institutionalisation as it has observed the establishment of several quasi-banking institutions, including Jiao Zi Pu, Piao Hao, and Qian Zhuang. Such financial institutions indicate people’s growing need for various financial services like saving, lending, and transferring money. 2.2.2  Financial modernisation in the Republic of China (1912–1949) The imperial government of the Qing Dynasty was neither capable of ­modernising China’s economic and political systems nor able to defend foreign aggression. In 1911, Sun Yat-Sen led the Xin Hai revolution, ending the ruling of the Qing Court and leading to the establishment of the ­Republic of China (ROC).10 It marked the start of China’s Republican era. The ROC period has been perceived as the golden age of China’s financial industry for hundreds of new banking corporations were launched by the state, private investors, and foreign investors. The examples of state-owned banks include the Bank of China (BOC), specialising in foreign exchange businesses, and the Bank of Communications, providing financial support for ­industrialisation. Both banks survived several revolutions in the 20th ­c entury and are still operating today. The BOC was founded in 1912 by the national government, and it was given the mandate to operate as a ­commercial bank as well as a central bank for the Nationalist government.11 In 1928, the ­Nationalist government decided to set up a separate central bank in Shanghai and appointed the Minister of Finance Song Ziwen as the first governor.12 ­Consequently, the BOC’s central banking function was halted, and it obtained an exclusive charter to conduct international exchange and trade financing. During the Republican era, private capitalism mushroomed and new businesses called for more banks to be built to satisfy their financing needs. In addition to state-backed banks, a group of Chinese entrepreneurs either set up new banks or converted traditional Piao Hao and Qiang Zhuang into Western-style banks. Major players in northern China comprised Yien Yieh Commercial Bank, Kincheng Bank, Continental Bank, and China & 10 Supra note 3 at 242. 11 Bank of China, History of Bank of China, available at www.boc.cn/en/aboutboc/ ab1/200808/t20080814_1601747.html, accessed 1 May 2018. 12 Zhaojin Ji, A History of Modern Shanghai Banking (Routledge 2002) at 170.

Private lending market  21 South Sea Bank, which were collectively called “Four Northern Banks”.13 Meanwhile, “Three Southern Banks” dominated the banking business in southern China, which included Shanghai Commercial and Savings Bank, National Commercial Bank, and Zhejiang Industrial Bank.14 Moreover, foreign banks took up a leading position in certain business areas like ­foreign trade financing, while most commercial banking businesses were provided by Chinese lenders.15 Following the fast expansion of the banking industry, the Republican government established the Financial Supervisory Bureau in 1927 and charged it with the power to supervise monetary and banking businesses in China.16 The Financial Supervisory Bureau was affiliated to the Ministry of Finance, and it was considered the earliest financial ­regulator in China’s modern history. In the early 20th century, Shanghai, as China’s economic centre, ­benefited from the country’s fast-growing economy. The city rose rapidly and became the largest financial centre in the Far East competing with international financial centres like London and New York.17 Then Shanghai held the headquarters of 54 Chinese banks and branches of 27 foreign incorporated banks. Shanghai also had a variety of financial markets and exchanges for the trading of securities, commodities, gold, and silver. Along with ­Shanghai, a number of national financial centres like Beijing, ­Tianjin, and Chongqing emerged. In a nutshell, the ROC period observed the ­emergence of a modern banking industry in China as government-funded banks and privately funded banks flourished in most regions. In response, the ­Nationalist government launched China’s first central bank as well as the first banking regulator. 2.2.3  China’s banking industry under centrally planned economy (1949–1978) After World War II, China experienced a civil war called Jie Fang Zhan Zheng (War of Liberalisation) from 1946 to 1949. It was fought between the incumbent Nationalist Party and the rising Communist Party (CCP). The CCP finally won the war and gained the full control of most Chinese provinces. In October 1949, Mao Zedong declared the founding of the People’s 13 Ibid. at 121. 14 Ibid. at 114. 15 Albert Feuerwerker, “The Foreign Presence in China” in John K. Fairbank (eds), The Cambridge History of China: Volume 12, Republican China, 1912–1949, Part 1 (Cambridge University Press 1983) at 199. 16 Financial Supervisory Commission, The Overview of Banking Bureau Financial ­S upervisory Commission (March 2014), available at www.fsc.gov.tw/fckdowndoc?file=/ BB-20140520BankingBureauOverview(1).pdf&flag=doc, accessed 1 May 2018. 17 Economics & Finance Net, How Did Shanghai Beat Beijing to Become the Financial Centre During the ROC Period? available at http://finance.cenet.org.cn/show-99-67168-1.html, accessed 1 May 2018.

22  Private lending market Republic of China (PRC).18 The socialist revolution resulted in massive ­upheavals of the Chinese society as the CCP transformed the capitalist economy into a Soviet Union-style centrally planned economy. From the 1950s to the 1970s, the government played a primary role in the economic operation, and the majority of private businesses had been converted into state or ­collective ownership. Under the socialist regime, banks have been seen as an integral part of the economic system, which should be fully controlled by the state to implement central economic plans.19 Accordingly, the banking industry was the first sector to embrace nationalisation in the early years of the PRC. All commercial banks were taken over by the Communist government and managed by the Ministry of Finance. The People’s Bank of China (PBOC) was established to perform the function of central banking as well as work as the sole commercial bank in the country.20 The nationalisation process, therefore, resulted in a full stop of the prosperous banking sector in the ROC period. Under the centrally planned economy, there was no need for hundreds of banks competing with each other to serve customers.

2.3  Private lending in contemporary China Again, things have changed completely. When Deng Xiaoping took over the CCP after the death of Mao Zedong in the late 1970s, he was determined to bring back the market discipline to revitalise the sluggish economy. During the third plenary session of the CCP’s 11th Central Committee in December 1978, the Chinese leadership launched a series of market-based economic reforms guided by the “reform and opening-up” policy.21 The priority on the CCP’s agenda was to shift the working focus from political movement to economic development. The meeting has been considered a pivotal turning point in modern China for it proposed a new economic system called the socialist market economy, a hybrid model of having elements of both free market and state intervention. The market-oriented reform turned out to be a huge success. China saw unprecedented economic growth from 1978 to 2012, with a double-digit increase in GDP each year.22 Although the story of China’s economic achievements is known to Western readers, very few people have an understanding of the underlying problems of China’s d ­ ual-track economic system. For example, despite the rapid economic growth, China’s 18 Michael Lynch, Access to History: The People’s Republic of China 1949–76 (2nd Edition, Hodder Education 2008) at 4. 19 Paul Bowles and Gordon White, The Political Economy of China’s Financial Reforms (Westview Press 1993) at 47. 2 0 Robin Huang, Securities and Capital Markets Law in China (Oxford University Press 2014) at 5. 21 Xinhua, “Third Plenary Session of the 11th Central Committee of the Communist Party of China (1978)”, available at http://news.xinhuanet.com/ziliao/2003-01/20/content_697755. htm, accessed 1 May 2018. 22 People’s Daily, “35 Years Chinese Economy Kept Rising” (21 November 2013) at 4.

Private lending market  23 state-dominated banking sector failed to provide sufficient credit to millions of private businesses. Hence, entrepreneurs have to seek alternative financing channels outside the banking sector, leading to the formation of the private lending market. The following section will use the supply and demand theory to explain the operating mechanism of the private lending market. 2.3.1  Socialist market economy (1978–present) After the initiation of market-oriented reform, the CCP put forward the socialist market economy to accommodate people’s increasing demand for economic development and improvement of life quality.23 Apparently, the new economic model contradicts with the previous centrally planned economy, in which all economic activities regarding investment, production, and distribution are planned and executed by the state. However, the socialist market economy is also largely distinguished from traditional market economies where economic activities and prices of goods are generally determined by the market’s invisible hand. In fact, a socialist market economy is a mixed approach, combining the free market with state control in some key industries. It is also referred to as state capitalism for the growth of private businesses is in parallel with the prioritisation of state-owned enterprises (SOEs) in limited crucial sectors.24 The reason for the CCP to create this economic model is simple for it is eager to utilise the market force to rejuvenate and industrialise the Chinese economy while it has to ensure the party’s absolute control over the country’s economic affairs. Therefore, the socialist market economy seems to be an optimal option which is compatible with China’s political reality as well as the urgent need for economic growth. Although China’s current economic system has been defined as a variety of classical market economies, its market economy status has not been fully recognised by the international community. At a European Parliament session in May 2016, the EU lawmakers voted against granting China market economy status, considering that its economy has been largely influenced by the government, and many firms have been heavily subsidised to lower their exporting prices.25 However, Chinese experts suggested that the denial of China’s market economy status was due to the EU’s trade protectionism for extra taxes can be levied on goods imported from a non-market ­economy country.26 Apart from the EU, major economies, including the

2 3 Supra note 19 at 12. 24 Kellee S. Tsai, “The Political Economy of State Capitalism and Shadow Banking in China” (2015) 51 Issues & Studies at 55. 25 Viktoria Dendrinou, “Europe Opposes Market Status for China”, Wall Street Journal (13 May 2016) at A8. 26 Qingqing Chen, “EU Should Admit China’s Market Economy Status”, Global Times (13 May 2016), available at www.globaltimes.cn/content/982842.shtml, accessed 1 May 2018.

24  Private lending market United States, Canada, Japan, and India, have not yet admitted to the market economy status of China. Under the socialist market economy, the state intends to exert utter control over a few industries with strategic importance. In 2003, China established the State Assets Supervision and Administration Commission (SASAC) to represent the country to perform the duty of managing and supervising SOEs having the central government as their majority shareholder.27 Affiliated to the State Council, the SASAC enjoys powers such as appointing directors and senior managers for SOEs, approving business decisions relating to large-sum investments, and approving resolutions regarding merger and acquisition. In ­ ossess controlling 2006, the State Council reaffirmed that the state should p stakes in companies in seven sectors: armament, power generation and distribution, oil and petrochemical, telecommunication, coal, aviation, and shipping.28 It clearly indicates the vital role played by the ­Chinese government in the economic operation. At present, there are 106 SOEs ­directly managed by the SASAC, ranging from the China National Nuclear Corporation and ­Wuhan Iron & Steel Corporation to China Mobile.29 Most of these businesses are national champions in their respective sectors. Nonetheless, it should be noted that financial institutions, including banks, securities firms, and insurance companies, have not been governed by the SASAC, despite the fact that most of them have strong government backgrounds. In the latest Fortune 500, a ranking of the largest 500 companies in the world, China occupied 98 places, including 76 state-owned firms.30 Chinese SOEs, ­assisted by favourable policies and financial support, have become the most profitable businesses in the world. In the non-key industries where the state plays a less significant role, such as Internet technology, we have also seen the emergence of some global brands, including Baidu, Alibaba, and Tencent (widely known as the “BAT”).31 Evidently, both Chinese SOEs and private businesses have achieved great economic success in the age of economic transformation. 2.3.2  The demand side: private businesses call for more capitals As the state plan gave way to market discipline, the Chinese population who had experienced extreme poverty and limited material conditions under the 27 State Assets Supervision and Administration Commission, Main Functions of SASAC, http://en.sasac.gov.cn/n1408028/n1408521/index.html, accessed 1 May 2018. 28 Huanxin Zhao, “China Names Key Industries for Absolute State Control”, China Daily (19 December 2006) at 1. 29 State Assets Supervision and Administration Commission, Directory of Central SOEs, available at www.sasac.gov.cn/n86114/n86137/c1725422/content.html, accessed 1 May 2018. 30 Scott Cendrowski, “China’s Global 500 Companies Are Bigger than Ever—And Mostly State-Owned”, Fortune (22 July 2015), available at http://fortune.com/2015/07/22/­chinaglobal-500-government-owned/, accessed 1 May 2018. 31 Yuan Li, “China Circuit: Troika Spends Big To Rule Internet”, Wall Street Journal (20 October 2016) at B4.

Private lending market  25 planned economy started to run private businesses and pursue personal wealth (Figure 2.1). It led to a period of fast economic growth lasting four decades. The following chart displays China’s GDP data after the launch of economic reform. The economic scale increased 202 times from CNY 367.9 billion in 1978 to CNY 74.4 trillion in 2016. It is rare to observe such a high speed of economic growth and industrialisation in the history of humanity. In 2010, China replaced Japan as the world’s second-largest economy, just next to the United States.32 The real driving force behind China’s economic rise, clearly, is the explosion of private enterprises which have replaced low-efficient SOEs in most sectors.33 Even though it is unusual to witness the coexistence of socialism and private capitalism in the same country, this does happen in contemporary China. The private sector has brought competition, innovation, and productivity to the economy, and as a result, the country has seen the emergence of an entrepreneurial class that endeavours to operate profit-driven firms to compete in the market.34 As economic reform continues, the private sector has become a major component of the Chinese economy. In particular, small and medium-sized enterprises (SMEs) play an important and indispensable role in the progress of

800000 700000 600000 500000 400000 300000 200000 100000 0 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Figure 2.1  China’s GDP, 1978–2016 (Unit: CNY 100 million). Data Source: National Bureau of Statistics, PRC. 32 Mure Dickie and Jonathan Soble, “China Displaces Japan as Second Biggest Economy”, Financial Times (15 February 2011) at 9. 33 Ross Garnaut et al., Private Enterprise in China (ANU Press 2012) at 15–20. 34 Linda Yueh, “China’s Entrepreneurs” (LSE Working Paper Spring 2008), available at http://cep.lse.ac.uk/pubs/download/cp253.pdf, accessed 1 May 2018.

26  Private lending market industrialisation. The definition of SMEs can be found in the Regulation on the Classification Standards for Small and Medium-sized Enterprises (GXBLQY [2011] No. 300) jointly published by the Ministry of Industry and Information Technology, National Bureau of Statistics, National Development and Reform Commission, and Ministry of Finance. Chinese SMEs are divided into three subcategories: microenterprise, small enterprise, and medium enterprise. The regulation lays down different standards for 15 specific industries, plus one category for businesses that do not fit into any specific sector. A business is classified based on its annual revenue, total asset scale, and/or number of employees. The table below presents examples of classification in four sectors (Table 2.1). SMEs are critical to China’s economy as they account for 60 per cent of GDP and 80 per cent of employment.35 The private sector has been contributing to a larger share of economic outputs than their state-owned rivals do. However, it has been difficult for most private businesses to borrow sufficient credit from banks. A paper by Justin Yifu Lin, an economist and former vice president of the World Bank, estimated that less than 1 per cent of Chinese SMEs have access to bank loans.36 Professor Wang Yijiang’s research also suggested that SMEs only utilise 20 per cent of financing resources in the country.37 Therefore, the financing resources available for Table 2.1  S  elected Examples of the Classification Standard for Chinese Businesses Industry

Standard (CNY Million)

Micro Small Enterprise Enterprise

Agriculture, forestry, Revenue (Y) Y < 0.5 husbandry, and fishery Heavy industry Number of X < 20 employees (X) Revenue (Y) Y < 3 Property development Other unlisted industries

Revenue (Y) Y < 1 Total assets Z < 20 (Z) Number of X < 10 employees (X)

Medium Large Enterprise Enterprise

0.5 ≤ Y < 5 5 ≤ Y < 200 20 ≤ X < 300 3 ≤ Y