China Microfinance Market: the untamed territory
 Greg Au-Yeung
When people talk about China’s financial market, they naturally refer to the capital market such as stock trading, or the banking sector like personal savings or commercial lending. After all, this is the mainstream market, which is more visible to the outside world. There is a lesser known territory which already catches the attention of foreign investors over the past few years. It is the microfinance market. By definition, it is financial services for micro-entrepreneurs, small businesses, and individuals who lack access to traditional banking services.

The Market
In China, microfinance products range from consumer loans to commercial lending. Similar to other nations, this financial market segment has become a necessity rather than a choice. The growth of China’s microfinance market is also fueled by an imbalanced financial eco-system and the central government’s strict control of interest rates which resulted in banks deserting this market segment. Subsequently, new operators arose to provide financial aid for those in need. This includes microfinance (microcredit) and guarantee companies, P2P (person to person) lenders, as well as underground banks. Although there are banks in China that also provide microloans, they are still relatively small and not regarded as a mainstream service.

Middle Kingdom’s Challenges in Borrowing
It is not news that many enterprises and individuals struggle to secure loans from banks, especially those who lack collateral (e.g. properties, cars). Chinese banks in general prefer lending money to large corporations as it is in line with government policy. As one official puts it, the branch manager will not lose his job owing to the default payment of a State-owned-enterprise (SOE), but will most certainly be held liable if a Small- to Medium-sized Enterprise (SME) is unable to pay, let alone default payments on unsecured personal loans. Nevertheless, the central government has already issued new policies (and quotas) to encourage banks to increase lending to the “underprivileged”. But the change is slow and the banks are happy to earn a handsome spread of 3% without taking much risk. As per BCG’s projection, the market will grow to three times its size by 2015. China’s consumer loan market is around 20% of GDP, compared with Korea (40%), Hong Kong (56%), and US (90%). Even though 80% of China’s consumer loans account for mortgages, it is clear that the growth potential is colossal.

Size matters. According to the Boston Consultant Group’s (BCG) 2011 report, the dragon wants to spend. China’s total outstanding loans stood at 1 ￥50 trillion ($8 trillion) , with ￥7 trillion consumer loans, already the largest lending market in Asia, despite its infancy.

China Microfinance Market 2012  Greg Au-Yeung

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Various Types of Lenders
Among 4,600 microcredit companies in operation, the total outstanding loan is around
￥500

billion, which represents 1%

of China’s lending market. Although the market is lucrative with great potential, it’s not smooth sailing. Microcredit (and 2 guarantee) companies fall under the jurisdiction of local financial bureau (not the four regulators) , but there are strict rules for business geographical coverage, shareholder structure, debt ratio, and capital requirement. There is a slight variation that applies to local versus foreign companies. Regardless of some of the constraints, the number of microcredit companies is growing at 20% per annum. Foreign competition is also entering China as this financial sector is yet to restrict non-Chinese ownership ratio, i.e. 100% foreign ownership is allowed3. Fullerton from Singapore and United Asia Finance from Hong Kong are some of the examples. Setting up a microcredit company is one thing, managing it is another matter. For most microcredit (and guarantee) companies, the clientele is SMEs with large ticket sizes (average of ￥500MM), governance is relatively simple as there are few clients to manage. According to government sources, with an average interest rate of 16%, 90% of microcredit companies are profitable. It is also common that many microcredit businesses operate like convenience stores, with few staff and no systems in place. But there is also a down side, namely, the concentrated default risk from borrowers, especially involving bridging loans which bear relatively high risks. One default borrower may end up wiping out a whole year’s profit. Owing to its undersized operation and the lack of governance concept, there may be other issues too. One microcredit firm that I know of forgot to process payments at month-end and the clients ended up calling the firm to remind them.

Consumer Finance
For the retail client segment, such as consumer finance, it is a different ball game. Retail business is about scale. With the right model and credit policy, risk mitigation is sustainable with an enormous customer base. In addition, proper checks and balances through good governance, business intelligence, and standardized processes can lower unit costs, detect fraudulent loans, speed up approval cycles, and cross sell. These investments will pay off. P2P lending, another form of microfinance, has also experienced exponential growth since 2006, when CreditEase, a Beijing-based P2P lender imported the idea into China. In summary, P2P (person-to-person, peer-to-peer, or social lending) occurs directly between individuals (borrowers and lenders). It is probably one of the oldest forms of transaction predating formalized financial institutions. But during the early 21st century, internet technologies, especially Web 2.0, gave it a final boost, encouraged by the 2008 economic meltdown. The pioneer, Zopa in the UK, invented the idea, shortly followed by other copies cats (according to Zopa) like Prosper and Lending Tree in the US. According to an unofficial source, there is an estimated 2,000 P2P lenders in China this year – with total outstanding loans of ￥18 billion (1% of the consumer lending market) – who offer online service to participants for investment (lending) or borrowing. Some leading players have daily transactions of ￥5 million. The king of P2P, CreditEase’s total disbursed-loans since ’06 is estimated to be more than ￥2 billion, which is of a similar size to Zopa. The attraction of this market is its relatively low entry barrier. As it is unregulated, a P2P company can be set up under an IT or consultant company with a few million Renminbi. Underground banks all over the country provide personal lending with ultra-high annual interest rates (50%+)4, which are accepted by borrowers, due to the lack of borrowing channels for these individuals. The total size of this market is estimated at an astounding ￥2 trillion. It is only a matter of time before these “banks” become history in China’s financial market. As a friend of mine once said, even loan sharks are close to extinction in Macau, where gamblers can now gain
China Microfinance Market 2012  Greg Au-Yeung 2

access to countless short-term funding sources, legally. When China’s financial market continues to develop and normalize, equilibrium will take place.

Technology as Key
Technology plays a pivotal role in microfinance’s development, particularly when efficiency, accuracy, prognosis and proficiency are required. A credit scorecard, for example, provides statistical analysis of an individual’s creditworthiness, measuring his or her probability in future defaults. Loan underwriting requires system logic that automatically filters the good and bad borrowers with application approvals and rejections. An individual’s credit information is fed, massaged and cleansed from the PBOC bureau before feeding into the loan system. As for P2P lending, Web 2.0 tools provide an electronic marketplace for loans supply and demand. All these require subject experts, standardization, and business intelligence to design, construct and maintain.

The Future
Unlike banks5, there are no ownership restrictions for foreign firms setting up a WOFE (wholly-owned foreign enterprise) microfinance (microcredit) company in China. Nor are there qualification requirements for senior executives to pass local examinations. The major requirement is capital. Another problem is that microcredit companies are not regulated like banks. Finally, China Bank Regulatory Committee’s (CBRC) recent deregulation efforts allow microcredit companies to convert into rural banks6. Guarantee companies are similar to microcredit companies, except that loan disbursement needs to be through banks (or microcredit companies), and the leverage is 10 times its capital, which is appealing to investors.

I have strong faith that the lending market for microcredit companies in China will be further deregulated, with larger debt ratios that allow lower cost of funding for lending firms. With an ROE as low as 10% for some microcredit companies, it is clearly not sustainable. Since tax incentives are given to the financial sector in the capital market, and even the IT industry, it is only a rational and reasonable call for such inducements for the microfinance trade. It is probably wise to encourage more products and diversification among players in the microfinance industry. Adding consumer finance to the product offering may not be a bad idea. Outsourcing services may become the future of microcredit companies, as a facility to banks. Similar to capital markets, it is now a common practice for investment managers to outsource their non-strategic functions, such as back-office operation, to custodian banks. In China, CSRC now permits third-party operators to provide outsourcing services to fund managers, thirteen years after the pioneer deal between PIMCO and State Street Bank in the US. Just as the laws of gravity that cannot be defied, the microfinance market will inevitably continue to expand and self-adjust. In the not-too-distant future, consolidation will take place and only the fittest will survive. Superior governance, advanced technology, and trained talents will be the differentiator among the operators. For shareholders and investors, this is a plausible financial venture that shows promising growth and returns. As for overseas investors eyeing China, this is one of the very few avenues that allow foreign competitors to enter China as wholly-owned financial institutions, with a relatively low entry barrier and investment.
China Microfinance Market 2012  Greg Au-Yeung 3

Author
Greg Au-Yeung is currently Chief Information Officer of VantAsia (formerly AIG) Finance in China. As part of senior management committee in building and expanding the firm’s mainland consumer finance footprint, in addition to fund raising, and client relationship building. Greg is also in charge of Technology & Operations department, the backbone of the firm's retail (personal loan) business. Prior to joining of VantAsia, Greg has held senior management positions at Morgan Stanley and State Street Bank in China, and other Asian locations. Greg has been covering China for more than a decade and based in China since 2005. He is also the visiting professor for Fudan and Zhejiang University. cn.linkedin.com/in/gregauyeung gauyeung@hotmail.com

Footnotes:
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Exchange rate: US$1=￥6.3 China’s regulatory bodies: People’s Bank of China (PBOC), China Banking Regulatory Committee (CBRC), China Securities Regulatory Committee (CSRC), & China Insurance Regulatory Committee (CIRC) Exception: Shanghai government requires foreign microcredit companies to be set up as joint-ventures rather than WOFE. Interest rate: According to the law, interest rate below 4 times PBOC benchmark rate is protected under Chinese law. Anything above that is regarded as usury. However, the loan may include other fees not considered interests, which could bring the total charge to above the 4 times limit. Including retail, trust, and investment banks, and fund management companies. Rural bank conversion criteria: 3 years in operation; 3 consecutive years in profit; delinquent ratio below 2%; loan reserves of 130%+.

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Images
Page 1: Page 2: Page 3: Loan advertisement Consumer lending Reminbi Sign on mainland newspaper Microcredit Company Slogan

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