Caixin
Nov 23, 2011 07:23 PM

Wild, Wooly Financing Threads Unravel in Erdos

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Erdos is a city surrounded by Inner Mongolia's vast grasslands, where grazing flocks of sheep provide a fine cashmere wool that's made the city famous.

Today, textile mills in Erdos continue to produce some of the world's best cashmere goods.

But in recent years new business sectors with far more wealth-making power have eclipsed sheep and wool – and have been blamed for turning this city of soft cashmere into a hardened center for financial risk-taking.

Making big money in Erdos today generally involves coal mining, natural gas extraction, real estate speculation and/or loan-sharking. Indeed, these four sectors are interrelated, with energy businesses providing cash that's invested in real estate, often speculative house-flipping, or loaned at high interest rates through a non-bank network for real estate-related projects.

A recent slump in the property market in Erdos has strained this four-way relationship, prompting the city government to promote business diversification even while tension grips investors, company owners and loan-sharkers.

As part of the diversification effort, local officials have promoted Erdos as "northeast Asia's financial center" and "a private equity capital." Financial service platforms are being established, such as the stock exchange for small-and medium-sized enterprises in Erdos, which gives PE funds a way to sell their stakes in investment targets and exit with profits.

The campaign has attracted foreign investors' attention. Officials from Credit Suisse and JP Morgan, for example, traveled to Erdos in late September to propose more than US$ 5 billion in local company investments. A Credit Suisse source told Caixin that cooperation agreements were signed with local enterprises in fields ranging from mining to catering service.

But most of the seven, local PE funds now operating in the area help finance companies with specific projects. But to date none has raised funds from external investors. And among local investors, according to a source with an Erdos PE fund, illegal fund-raising including private lending have been more attractive among local investors due to the lure of sky-high yields.

Tight Weave

Deputy Mayor Li Guojian, who oversees the city's economic affairs, said reining in private lending operations is another facet of the effort to transform the city into a financial services hub. A registration system for private lenders has been created, and "protection funds" now support qualified private lenders by guaranteeing loans.

But already, speculation in real estate and more serious forms of gambling-like investing have started to take a toll on the Erdos economy. Small credit companies, unlicensed banks and pawn shops across the city are now in deep trouble.

Borrowing and lending operations outside licensed banks – through credit companies that can charge 35 percent annual interest, to pawn shops that command 100 percent – has woven together local companies, government workers, coal mine bosses and ordinary people into a tight financial fabric. So when one falters, all have reason to worry.

Fan Zhiguang, an expert on the local credit scene who serves as assistant to the president at Inner Mongolia Broadcast University, said privately borrowed capital provides significant support for the economy. He notes that Erdos' GDP last year was 264 billion yuan, but that the outstanding loan balance for all local, licensed financial institutions was only about 133 billion yuan. The gap, he said, points to the size of the underground credit system.

Fan conducted a study that found 912 private lending institutions including pawn shops, credit-guarantee companies and investment companies operating in Erdos as of 2009 – a number that had increased 6.3 times since 2004. Separately, a recent local government report said 81 microfinancing companies were doing business by the end of March.

Private lending risks have grown as well, and in recent months several cases of illegal fundraising surfaced. At least three cases investigated by authorities involved more than 100 million yuan. Police say another eight are under investigation.

In one Ponzi scheme recently uncovered, police said a woman named Su Yenv borrowed several hundred million yuan from private lenders but never repaid most of them. "She used it all for fun, to gamble," said a creditor familiar with the matter.

Real Estate Hole

Most investors seeking high yields in Erdos in recent years turned to real estate. A lot got rich: Some small investors doubled their returns in three years.

But the market is now saturated, and in recent months new homes can hardly be sold, hurting investors and disrupting the private lending network.

Li subscribes to the "build and they will come" theory, and thus sees no reason to worry about the city's economy over the long run. What's now a glut of housing, he said, will be digested in "three to five years."

"Too many homes may have been built," Li admitted. "But you have to build a nest to attract the phoenixes. Many large companies will come, and they will bring a lot of industrial workers."

Indeed, Li said the city plans to build several large industrial parks with an annual production capacity worth more than 10 billion yuan. The city also hopes to promote joint ventures between local and external PE funds, through which local investors would provide capital and non-local professionals manage the funds.

Li also has hope for the government's recent effort to counter illegal fund-raising by registering small lenders and coordinating banks in hopes of bringing down borrowing rates for local companies.

"Erdos has money," Li said. "It just lacks people."

For now, though, local investing and private credit operations are in flux as housing sales froze. Individual home buyers, investor-flippers and builders in Erdos who relied on private borrowing against what seemed to be insatiable demands and ever-rising prices have been caught by a capital crunch, and can no longer afford high interest rates.

New housing costs averaged 1,500 yuan per square meter a decade ago and climbed to hit 20,000 yuan in 2011. Since May, however, many new properties have not been sold, bringing construction at unfinished developments to a halt. Small credit companies and underground banks have stopped lending and are making loan recovery a top priority. The pawn business has plummeted, too.

Many local investors and construction companies are now pinning all their hopes on coal. "A shovel in the ground strikes money," said one building company official. Contractors "will have a very tragic shift, but all won't die."

Coal became a kingmaker in 2004, after the central government lifted price restrictions on the mineral. More than 300 mines in the Erdos area operated by small- and medium-sized enterprises quickly accumulated enormous amounts of wealth, and soon this money flooded into the real estate and private lending markets.

Erdos officials saw the economic risk posed by what became an over-emphasis on coal mines, and started trying to attract manufacturers by offering companies or investors 100 million tons of coal for every 2 billion yuan invested locally.

The gimmick worked, and as of August some 45 projects including auto and electronics manufacturing had gotten under way, with combined investments of more than 320 billion yuan.

However, Li admitted that some projects have failed because "management was poor, products were not produced, and companies simply sold their coal."

For example, Hawtai Motor Group in 2006 promised to build a 15 billion yuan auto factory in exchange for two coal mines. One mine was sold in 2008, earning the company 700 million yuan. But today, the 400 hectares where Hawtai plans to build a factory remains vacant.

A source close to the Hawtai project told Caixin that Erdos is unattractive due to its harsh climate, remoteness, expensive commodities and a lack of culture, which makes it difficult for companies to attract professional staffers.

Nevertheless, unlike several other companies that signed up for Erdos' investment-for-coal plan, Hawtai has at least partly fulfilled its commitment.

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