News

China: An Alternative Future

June 12, 2017 • By TAB team

Alternative finance is a social and economic movement that is transforming China from the bottom up. This report aims to provide readers with a comprehensive, nuanced and yet digestible understanding of alternative finance in China.

Alternative finance is a social and economic movement that is transforming China from the bottom up. This report aims to provide readers with a comprehensive, nuanced and yet digestible understanding of alternative finance in China. First, we survey the financial landscape in the country, outlining the size, structure and growth potential of China’s alternative finance sector. We go on to discuss the drivers of this financial metamorphosis, before looking to the future with an exploration of the opportunities and challenges facing alternative finance in China.

The state of alternative finance in China

China is the world’s largest alternative finance market, with an estimated $101.7 billion transacted in 2015(1), far outstripping the $36.1 billion raised in the US(2) and $6 billion transacted in Europe(3). Growth has accelerated in recent years, registering an impressive average rate of 328% between 2013 and 2015(4), with huge potential for further expansion. Consumer lending by registered Chinese banks in 2015 was $3 trillion, 57 times larger than the $52.4 billion reported by consumer lenders operating in the alternative finance sector(5) and the World Bank estimates China will generate 52% of all funds raised via crowd finance globally by 2025(6).

Source: Cambridge Centre For Alternative Finance

P2P lending dominates the Chinese alternative finance market. In September 2016 there were more than 2,200 online lending platforms operating in China(7) with $52.4 billion lent to consumers in 2015 and business lending at $39.6 billion(8). The largest, Lufax, is a subsidiary of Ping An Insurance and was recently valued at $18.5 billion(9). Equity crowdfunding represents a comparatively small proportion of the market, with $948.3 million raised in 2015(10). This means lending platforms processed 25 times more volume than crowdfunding platforms, in stark contrast to the UK, where crowdfunding represents 16% of total marketplace lending volumes(11).

Alternative finance is deeply integrated with traditional financial services in China. Platform ownership in China is dominated by incumbents, with 23% of platforms claiming majority ownership by a traditional financial institutions and 15% stating that a major corporation is a majority shareholder(12). These companies already enjoy huge customer populations, volumes of data and technological infrastructure, so it makes sense for them to bundle services in order to efficiently monetise users.

Financial crime is an on-going concern and a mixture of incompetence and fraud have resulted in a wave of scandals. In 2015,

P2P lending platform E’zu Bao was exposed as swindling US$7.3 billion from 900,000 investors via fake investment products(13). According to data company Wangdaizhijia, negative “incidents” relating to alternative finance platforms stood at 1,263 in 2015(14). The negative actions of the few risk damaging the positive work of the many.

Key drivers of alternative finance in China

  • Traditional financial services fail the majority – State-controlled banks dominate lending in China and are subject to strict regulation and bureaucratic intervention. The country has seen explosive credit growth in recent years, and since much lending is directed by the state, it is believed that banks are awash with NPLs. Whilst the bank oligopoly has evolved in recent years, it has been slow to innovate and respond to increasingly diverse needs of consumers and SMEs during a time of huge economic expansion. According to the China Household Finance and Research Center, one third of the 56 million small businesses in China have taken on debt, but only 12% have obtained loans from banks. There remains a large “institutional gap” (15), with financial institutions failing to supply adequate financing to low-income consumers individuals, households and SMEs. The system is simply not geared towards addressing the needs of the long tail, which in China, is long indeed. Those with assets less than $100,000 make up 94% of all households in China, versus only 49% in the US, for example(16).
  • Source: The Boston Consulting Group

    • The government has cracked down on shadow banking – A huge shadow banking industry has developed to meet the needs of those seeking funding and investment opportunities. Shadow banks exist outside the formal banking sector, offering customers flexibility, but operating with minimal regulatory oversight. These operators exist not because the traditional banking system is unable to lend, but because the government is concerned about the huge leverage in the system and has slammed on the brakes to inhibit credit expansion. China is the second largest economy in the world and a system of such scale and complexity requires a flexible financial services industry to fund sustainable economic growth. Shadow banking has traditionally played this role due to the inflexibility of traditional financial institutions, but a series of high-profile scandals and increased regulatory scrutiny have reduced its efficacy. Alternative finance is the only option for many people excluded from traditional financial services and shadow banking.
    • Platforms have economies of scale – Alternative finance platforms can compete with large banks precisely because they lack their size, cost-base and regulatory burden. And they can compete with shadow banking on price. Platforms operate across large distances and scale user bases with low incremental costs. Since unbanked businesses and individuals lack credit history there is a paucity of data, but lenders such as Tencent Credit and Sesame Credit are able to utilise transaction data from their e-commerce services to analyse lending risks(17). For example, China Rapid Finance analyses social networking and computer gaming data from Tencent’s huge user base to make lending decisions, claiming that 90% of loans are made to prime and near-prime borrowers(18). It remains to be seen whether this new breed of risk management tools are any better than those of the banks. The explosive growth in lending suggests otherwise.
    • Digital economy is fertile ground for alternative finance – Consumers in China have embraced the digital revolution. Internet access and smartphone usage are universally high, with 668 million Internet users(19) and people in the country are comfortable using the web to access utilities and pay for goods with apps like WeChat and Alilpay. So much so, that in 2016 online transaction volumes reached $280 billion and mobile payments hit $559 million(20). According to the China Financial Certification Authority, personal Internet banking transactions have replaced 56% of over-the-counter transactions(21). China is the world’s largest e-commerce market, dominated by trusted names such as Alibaba and JD.com who have moved into the alternative finance space to diversify business models and monetise huge user populations. E-commerce platforms in China enjoy far-reaching distribution via their vast networks and by leveraging long-established brand names, they have cultivated trust in fin-tech.
    • Regulators have been slow to respond to market developments – For years, the market has been under regulated – some might say, unregulated. This is now changing, and the regulatory environment is becoming more developed and cohesive. The Chinese government is generally supportive of alternative finance and fin-tech, introducing “moderately loose regulatory policies(22)”, but after a series of major scandals, the China Banking Regulatory Commission now requires all P2P platforms to abide by a new set of rules and register to prove they have complied. Most seed stage funding in China happens via private placements, so crowdfunding has the potential to revolutionise start-up funding and investing in the country – although the framework for equity crowdfunding restricts participation in accredited investors, precluding involvement for the majority of retail investors.


    The future of alternative finance in China

    Alternative finance has gained unstoppable momentum, and positive feedback loops will accelerate adoption going forward. As more consumers come into contact with innovative finance solutions they will accumulate financial assets, creating further opportunities for financial services. On the business side, access to flexible, affordable SME financing will drive small business growth and job creation, creating more demand for financial services. If effectively regulated, the proliferation of alternative finance will lead to a further liberalisation of interest rates, whereby the price of capital is based on market forces – including supply and demand in the alternative finance market – rather than monetary policy based on tightly-controlled quantitative targets.

    Levels of financial inclusion are bound to accelerate. Chinese e-commerce and financial services are inextricably linked. Expect further integration between alternative finance providers, technology platforms and ecommerce brands looking to bundle services in order to monetise large communities. This will lead to lower transaction costs due to advantageous economies of scale and increased competition in financial services.

    As alternative finance consolidates its mainstream status, traditional financial institutions will adapt. Expect banks to address the challenge of scalability by investing in technology. This will drive integration of alternative finance and traditional financial services. There has already been a culture shift towards a more customer-centric approach to financial services, and this will continue.

    Challenges lie ahead, too. Meteoric growth is bound to increase competition and squeeze margins. Expect a wave of negative headlines, too, as incompetent (or corrupt) platforms inevitably fail. This evolutionary process will be painful but its long-term impact will be positive, as regulators learn to manage risks. There are deeper questions to answer concerning the aggressive credit expansion facilitated by alternative finance and the risks of a credit bubble. China is an outlier, raising large volumes of alternative finance relative to its GDP per capita. This disconnect is unsustainable and a correction may soon be on the way.

    Source: Cambridge Centre For Alternative Finance

    Growth and change on this scale will attract increased oversight from policymakers. The regulatory approach will become more cohesive and we’ll see a simplified framework emerge alongside industry bodies concerned with self-regulation. Proactive, cohesive regulation is a net benefit for the industry, but it could act as a brake on growth by raising barriers to entry, stifling competition and limiting consumer choice. Fang Yihan, CEO of Yirendai, one of China’s largest P2P platforms, believes that half of the country’s P2P platforms will fold due to regulatory reforms(23).

    Conclusion

    China’s economy is undergoing profound change as it moves from credit and export-led growth to a model based on internal demand and reinvestment of cash flows from consumers and businesses. Alternative finance is both product and driver of this change, with the power to transform levels of financial inclusion in China, helping the long tail of low-income households access financial services for the first time. It also has the capacity to do large-scale damage by ushering in an era of untrammelled credit growth and reducing the financial control of government.

    Alternative finance presents a “market driven response to long-standing repression of the financial service industry”(24), offering unprecedented levels of flexibility and customer service to consumers and businesses, particularly those in expanding urban areas. The competitive advantages of financial institutions that previously dominated the market with large-scale operations and uncompetitive pricing have been washed away in favour of cheap, accessible, integrated and scalable services.

    The sector is undergoing remarkable growth and innovation, presenting Chinese policymakers with a tricky balancing act. Protecting consumers whilst facilitating the democratisation of financial services and mitigating broader systemic risks is a challenging mission, and imperfect visibility remains an issue. There is a real risk that credit growth could spiral out of control and the economy could ultimately collapse under the weight of its own leverage. The ascent of alternative finance in China is a mixed blessing and one that must be monitored with vigilance. The relationship with traditional financial services and the real economy is complex and there is a dearth of easily accessible industry data at present. Increased transparency will come through improved access to such data. This will be critical in driving effective regulation of the sector and ensuring that alternative finance becomes a sustainable and positive influence on China’s economy over the long term.


    References

    1. Cambridge Centre For Alternative Finance. Harnessing Potential: Asia-Pacific Alternative Finance Benchmarking Report. 2016.
    2. Breaking New Ground. The 2015 Americas Alternative Finance Benchmarking Report. 2016.
    3. Sustaining Momentum: The 2nd European Alternative Finance Industry Report. 2016.
    4. Ibid.
    5. Cambridge Centre For Alternative Finance. Harnessing Potential: Asia-Pacific Alternative Finance Benchmarking Report. 2016.
    6. Ibid.
    7. International Comparative Legal Guides. China: Fin-tech. 2017. https://iclg.com/practice-areas/fintech/fintech-2017/china
    8. Cambridge Centre For Alternative Finance. Harnessing Potential: Asia-Pacific Alternative Finance Benchmarking Report. 2016.
    9. Gabriel Wildau, The Financial Times. Chinese P2P lender Lufax valued at $19bn in latest funding round. 2016.
    10. Cambridge Centre For Alternative Finance. Harnessing Potential: Asia-Pacific Alternative Finance Benchmarking Report. 2016.
    11. Pushing Boundaries: There 2015 UK Alternative Finance Industry Report. Nesta. 2015.
    12. Cambridge Centre For Alternative Finance. Harnessing Potential: Asia-Pacific Alternative Finance Benchmarking Report. 2016.
    13. Cambridge Centre For Alternative Finance. Harnessing Potential: Asia-Pacific Alternative Finance Benchmarking Report. 2016.
    14. Wangdaizhijia. 2015.
    15. He S., Yan G., and Chen K. Microfinance Theory and Practice. 2013.
    16. The Boston Consulting Group. The New Drivers Of Digital Finance. 2014.
    17. http://www.altfi.com/article/0766_an_observation_of_chinese_e_commerce_giant_ alibaba _in_alternative_finance
    18. http://www.lendacademy.com/china-rapid-finance-ipo/
    19. http://www.mckinsey.com/business-functions/marketing-and-sales/%20our-insights/understanding-social-media-in-china
    20. https://iclg.com/practice-areas/fintech/fintech-2017/china
    21. The Boston Consulting Group. The New Drivers Of Digital Finance. 2014.
    22. PBOC (People’s Bank of China). Guiding Opinions on Promoting the Healthy Development of Internet Finance. 2015.
    23. Don Weinland, The Financial Times. Cleaning up China's P2P lending. 2017.
    24. Ibid.