Over leveraging in China.

This was one of those “Ah-Ha” moments for me.

Many of you who do business in or with China ask the same question on a weekly or even daily basis of your Chinese counterpart: “Why, WHY are they doing THIS?!”

Sometimes the moves a Chinese company will make may strike you as completely without sense. I can now attest that for the great majority, there is a very clear line of reasoning. I can further attest that it is usually pretty solid reasoning.

The difference lies in the structure of the country’s rules of the game.

In the US, if we want to start a business we start it. Next week I plan to register the first of three companies I’m starting. One will export products to China. One will import products to the US, and a third will offer consulting and management services, on the ground in China. The grand total cost of opening all three of these businesses will be less than $1K USD.

In China, in many cases, you need to show $100K RMB in liquid assets before you are allowed to register just one business. That’s around $18,000 USD. It’s not needed for anything, you just have to have it in savings. Other companies (it depends on what you’re hoping to trade or sell) require a much higher input. In some cases over $100K USD in savings just to get a business license.

That’s just to give you an idea of how much more difficult it is to start and operate a business in China, right from the start.

I noticed over the past year of working for a Chinese company that many, many Chinese businesses are heavily over leveraged. Why? Is it because they can?

No. Not really.

Most businesses with the goal of long-term growth and survival will not choose to over encumber themselves with choking levels of debt. In the west we often talk about Chinese companies borrowing money that they either fail to pay back or pay back extremely late. This does happen with a lot of SOEs.

Private companies are different.

First of all, they are not party-controlled or nearly as heavily party-influenced as SOEs. They don’t have a CEO who also holds a government position of authority that can just call up the head of an SOE bank and resolve issues. Their company pays lip service to the idea of bringing technology into the country and spreading it around, but they are still in business to make money rather than to support the motherland.

Secondly, they still have to put up corporate assets as collateral, and they have to find, usually, a local government entity to guarantee their loan to the bank. That local government entity will want the assets as collateral.

Then, after the purchase has been made, things have to go exactly as planned. Usually the plan was drawn up with the most optimistic scenario in mind. In most cases, those scenarios were never meet-able.

So the local entity will start conducting audits and demanding their money back. This often happens mere months after the transaction has closed.

The private company, meanwhile, has been going to another small government entity in the neighboring town (or eventually in a neighboring province) and offering different assets as collateral. They can then try to use their new pull with a slightly higher-ranking government official to coerce the guarantor of the earlier transaction into sitting tight while the company struggles to turn a profit. If they need to make some payments, some of the loan money from the second transaction can be used to satisfy the parties involved in the first.

The result is a company that has expanded rapidly through lending aimed at reaching profit margins that were probably never attainable. The hope is that eventually they will start turning a profit and become competitive enough to expand further, creating JV agreements with foreign entities and possibly even buying western companies.

Once a private firm has gone international, it’s a lot tougher for some local government guarantor to try to tear them down by demanding assets as collateral for failed investments at a lower level. The company could very well still not be profitable enough to pay off all of its debt obligations.

I regularly see things I don’t understand in my current working environment. To my amazement, I’ve found that if I dig long enough and find the right person, and convince them to share, I get an answer that makes some level of sense. Of course, the biggest question is why get into private business in China in the first place. People here are brave beyond belief, and risk aversion is nearly nonexistent by western standards.

What does that last sentence mean for the future? It means look out western markets, because if China ever creates a safer, easier environment in which private citizens can freely open their own entrepreneurial endeavors, we’re going to be competing with people willing to risk it all on much lower odds than we would.

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