China’s tech is addicted to debt

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China has become addicted to debt. Now, its tech industry is hooked too.

It started innocently enough. Back in 2008, when the fallout of America’s own debt binge was giving the whole world a hangover, China engaged in a decisive and robust economic stimulus, injecting RMB 4 trillion into key sectors of its economy. Banks, mostly state-owned in China, were directed to lend more, particularly to other state-owned firms. As a result, China recovered quickly from the global financial crisis, even as the US and Europe struggled to get back on their feet.

However, even as the Chinese economy recovered, the banks continued to lend, and Chinese companies continued to invest, most notably in infrastructure projects. Not only did they invest, they invested A LOT.

China’s lending firehose has injected more cash into the economy than the quantitative easing measures of the US Federal Reserve, European Central Bank, and Bank of Japan combined. While this lending has kept the economy growing, it has had detrimental side effects as well. Here are just a few of the most notable:

Low-productivity investments 

As often happens when credit is too readily available, borrowers have tended to be less prudent about the feasibility of their investment projects. The necessary, practical roads and bridges may get built, but so do inefficient and wasteful projects like 100-story skyscrapers and the hundreds of “ghost cities” across the country, massive residential districts where houses are purchased, but few actually live.

Corruption and waste

When money flows freely, it becomes easier for business or political leaders to cut a few pieces off for themselves. This is not necessarily a bad thing. Corruption becomes more of a problem, however, when it incentivizes unproductive investment. After all, the companies must pay back the loans that they took out for the project in the first place. The corrupt executives and government officials keep their money, but the company is left with the bill.

A vicious cycle of corporate debt

As high-productivity projects have become scarcer and the heyday of China’s infrastructure boom is in its past, more and more companies have found themselves with far more capacity than they can reasonably use, so they borrow money to stay in business, or to complete unproductive projects. When those projects do not yield the returns they were hoping for, they borrow more money, to embark on another project, or simply to keep the lights on, or service the interest of their existing debt. Once that money is spent, they have to borrow more, and the cycle continues.

The level of total debt in China is now officially approaching 300% of GDP, with the bulk of that coming from ballooning corporate debt, although household debt is rising sharply as well. Considering the cost at which these loans are being taken out, servicing the debt alone takes up roughly 18% of GDP. That’s almost three times the country’s official GDP growth rate.

With all that lending to unproductive companies (usually state-owned enterprises), the banks need to find other sources of returns.

Shadow banking surge

With the state-owned companies underperforming, but with monetary expansion placing inflationary pressure on the economy, both investors and banks demand higher returns on their investments. So the banks sponsor “trusts,” off-balance-sheet entities which make higher-risk/higher-reward loans, securitize them, and then sell them to investors as wealth-management products (WMPs).

These shadow banking institutions include hedge funds, VCs, private equity, and other entities that are not required to comply with the same strict regulations as China’s traditional banks. Chinese shadow banking has expanded rapidly over the last decade into a massive, $10 trillion ecosystem that connects financial institutions with companies, local governments and hundreds of millions of households.

With all that money sloshing around the Chinese economy, looking for high returns, the result has been a surge in asset bubbles. Most notable is housing, where apartments sit empty, held as investments, while—as a ratio of the average wage to average apartment price—China’s major cities have some of the least affordable housing in the world. We’ve also seen asset bubbles in liquor,  Tasmanian lavender bears, and even illicitly-traded animal products like ivory and rhino horn.

Shadow banking in China has created an economic environment where not much genuine value is created, although GDP keeps going up. Wages and living standards do not particularly increase, but prices for assets do. Most people and companies are unable to build wealth in the traditional way, so many do so by bringing on debt, and investing it in speculative ventures, usually based around asset bubbles. In this environment, “working” is something that suckers do, because no matter how much a worker saves, they will struggle to make as much money as those playing financial games. As long as these bubbles keep inflating, the irresponsible gamblers get rich, while prudent, hard-working people see others pass them by.

Tech’s debt addiction

China’s speculative bubble-riders, like those from anywhere in the world, move in stampede-like herds. “Hot money” rushes into assets on one day, and then out again just as quickly the next, most evident in the financial roller-coaster rides that are China’s stock exchanges.

This phenomenon becomes even more extreme when the government gets directly involved. By investing aggressively in the technology sector and strongly emphasizing innovation, the Chinese government has been injecting cash both directly and indirectly into tech ventures.

“Much of the VC money in China is government money, from state-owned companies or institutions,” explains Christopher Balding, Bloomberg contributor and former associate professor of business and economics at the HSBC Business School in Shenzhen.  “The government is pumping money into the tech sector. They are directing the herd, but also part of the herd as well.”

The result has been a historic surge in venture funding. In Q2 2018, China accounted for up 47% of global venture capital, surpassing even North America. However, it is unclear how the reality on the ground can support this level of investment. China certainly has strong engineering and technical talent but is unlikely to be currently on par with that of North America. The same goes for managerial talent, venture investment expertise, corporate governance, or access to global consumer markets.

An economy full of asset bubbles seems to have created quite a large one in its tech sector, to both the benefit and detriment of its tech firms. But as with just about any major bubble, there are some common characteristics which stand out.

Ponzi schemes

China’s tech industry is seeing more than its fair share of Ponzi schemes, although branded in different ways. This has become evident through the recent collapse of China’s P2P (peer-to-peer) lending industry.

The rise and fall of China’s online P2P lending

As Martin Chorzempa thoroughly explained, peer-to-peer lending should theoretically be very difficult to suffer a run and collapse. After all, if the lending is truly peer-to-peer, a P2P lending platform simply serves as an intermediary between a borrower and a lender. That, however, is not what these platforms actually were. As Chorzempa put it:

True P2P lending means lenders are only paid if and when borrowers repay the loans. For example, investments in a 12-month loan cannot be withdrawn after three months if the investor panics, because it is not yet due, and the lender cannot ask the platform for reimbursement if the borrower stops making payments. A “run” on P2P platforms that precipitates its failure should therefore not be possible. These attributes are critical in distinguishing a P2P platform from a bank. The credit risk and maturity mismatch of bank loans means they tend to be more strictly regulated.

Sadly, a “run” on P2P platforms is happening anyway. In practice, P2P platforms in China provide guarantees, meaning that investors get no hint that risk is piling up until suddenly the platform cannot meet its obligations and goes offline. These platforms also issue wealth management–type products that have maturity mismatches, putting them at the risk of a run if spooked investors pull out their investments. The China Banking Regulatory Commission (CBRC) issued rules in August 2016 making these practices illegal, but the turmoil over the last two months indicates that numerous platforms have ignored them.

P2P platforms, unfortunately, are not the only Ponzi startups out there. As excitement has risen over the potential of blockchain technology, fraudsters have taken advantage. In May, police in Jinan, Shandong province arrested a gang of more than ten suspects involved in a $47 million scam under the guise of a “blockchain” project.

Cases of blockchain or cryptocurrency-related fraud have skyrocketed, according to a government report released in July, and although Chinese authorities have taken decisive action to limit such fraud (they banned ICOs, and have even cracked down on cryptocurrency discussion forums). However, it is a tricky balancing act, since they would also like to encourage the development of blockchain technology, and many legitimate projects need to fund themselves through ICOs. The problem is, therefore, how to discourage the fraudsters without alienating the legitimate actors.

2VC Business models: “Ponzi-lite”

While there are some con artists out there, scheming to defraud investors out of their money, there is a far more frequent, and possibly more harmful phenomenon. In this scenario, entrepreneurs often begin with a legitimate idea for a startup. However, with funding so readily available, and valuations soaring based more on speculation than tangible results, entrepreneurs are perversely incentivized to spend their time, effort, and funds building hype rather than focusing on the core of their business.

The result is an epidemic of cash-burning and “2VC” business models, in which a startup’s operations are oriented towards the pursuit of funding, rather than delivering value to its users. In these situations, a startup may ostensibly hold on to an original mission or purpose, while in essence, the financial model is very Ponzi-esque. We can call these startups “Ponzi-lite.”

Chinese tech giants burn cash and users are paying for it

One of the clearest examples of this is what has occurred in the bike-sharing industry. With an appealing concept and strong support from the Chinese government (branding them as one of China’s “four new great innovations”), bike sharing exploded, and funding poured in. The flood of cash prompted a race for market share, with millions of bikes hitting the streets of China’s cities in an attempt to acquire users, as more users would mean higher valuations, and garner more investment.

The combination of access to capital as well as the urgency and competition to get more market share and funding created a perverse incentive structure, in which those in charge of the companies developed unrealistic expectations for what was possible, and made decisions which placed their firms and stakeholders in unsustainable situations.

ofo’s young founder and CEO, Dai Wei, was known to have been particularly detached from reality. He stated an ambition to turn the company into the “next Google,” and feuded with investor-appointed managers at the company. A long-time acquaintance of his, in the summer of 2017, observed a disturbing loss of humility in the young entrepreneur, saying “his ego is out of control.” A former ofo employee recalled being astonished by the flippancy of his decision-making, saying “there seemed to be no rhyme or reason to the company’s strategy, it was just doing everything at once, based on his whims.”

As bike rentals cool, ofo chooses to stand alone

As access to capital allowed bike-rental firms to expand, their costs ballooned as well, requiring even more investment. One method of attracting investment was through highly-publicized global expansions, which in many instances seemed to be more of a form of marketing to VC funds, as opposed to actually serving overseas users. One manager appointed to run a Chinese bike-sharing expansion in the US shared a case in which they were pressured to deploy bikes on a prestigious university campus, despite not receiving approval from campus authorities. “[The managers in China] didn’t seem to care if all the bikes were removed the following day. They just wanted to get a photo of the bikes at [the university] and publish some PR to promote that they were there. They didn’t care about building a business, just scamming some investors out of more funding.”

As the flood of cash in bike-sharing has dried up, and the firms have returned to reality, some have faced harder landings than others. Bluegogo’s bankruptcy left investors angry and users unable to get their deposits back. Rumors have also been swirling that ofo is on the verge of bankruptcy, as they pull out of international markets, place bikes for sale, are unable to pay vendors, and are laying off workers. While the future is still not entirely certain for Mobike, they have attempted to stabilize their business, after being acquired by Meituan-Dianping, eliminating the requirement for user deposits, and emphasizing a renewed focus on “responsible growth.”

As the bike-share frenzy dies down, many are now expressing concern over the expansion practices of long-term housing rental platforms like Ziroom and Danke. These platforms take advantage of collateral-free loans offered by state banks to renters, which can be as high as RMB 1 million (approximately $150,000), which renters can pay back over a maximum of ten years. The platforms act as an intermediary between homeowners and renters, providing some management services as well, and take the entirety of the loan amount from the renter, and take a percentage for themselves before paying the homeowner.

One way that Ziroom and others have raised funds for expansion is through selling asset-backed securities, based on rental income.  As they expand and compete for market share, they aggressively offer homeowners attractive terms to lease their homes, which many have claimed is driving up rental prices in some of China’s largest cities. What’s of greater concern, however, are the risks that these companies pose to renters and state banks.

Like the bike-rental companies, they are rapidly expanding, and dependent on external funding. If they cease to be able to raise money from the sale of securities or are unable to make good on paying back investors, they could experience the same fate as Bluegogo and ofo. However, the results, in this case, could be far more severe for the users. While users of a failed bike-rental company may lose a deposit of few hundred yuan, the users of a failed long-term rental platform would be forced to find new homes, but still be on the hook to repay the entirety loan they’ve taken out, which could be years’ worth of salary. In many cases, the banks would have to write off those loans and add them to an already-massive stack of bad debt.

As genuine value growth in China’s economy has slowed and consumers are squeezed, financial games are seen by many startups as the only way to ensure that they stay in business. Even for China’s most established names in e-commerce, much of their growth seems to be coming from financial services, rather than core business.

“When looking at the growth from the e-commerce world [Alibaba, JD, VIPshop], my brief point of view is that actually, it’s banking, it’s not the sale of goods. . . [I]t’s investment-driven, but the key motivation of these companies is to aggregate capital using these payment systems that they control, and the ability to move that capital into investment vehicles,” explained Anne Stevenson-Yang, Co-founder of J Capital Research, at a 2015 event for the Center for Strategic and International Studies.

This trend seems to have largely continued since then, as the crown jewel of the Alibaba ecosystem over recent years has been Ant Financial, which reached a valuation of $150 billion in an April funding round. For many of these companies, the bright spots are coming through financial services based on asset valuations, while their core businesses struggle. Once asset values slump, these firms are likely to struggle as well.

Non-tech businesses, turning into VCs

With weak consumption, government restrictions of real estate investment and outbound capital flows, and promotion of its tech industries, China’s traditional firms are finding themselves with few other options than to get into the tech venture investment business. Real estate conglomerates like Wanda and Evergrande have sizeable VC funds, and it seems just about every other real estate giant in China has as well. However, one must wonder as to the productivity of the investments that they are making, as the highly-tangible business of real estate development operates by very different principles than that of tech entrepreneurship. Real estate developers in China are often known to be synonymous with corruption and waste as well, but when there is corruption and waste in the real estate business, apartment buildings and malls still get built. When there is corruption and waste in the tech sector, there is often nothing but vaporware and broken promises in the end.

Good firms become overvalued and overfunded

To be sure, there are many legitimate tech firms in China that produce valuable products and services. However, in a cash-bloated environment full of investors looking for safe places to park their money, these companies often are valued at higher levels than is justified. Take Xiaomi, for example. The smart-device maker, known as “China’s Apple,” was expected to be this year’s star Chinese tech IPO. The company, as well as some bullish analysts, expected them to go public with a $100 billion valuation. At the time of IPO, however, Xiaomi shares hit the markets with a total capitalization of only $50 billion. At the end of last month, the shares were trading below the IPO price.

This gap between inflated private valuations and weak performance on public markets, according to many analysts, stems from the gap between what Xiaomi bills itself as vs what it is. Its bulls invested in it with images of a Chinese version of Apple, with excellent hardware margins, an addicted and wealthy user base, and robust revenues from internet services. However, at this current point in time, Xiaomi’s hardware is mostly low-margin, its “Mi fans” are minuscule in size, loyalty, and spending power compared to the “cult of Mac,” and it has failed as of yet to achieve strong monetization from its internet services. It claims that it will one day become Apple, but at the current moment, it bears a stronger resemblance to Lenovo.

Xiaomi is not the only overhyped tech firm to experience a rough return to reality when going public. After hitting the market with a share price of over $26 in late July, social e-commerce start-up Pinduoduo has spent most of its time trading under $20 after reports surfaced of ubiquitous counterfeit products on its platform. EV-maker NIO, after announcing an IPO earlier this summer, has seen Japan’s SoftBank, who had earlier planned to buy 200 million USD worth of its shares, back out. News aggregator Qu Toutiao, who plans to IPO in the US this month, recently announced that it was cutting its financing volume by nearly 50%. All three of those companies are backed by Tencent.

Tighter credit means tougher times ahead

As debt levels in China approach a crisis point, its central bank has been attempting to curtail lending, walking the precarious tightrope of tightening credit while avoiding a major economic collapse. However, as the cash is getting increasingly difficult to come by, tech firms are starting to feel the pain.

Other vulnerabilities are also showing. After accounting for 60% of the world’s AI investment since 2013, many once-promising start-ups in the field may soon find that their days are numbered, with one of China’s top venture investors predicting that 90% of Chinese AI start-ups will encounter “great difficulty” over the coming two years, as the tightening of funding becomes “especially obvious this year”.

The growth of China’s tech industry over the past few years has truly been impressive. As liquidity begins to dry up, it can serve as a corrective mechanism, allowing the underperforming and irresponsible firms to fail while the strong, well-managed ones can thrive. However, given the vulnerabilities in the rest of the Chinese economy, it may not work out so neatly or fairly.

In the financial crisis of 2008, imprudent homebuying and real estate investment decisions of families and firms, coupled with highly-leveraged financial institutions, were the guilty parties. While some irresponsible homebuyers lost homes that they never should have had in the first place, and investment banks like Bear Sterns and Lehman Brothers collapsed as a result of poor management, there were many for whom justice was not served. Many of the banks who caused the crisis were bailed out, while countless hard-working people lost their savings or their jobs for no fault of their own. As China’s tech bubble bursts, there are likely to be many good companies—and good people—who suffer as well.