China Regulator Is Paper Tiger as Banks Fund Stocks (Update1) By Luo Jun and Simon Pritchard http://www.bloomberg.com/apps/news?pid=20601109&sid=a5F_DOqtJDjA&refer=home March 21 (Bloomberg) -- Deng Yijun, a cargo freight agency manager in Shanghai, faced a dilemma last December. ``I needed a car, but I didn't want to use up my savings as the stock market was booming,'' she says. ``So I used credit cards.'' Deng, 32, was eyeing a Ford Focus that cost about 200,000 yuan ($25,815), roughly equal to her savings. Maxing out three cards, she put 140,000 yuan on plastic and gained 56 days of interest-free credit. She paid the rest herself. Most of her remaining cash went into stocks, including Sichuan Swellfun Co., a distiller whose share price more than tripled in the past year. Deng is typical of Chinese who are using easy credit to fuel a stocks boom only briefly deflated last month by government threats to crack down on illegal lending. The willingness of banks to break the law to finance stock trades shows the blunt tools regulators wield as they try to manage China's markets. ``Banks have no incentive nor means to track loans that flow into the stock market so long as borrowers make timely payment,'' says Yuan Lin, a Beijing-based analyst at BOC International Holdings, the investment banking arm of Bank of China Ltd. ``Banks are more concerned about the repayment of the loan than its whereabouts.'' The Shanghai and Shenzhen 300 Index rose 121 percent last year, fueled by as much as 20 billion yuan of personal bank loans illicitly used to buy stocks, Yuan estimates. Broke No Rules The government last month announced the creation of a task force to clamp down on illegal lending, triggering a 9.2 percent plunge in the index on Feb. 27. That sparked a 6.7 percent drop in the MSCI World Index over the next five days. Deng says she was able to buy the car for three times her annual salary and purchase stocks after card issuers Bank of Shanghai, China Merchants Bank Co. and China Construction Bank Corp. gave her credit over the phone. While Deng broke no laws, many investors are illegally buying stocks with borrowed money. ``Some borrowers invest the money in stock markets and some use it in ways that are different from what they claim in loan applications,'' says Liu Mingkang, chairman of the China Banking Regulatory Commission. Mortgage applicants often conspire with real estate agents to secure bogus home loans before shifting funds to a third party bank account, says Zhao Jie, a loan officer at Industrial & Commercial Bank of China Ltd., the nation's biggest bank. Shanghai-based Zhao says banks are countering the scams by sharing information to track down funds that are used illegally. `What's the Incentive?' Such countermeasures haven't been aggressively implemented because banks have little incentive to rein in lending, says Yin Jianfeng, a researcher at the Chinese Academy of Social Sciences' Institute of Finance & Banking. ``Banks are lending for profit,'' he says. ``They have collateral on hand, they have payment on time and they have lucrative interest income, so what's the incentive to work with regulators?'' Some 300 billion to 500 billion yuan of bank loans, almost all refinanced mortgages and revolving consumer loans, may have gone into the stock market in the past year, Yin estimates. The Shanghai and Shenzhen index has gained 8.8 percent since Feb. 28, as the government failed to announce measures to curb speculation during the annual meeting of the National People's Congress from March 5-16. Investors had been concerned that regulators would impose a capital gains tax or increase the stamp duty on stock sales. Relying on Persuasion ``Within the government, people have divergent views on whether the bubble is big enough to burst,'' Yin says. For now, policy makers are relying on persuasion, warning investors about the risks of buying stocks. ``Investors should have a reasonable assessment and judgment of the stock market,'' says Ma Kai, director of China's highest economic-planning agency, the National Development and Reform Commission. ``The responsibility of the government is to provide transparency and equality.'' China's last stocks boom ended in the second half of 2001, when regulators shut brokerages that used client money for their own trades and the government announced plans to make state-owned shares fully tradable. In 2001, the Shanghai Composite Index dropped 22 percent and Shenzhen's index 26 percent. With China's economy growing more than 10 percent a year, this boom has been driven by restrictions on overseas investment that leave people with few options but to invest in domestic stocks, says Qin Xiao, chairman of China Merchants Group, which controls China Merchants Bank and China Merchants Securities. ``China has more than 30 trillion yuan of bank deposits, but stock market capitalization is only 10 trillion yuan, of which about 30 percent is freely tradable,'' Qin says. Administrative Controls China's underdeveloped capital markets have forced the government to try to control investment with administrative levers such as increasing deposit reserve requirements for banks and restricting loans to specified industries. Concerned about fast-rising property prices, the People's Bank of China, the central bank, in July 2003 limited lending to developers and home buyers. A year later, loans to rapidly expanding industries such as steel, cement and construction were restricted to curb investment. U.S. Treasury Secretary Henry Paulson on March 8 challenged China to ease controls on its financial markets and remove caps on bank interest rates. ``An open, competitive and liberalized financial market can effectively allocate scarcer resources in a manner that promotes stability and prosperity far better than government intervention,'' Paulson said at the Shanghai Futures Exchange. Greenspan Couldn't Do It China on March 18 raised interest rates for the third time in 11 months to cool investment. The central bank increased the benchmark one-year lending rate to 6.39 percent from 6.12 percent and the one-year deposit rate to 2.79 percent from 2.52 percent. Even in developed markets, central bankers and economists debate whether interest rates can be used to influence asset prices. U.S. Federal Reserve Chairman Alan Greenspan's 1996 warning about ``irrational exuberance'' in the U.S. stock market was ignored until the technology bubble burst in 2000. The worldwide stocks boom leading up to the Feb. 27 sell-off was the result of capital inflows from growing Asian economies and pension funds in Europe and North America that no regulatory agency could control, says China Merchants Group's Qin. ``Excess liquidity is a global issue, not a China issue alone,'' he says. The challenge for China is to slow the rising stock market without triggering a collapse. ``The Chinese government is the chief engineer of the A- share market; it can make or break it,'' says Chris Leung, a senior economist at DBS Bank Hong Kong Ltd. ``It has a range of policy tools at its disposal, from mild tightening of monetary policy to direct intervention.'' `Zero-Cost Funding' Investors can take comfort from the knowledge that their interests are aligned with those of the government, which controls 70 percent of the Shanghai stock market and needs high returns to fund social welfare programs, says Isaac Meng, an economist BNP Paribas Peregrine Asia in Beijing. Cargo agency manager Deng has no doubts about using legitimate credit to capitalize on the boom. ``I'll definitely do the same thing again,'' she says. ``This is zero-cost funding, and I didn't see any risk.''