Informal Finance in China: Risks, Potential and Transformation
Lead Research Organisation:
University of Cambridge
Department Name: Centre For Business Research
Abstract
China's rapid economic growth in recent decades has been attributed to its reliance on informal contracting and trust-based relationships. This claim is a reflection of the absence in China of some of the more formal legal and regulatory institutions of the market economies of the global north. Although the claim that China lacks formal legal mechanisms of market governance may have been somewhat overstated, it is the case that informal finance, particularly in the form of trade credit, family lending and communal investing, has played a major role in supporting China's growth. The prevalence of informal finance constitutes a significance source of flexibility for China's economy given the limitations of the formal sector, which remains dominated by state-owned banks lending largely to state-owned enterprises. Informal finance is also evolving quickly and is converging with the use of internet technologies to deliver finance ('fintech') through such mechanisms as crowdfunding.
However, there are downsides to the reliance of the Chinese economy on informal finance and significant risks arise from its convergence with fintech. The large shadow banking sector, by virtue of its positioning outside most of the regulations applying to mainstream banks, adds to systemic risks. The formal and informal sector coexist in an uneasy relationship: they may substitute for each other, or provide complementary modes of finance, but they can also operate to reinforce and magnify systemic risks, as in the case of the crisis in Wenzhou after 2011.
Similarly, the rise of fintech is a double edged sword. On the one hand, cloud computing and big data may be facilitating new forms of social credit and collective investment schemes which have the potential to meet the needs of the growing social credit sector. Crowdfunding may provide a new and flexible form of financing for start-ups and innovative ventures. However, these new forms of finance also have the potential to undercut or render otiose regulations designed to maintain market transparency, and to intensify the risks facing investors.
Against this background, we propose to conduct a multiple methods research project which will explore the phenomenon of informal finance in China, identify the risks and potential associated with it, and assess how regulation can best respond to the risks while not sacrificing the innovations and flexibility associated with it, particularly in the context of 'fintech'. The projects will be organised in four work packages which correspond to three of the five themes identified in the ESRC-NSFC Call:
WP1 [theme 1]: Understanding the limits of informal financing
WP2 [theme 2]: Regulating shadow banking
WP3 [theme 5]: The potential of new technology to promote financial innovation and development ('fintech')
WP4 [theme 2]: Building a social credit system
However, there are downsides to the reliance of the Chinese economy on informal finance and significant risks arise from its convergence with fintech. The large shadow banking sector, by virtue of its positioning outside most of the regulations applying to mainstream banks, adds to systemic risks. The formal and informal sector coexist in an uneasy relationship: they may substitute for each other, or provide complementary modes of finance, but they can also operate to reinforce and magnify systemic risks, as in the case of the crisis in Wenzhou after 2011.
Similarly, the rise of fintech is a double edged sword. On the one hand, cloud computing and big data may be facilitating new forms of social credit and collective investment schemes which have the potential to meet the needs of the growing social credit sector. Crowdfunding may provide a new and flexible form of financing for start-ups and innovative ventures. However, these new forms of finance also have the potential to undercut or render otiose regulations designed to maintain market transparency, and to intensify the risks facing investors.
Against this background, we propose to conduct a multiple methods research project which will explore the phenomenon of informal finance in China, identify the risks and potential associated with it, and assess how regulation can best respond to the risks while not sacrificing the innovations and flexibility associated with it, particularly in the context of 'fintech'. The projects will be organised in four work packages which correspond to three of the five themes identified in the ESRC-NSFC Call:
WP1 [theme 1]: Understanding the limits of informal financing
WP2 [theme 2]: Regulating shadow banking
WP3 [theme 5]: The potential of new technology to promote financial innovation and development ('fintech')
WP4 [theme 2]: Building a social credit system
Planned Impact
Who will benefit from this research?
Beneficiaries in the commercial private sector will include financial firms and banks with interests and activities in China and the UK. We expect the research to be of particular interest to UK-based and other multinational banks and financial institutions which are active in China. We already have good contacts with a number of these financial firms and would build on them further to ensure effective dissemination of results. Another group of stakeholders where we have good contacts are international law firms including those based in the City of London; we would expect this group to be very interested in our research, as they have been with our recent ESRC-funded research on law and financial development.
Beneficiaries among policy makers and governmental bodies will include, firstly, officials in international organisations with an interest in financial development in China. These include the World Bank, the IMF, Asian Development Bank, EBRD and ILO. We have good links with these organisations and will be able to communicate effectively with them as in the recent past. Secondly, we expect that the work will be of considerable interest to officials and ministries in China and the UK. We expect to be able to liaise effectively with this group of stakeholders and will use the stakeholder workshop planned for the start of the project to further build relationships with them. Thirdly, we will be in a good position to communicate with civil servants and other governmental policy makers in other governments, using existing links and contacts.
Beneficiaries in the wider public sector and the third sector will include NGOs in the development field and other interested civil society organisations.
The findings of the work will be of direct interest to many members of the wider public and we will aim to communicate effectively with this audience by liaising with journalists and opinion formers and through use of social media.
How will they benefit from this research?
The research will lead to a deeper understanding of the role of informal finance in generating growth in China and of the risks and potential it creates. Understanding this issue will be critical to an objective and informed understanding of China's growth path, and its sustainability. China's economic trajectory is of interest at a global level, but is of particular concern to the business community and government in the UK given the strong development of UK-China ties in recent years. Our research will aim to foster mutual understanding between UK and Chinese researchers and research users.
Research users will particularly benefit from the extension of the CBR's leximetric datasets, the CBR Shareholder Protection Index and Creditor Protection Index, from their current 30 countries (http://www.cbr.cam.ac.uk/datasets/).
Beneficiaries in the commercial private sector will include financial firms and banks with interests and activities in China and the UK. We expect the research to be of particular interest to UK-based and other multinational banks and financial institutions which are active in China. We already have good contacts with a number of these financial firms and would build on them further to ensure effective dissemination of results. Another group of stakeholders where we have good contacts are international law firms including those based in the City of London; we would expect this group to be very interested in our research, as they have been with our recent ESRC-funded research on law and financial development.
Beneficiaries among policy makers and governmental bodies will include, firstly, officials in international organisations with an interest in financial development in China. These include the World Bank, the IMF, Asian Development Bank, EBRD and ILO. We have good links with these organisations and will be able to communicate effectively with them as in the recent past. Secondly, we expect that the work will be of considerable interest to officials and ministries in China and the UK. We expect to be able to liaise effectively with this group of stakeholders and will use the stakeholder workshop planned for the start of the project to further build relationships with them. Thirdly, we will be in a good position to communicate with civil servants and other governmental policy makers in other governments, using existing links and contacts.
Beneficiaries in the wider public sector and the third sector will include NGOs in the development field and other interested civil society organisations.
The findings of the work will be of direct interest to many members of the wider public and we will aim to communicate effectively with this audience by liaising with journalists and opinion formers and through use of social media.
How will they benefit from this research?
The research will lead to a deeper understanding of the role of informal finance in generating growth in China and of the risks and potential it creates. Understanding this issue will be critical to an objective and informed understanding of China's growth path, and its sustainability. China's economic trajectory is of interest at a global level, but is of particular concern to the business community and government in the UK given the strong development of UK-China ties in recent years. Our research will aim to foster mutual understanding between UK and Chinese researchers and research users.
Research users will particularly benefit from the extension of the CBR's leximetric datasets, the CBR Shareholder Protection Index and Creditor Protection Index, from their current 30 countries (http://www.cbr.cam.ac.uk/datasets/).
Organisations
Publications
Chen D
(2021)
Too Much Technology and Too Little Regulation? The Spectacular Demise of P2P Lending in China
in Accounting, Economics, and Law: A Convivium
Chen D
(2020)
When formal finance meets the informal: the case of Wenzhou
in Journal of Banking Regulation
Chen D
(2018)
Why is China's SOEs reform always disappointing? A new political economic explanatnio
in Journal of Comparative Law
Deakin S
(2018)
Is there a relationship between shareholder protection and stock market development?
in Journal of Law, Finance and Accounting
| Description | The research project began in February 2017 and was completed in January 2019. An initial round of interviews was carried out in China in April 2017. On 15-16 April 2017 a conference on Fintech was held in Hangzhou, Zhejiang Province, organized with our Chinese research partners, and with the participation of industry-level actors, policy makers and regulators. In July 2017 the Cambridge team convened meetings with each of the Chinese teams and UK financial regulators based at the Financial Conduct Authority and Bank of England (Prudential Regulation Authority). Further interviews were carried out in China in September 2017 and in January 2018, when a workshop was held at Hunan University. In December 2018 a final round of interviews was completed in Beijing, Hangzhou (including a visit to the Hangzhou Internet Court), Wenzhou, and Shenshen. Progress has also been made on the econometric aspects of the research. An event study analysis of the impact of regulation in the Chinese P2P sector has been completed, complementing the fintech fieldwork. In addition, we have been working on a cross-national study of the respective roles of law and culture in influencing financial development and a study of the interactions between labour regulation, firm-level productivity and shareholder returns in different Chinese provinces. We are also working on a paper on the use of machine learning in legal adjudication and decision making. Work on writing up the results of the interviews is continuing, along with statistical analysis of the effects of regulation of the fintech sector in China and of trends in insolvencies. Differences in institutional quality across Chinese provinces are also being explored through econometric analysis. A number of project-related articles have appeared or are forthcoming in peer-reviewed journals including the Journal of Law, Finance and Accounting, and the Journal of Comparative Law. Working papers are being written up on various aspects of the research including the regulation of the P2P sector in China; the role of the law in financial sector development; informal and formal finance in Wenzhou following the crisis of 2011; an historical analysis of the formalization of finance in the UK the relationship between firm-level productivity, shareholder returns and labour regulation; and the use of AI and machine learning techniques in the context of legal adjudication and decision making. Results 1. The sustainability of the Chinese model of fintech China's approach has been promoted as a means of meeting Sustainable Development Goals related to financial inclusion. However, the rapid growth Chinese fintech has been at least in part the result of regulatory arbitrage, given the relative weakness of the regulations governing Chinese fintech firms by comparison to those applying to the formal banking sector in China and to fintech firms in neighbouring jurisdictions, including Hong Kong. Regulation in China was significantly tightened from 2015 and there was then a shake out of firms, particularly in the P2P sector. There are continuing concerns about the opacity of techniques used in data analytics and hence of their adequacy as a replacement for more traditional mechanisms of credit evaluation. A related issue is the sustainability of marketplace funding from the point of view of risk allocation. P2P financing, in a context where the platform is a pure information intermediary, entails the transfer of risk to a diffuse group of individual lenders. The experience of past financial crises suggests that such wide diffusion of risk, far from allowing for optimal risk spreading, can exaggerate the effects of information asymmetries and give rise to herding. The Chinese model could be vulnerable to 'contagion' effects which could trigger a negative market-wide reaction to systemic shocks. 2. The distinctiveness of Chinese fintech This issue involves a consideration of how far the rapid growth of fintech in China is the result of country-specific factors which cannot easily be replicated elsewhere. Among the factors considered significant for the promotion of fintech are investment in internet infrastructure and training of fintech specialists with the relevant financial and technical skills. While there would not seem to be insuperable barriers to the recreation of these conditions elsewhere, other factors inherent in the Chinese success story so far may not be so readily transferable. The fieldwork carried out for the project suggests that Chinese fintech firms owe much of their stability and sustainability to their embeddedness in networks characterised, as elsewhere in the Chinese economy, by a high degree of repeated trading and interpersonal trust. Thus some of the more successful P2P platforms supplement data analytics with offline credit checks and relationship building (the 'O2O' or 'online to offline' model). There is also evidence that interlocking ownership structures and alliances between platforms and more traditional financial institutions, including state-owned banks, play a role in cushioning platforms against the risks of credit defaults (Chen et al., 2019). 3. Lessons of the Chinese experience for the evolving regulatory framework of fintech Traditional approaches to financial regulation, in so far as they rely on licensing, information disclosure and supervision by state agencies, are in danger of appearing antiquated in the context of the rapidly developing fintech sector. This poses the question of how far these can approaches be effectively applied when technology is changing the very nature of the business model in question. A further issue is concerned with the risk that existing regulatory models cannot iterate with the pace of change in the industry. Here, the UK FCA's 'sandbox', which provide a controlled environment within which experimental business models can be tried out and tested under close regulatory supervision, suggests a way forward. The sandbox model has the potential to trigger regulatory learning both for firms in the fintech sector and for the regulator itself. This experience has prompted a debate in China about the adoption of the sandbox there. However, it is unclear how new business models work once they graduate from the sandbox, and there are concerns that the sandbox does not provide a scalable model as fintech continues to evolve. 4. The changing nature of informal finance in China: the Wenzhou model The coastal city of Wenzhou in Zhejiang province has a reputation as the birthplace of China's private sector economy and is also well known as a centre of informal finance. In 2011, it was badly hit by a regional financial crisis. This crisis is widely believed to have been caused by the collapse of Wenzhou's informal financial market, and has therefore been referred as the 'informal financial crisis' (minjian jinrong weiji). The crisis drew a great deal of attention from policy makers in China and their interventions led to a pilot reform in 2012. The project studied the Wenzhou crisis through interviews with key actors (business owners and managers, officials and judges) conducted between 2016 and 2018. While the crisis of 2011 has been attributed to weaknesses in the system of informal finance, including predatory interest rates, the study (Chen and Deakin, 2019) finds that the roots of the failure lay in the way that the formal and informal systems became intertwined in the period following the global financial crisis of 2008 and the expansionary monetary policy initiated by the Chinese authorities to counter its effects. The research highlights the effects of the over-supply of formal credit in this period and the encouragement of group lending, a practice relatively unknown prior to 2008, and which magnified the effects of the crisis. It concludes that the lesson to draw from Wenzhou is not that informal finance is inherently more instable or inefficient than formal finance, but that encounters between formal and informal finance can trigger instabilities in both. |
| Exploitation Route | The research should be of interest to fintech firms and regulators as well as to those researching China's financial development and economic growth model. |
| Sectors | Financial Services, and Management Consultancy,Government, Democracy and Justice |
| URL | https://www.cbr.cam.ac.uk/research/research-projects/informal-finance-in-china-risks-potential-and-transformation/ |
| Description | A workshop was held in Cambridge in June 2018 with visiting Chinese commercial law judges and UK-based experts in insolvency and commercial law (Professor Gerry McCormack and Dr. Xinian Zhang of Leeds University and Dr. Natalie Mrockova of Oxford University), and an academic workshop was held at Sheffield University in September 2018. In March 2019 members of the Cambridge team took part in a conference on financial inclusion and fintech held at SOAS, University of London. In April 2019 Simon Deakin presented the results of the fintech fieldwork and case study to a workshop organized by the Financial Services Authority, Tokyo, and in June 2019 he presented the same research to a meeting of financial professions in the City of London, organized under the auspices of the Cambridge Endowment on Research in Finance. Simon Deakin and Ding Chen gave presentations to academic workshops at SOAS, University of London, in May and June 2019. In September 2022 Ding Chen gave a presentation of work, with Simon Deakin, based on the project, at the annual Society of Legal Scholars Conference in London. |
| Sector | Financial Services, and Management Consultancy,Government, Democracy and Justice |
| Impact Types | Economic |