Once touted as a way to transform China’s financial sector to allocate capital more efficiently via market forces, China’s online peer-to-peer (P2P) lending platform has collapsed. The number of new P2P failures has surged again since June 2018 after an initial wave in 2015-16 (Exhibit 1), sending the amount of outstanding P2P loans plunging (Exhibit 2).
Exhibit 1: Number of new P2P failuresSource: CEIC, BNP Paribas Asset Management (Asia), as at 27/08/2018
Exhibit 2: Outstanding P2P loansSource: CEIC, BNP Paribas Asset Management (Asia), as at 27/08/2018
Exhibit 3: Number of new P2P start-upsSource: CEIC, BNP Paribas Asset Management (Asia), as at 27/08/2018
China’s P2P platforms emerged in late 2006, connecting individuals looking to borrow money with those willing to lend directly to them without going through the traditional financial intermediaries. The model took off between late 2014 and 2015 (exhibit 3) amid a massive boom in internet finance.
Retreat from implicit guarantee for P2P loans backfires
The first wave of failures between 2015 and 2016 did not cause any financial panic. Indeed, the amount of P2P loans continued to grow during that time (see exhibits 1 and 2), reflecting a consolidation process as inefficient platforms exited the market.
However, the recent failures have triggered a crisis of confidence. Reports of mom-and-pop investors losing all of their lifetime savings, committing suicide or demonstrating outside the CBIRC headquarters in Beijing demanding justice have flooded the mainland media and even triggered criticism of President Xi’s policy direction. Such high-profile turmoil prompted Beijing to roll out 10 measures to counter online lending risk in early August to calm public sentiment.
The current panic was most likely caused by the retreat by the regulator from its implicit guarantee policy. In mid-June, Guo Shuqing, head of the CBIRC, issued a stern warning that people should be prepared to lose their money if an investment promised returns of 10% or more. Until then, people believed that the close relationship between P2P companies and local government authorities signified a kind of blanket state support that would underpin P2P investments.
P2P loans, underground banking and incentive problem
The P2P debacle reveals both supervisory failure and a serious incentive problem in China’s financial innovation process. The CBRC and any local government where a P2P platform is registered were supposed to supervise the activities of, and implement the rules governing, the P2P companies running the platform. But these companies were seriously understaffed. It was also impossible for the local governments to effectively oversee the platforms that operated across different jurisdictions throughout the country.
Most importantly, the local authorities formed symbiotic relationships with P2P platforms for rent-seeking and corruption purposes, giving the authorities the incentive to turn a blind eye to financial irregularities and even Ponzi schemes. This explains why the regulators failed to ensure that P2P lending platforms stuck to their role as ‘information intermediaries’ rather than financial intermediaries.
Unlike a bank which pools depositors’ short-term funds and lends them out in long maturities and has an obligation to pay back depositors even if the loans go bad, true online P2P lending simply uses a platform to match borrowers and lenders over the internet. P2P lending also means that lenders are only paid when the borrowers repay their loans. The lender cannot ask the platform for any form of guarantee of reimbursement if the borrower defaults. These are the critical attributes in distinguishing a P2P platform from a bank.
But in China, all these lines are blurred. Many P2P platforms are either Ponzi schemes from the outset or operate as illegal underground banks. They pool funds via the internet for lending, issue wealth management products that have maturity mismatches and even provide repayment guarantees. Since there is no due diligence process, investors/lenders have no idea what risks they face until the platform suddenly goes belly up. The CBRC did issue rules in August 2016 that outlawed these practices, but the crisis in June 2018 clearly shows that there had been no compliance.
What are the potential consequences of the P2P loans debacle?
China's P2P segment is small. As of July 2018, it accounted for only 0.7% of total bank loans and 0.5% of total bank assets. P2P loan growth has been declining since its peak in 2015 (exhibit 4). Only a tiny portion of the population, mainly middle class people in major cities, has invested in P2P loans. So the crisis is unlikely to have any systemic impact on China’s overall financial system.
Furthermore, new loans are increasingly hard to obtain due both to the government’s debt reduction drive and its regulatory crackdown on the lending platforms. This means that ‘bad’ borrowers cannot easily find another platform to lend them money to pay back previous loans. In our view, the P2P problem is thus unlikely to grow further.
Exhibit 4: Growth of P2P lendingSource: CEIC, BNP Paribas Asset Management (Asia), as at 27/08/2018
However, the risk of social instability is still unclear at this point as the losses from the crisis have become a socio-political issue that has added to President Xi Jinping’s policy headaches that currently include slowing momentum in economic growth, rising financial defaults and intensifying Sino-US trade tensions.
Furthermore, the local authorities’ symbiotic relationship with the P2P platform has directed some of the P2P loans to government-linked projects. Failures of P2P lenders will cut off the flow of funds to projects which banks would not fund. There is no data for tracking the share of P2P loans in government-linked projects, which is a very recent phenomenon. But we can use the share of the ‘others’ category in the total source of funds for fixed-asset investment as a proxy. As of July 2018, this was only 17% and includes other shadow banking activities besides P2P loans.
In a nutshell, the P2P crisis is a structural problem that Beijing has to resolve alongside its financial modernisation programme, but we believe it unlikely to become a systemic problem that could wreak havoc on China’s asset markets. As of July 2018, there are still more than 1 650 P2P lenders in China and further consolidation is inevitable. Obviously, investors should be careful if investing in quoted P2P players, some of which are listed on overseas exchanges.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
 “Xi’s Grip Loosens Amid Trade War Policy Paralysis”, by Willy Lam, The Jamestown Foundation, China Brief Volume 18, Issue 14, August 10, 2018.
 The CBRC admitted in private conversation in 2015 that they had only two to three full-time staff working on supervising, regulating and drafting rules for thousands of complex P2P platforms.
 The most famous case is the Ponzi scheme Ezubao, involving USD 7.6 billion and over 900 000 investors. See http://www.xinhuanet.com/english/2016-02/01/c_135065022.htmTo read more articles on China and other emerging markets, click here. To read more articles by Chi Lo, click here.