Chinese Rice Mills and Underground Finance

A Jiangxi Province newspaper recently told the cautionary tale of a rice mill owner who disappeared after his side business as an underground lender got him deep into debt to family and friends. The story appears to be a warning about the dangers of underground lending, but it illustrates how China's Ponzi-style economy is unraveling.

"Mr. Li" got into the rice-milling business in 2009 when he invested several hundred thousand yuan to buy some milling equipment. He was "instantly transformed from farmer to factory boss."

In 2011, he built a mill using a 2-million-yuan loan that was secured by his inventory of unprocessed rice. The debt kept spiraling. During 2012-13, he borrowed 10 million yuan from several banks, but rice-milling business started running into trouble as the Chinese economy slowed.

The rice mill wasn't generating enough cash to cover his daily expenses, so Mr. Li became an underground lender in 2013. He lent 8 million yuan to a businessman from Zhejiang Province at an interest rate of 5-percent per month. He raised the money largely by borrowing from family and friends.

For four months, the Zhejiang businessman paid the interest promptly, but he disappeared when he got into financial trouble and still owed Mr. Li the 8-million-yuan principal. Mr. Li still owed his family and friends, and he himself was effectively bankrupt. If he sold his factory and equipment, he thought he could only raise about 2 million yuan. His grain inventory was already pledged as collateral for bank loans. He was 10-million-yuan in debt. This year, the court seized his factory and warehouse to pay his creditors.

Mr. Li himself went into hiding. He couldn't go home because he owed so much money to family and friends. The Jiangxi newspaper says there are dozens of such rice mill bosses who have disappeared because their cash chain broke down. Because rice-milling generates low returns, many bosses got into underground lending. The Jiangxi newspaper chastises these rice bosses for using their rice-milling business to borrow money for underground finance--"using money to make money."

A bank worker confirmed that many rice mills borrow money secured by inventories of rice and guaranteed by a third party company. The Jiangxi newspaper explains that the third party guarantor is responsible for the loan if the rice mill can't repay. If the guarantor doesn't come up with the money, the bank is stuck with the loan.

Another journalist visited a Jiangxi county in August and found that 42 of the county's 105 rice mills  had shut down since 2012. With little cash and low profit margins, small and medium mills had no money to pay workers or buy unprocessed rice. Many were using family labor to mill small quantities held in inventory to keep supplying their loyal customers. The journalist gave an example of a mill that invested 20 million yuan to expand, but was only generating a few hundred thousand yuan in profit.

It's beginning to look like China's booming economy was largely a giant Ponzi scheme propelled by reckless bank-lending ordered by the government to recover from the 2009 recession. Chains of debt were sustained by one-way bets on real estate, commodities, and the exchange rate. The system is breaking down now that the one-way bets have disappeared.