http://www.forbes.com/sites/ceibs/2015/02/11/ceos-on-the-run-financial-crisis-with-chinese-characteristics/print/

2/11/2015 @ 4:37AM 336 views

CEOs On The Run: Financial Crisis With Chinese Characteristics

 China Europe International Business School , Contributor

POST WRITTEN BYSeung Ho Park and Shaomin Li

As China’s economy slows down, many firms cannot service their debt obligations . This isn’t abnormal, but what is unusual is that, faced with debt issues, there has been an increasing number of CEOs and owners of borrowing companies who simply choose to disappear . The local media have coined a new term to describe these vanishing acts: paolu  (running on the road).These bosses on the run, or the increasing insolvency of the informal financing system in general, have prompted the fear that China’s corporate debt problem is serious enough to trigger something similar to the 2008 financial crisis that started in the U.S. and eventually engulfed the world’s financial market. However, there are some important differences .

A typical victim in the 2008 U.S. financial crisis would look like this: a person who borrows heavily in the form of house mortgages, car loans, and credit card spending; when the economy goes bad, he loses his job, his house value plummets, and he is unable to service his debts.

In China, a typical victim of the vanishing act would be an individual who invested his personal savings in a company , through an informal network that connects him to the borrowing company, based on the promise of high interest payment. When the company loses its business and defaults on its loan as we’ve seen with the recent economic downturn, the individual investors’ monies are gone. It is reported that over 60% of the informal loan platforms that arrange individual investments to companies are facing difficulties.

In the U.S. case, the individual is the debtor. The bank is the creditor. When the individual debtor cannot service his debt obligation, it will trigger a chain reaction that has a destructive effect on the whole financial industry. It eventually spreads out to infect the entire economy and incurs heavy transaction costs such as legal processes, foreclosures, repossessions, and bankruptcies.

The Chinese case is different. Individual investors use their own cash to lend to the borrowing company. The debtor, in this case, is the company. The individual becomes the creditor. When the company cannot service the debt, it goes under and the individual investors lose their money. So, what is the chain reaction here? Well, the CEO of the borrowing company vanishes and the individual investors affected are upset. This chain reaction is rather limited, in a financial sense, since the individual investors do not leverage themselves to make these investments.

In many economies, including rapidly growing healthy economies, there are companies that are not able to pay their debts due to business failures. This is not a crime. So, in mature economies such as the U.S., we rarely hear that CEOs of debtor companies vanish due to bad debts . So why do many CEOs of borrowing companies in China choose to flee when their companies cannot service their debts? Based on our interviews of some CEOs (who are not on the run!) and our research, we can conjecture the following possible reasons: first, they face thousands of angry individual investors who may take the matter in their own hands — we all know what that means. Second, China is still a politically-driven society in which legal issues, such as a bad debt is determined by the Communist Party’s policies, which swing widely depending on the party’s priorities and social sentiment. This makes resolving a debt issue unpredictable and dangerous for company CEOs.

The major problem with the vanishing acts is not financial, but social . Of course, in China anything social is political as well. Small individual investors may cause social unrest by surrounding the borrowing firms, taking the CEOs or owners hostage, or protesting at local government facilities.

However, unlike the Western-style financial crisis, the relationship-based financial crisis in China is local and relatively small in scale with a limited chain reaction. The financial cost, while it could be huge for individual investors, tends to be small for public enforcement agencies, formal financial institutions such as banks, or taxpayers.

So while many CEOs of private companies are on the run and individual investors have lost their life savings, the current corporate financial crisis in China will not lead to a similar chain reaction and have as much impact as the recent financial crisis in the U.S. However, this is not something China should be proud of either, nor should it relieve our worries about CEOs’ vanishing acts. China needs to further develop its banking system so that it will replace the informal financing market and protect individual investors. Faced with bad debts, CEOs should be able to focus on reviving their companies instead of going on the run .