China’s Shadow Banking

What the execution of maverick businessman Zeng Chengjie reveals about China's netherworld of shadow finance — and its risk to the global economy

On July 12, 2013, businessman Zeng Chengjie, 54, was taken from his jail cell at the Second Detention Center in Changsha, the capital of China’s southern Hunan province, brought to an execution ground, and shot. The authorities did not inform Zeng’s family. The next day, his younger daughter Zeng Shan, hearing rumors of what had happened, rushed to the Changsha Intermediate People’s Court to discover her father’s name on a list of executed prisoners posted on an outer gate. “I became desperate,” she says. “I couldn’t believe it.” Two days later, her brother was unceremoniously handed a red pouch containing Zeng’s ashes. A shocked Zeng Shan still can’t accept her father’s fate. “I never saw my father’s body, so sometimes I think he is still alive somewhere,” she says. “If the legal system here is fair, I don’t think my father should have been executed.”
Many in China agree. Even in a country where capital punishment is commonplace and the courts are often a tool of political repression, Zeng’s execution sparked concern, bewilderment and anger. He has become a cause célèbre among many local businesspeople and lawyers fearful that they too could become victims of an opaque legal system and an overbearing government.

Zeng was sentenced to death in 2011 for illegal fundraising and fraud. Prosecutors asserted that his company, Hunan Sanguan Real Estate Development Group, was a massive Ponzi scheme that Zeng used to swindle investors out of more than $130 million. The accusations have earned Zeng the dubious distinction of being nicknamed China’s Bernie Madoff, after the American financier who pleaded guilty in 2009 to committing one of the largest frauds in U.S. history. Zeng’s supporters, however, tell a different story, of an honest, hardworking entrepreneur who became a scapegoat for dubious but widespread business practices, and a victim of capricious Communist Party cadres. Zeng himself always professed that the charges against him were false. In a 2009 letter from prison, he wrote: “I didn’t commit a crime.”

Guilty or not, his death exposes a dark side of the world’s second biggest economy. China is a marvel of hypercharged growth and burgeoning prosperity—a gargantuan export machine and a rising superpower. But it is also a place where fortunes rise and fall on the whims of bureaucrats, the rule of law is spotty, and the line between legal and illegal is murky. Zeng’s story opens a window on a China that many CEOs and economists, fixated on the country’s boundless potential, rarely factor into their rosy forecasts—the part where many don’t play by the rules and the risks of doing business go beyond profit and loss. Driven to achieve the Chinese dream, Zeng willingly threw himself into this cauldron of opportunity, uncertainty and chance—indeed, he took advantage of it. But rather than the one-dimensional evildoer the authorities make him out to be, Zeng was a product—and symbol—of a hydra-headed economic system that has brought torment as well as benefit to China.

Underground Economy
That system is “state capitalism.” More than three decades of reform have not quite loosened the tight grip bureaucrats have on the economy. Above all, they have an inordinate amount of influence over where money—the lifeblood of any business—is directed. Loans from banks usually go to the politically powerful or officially anointed: state-owned enterprises, targeted industries or business folk with guanxi, or connections. (Many such loans are for wasteful, grandiose projects—which the top leadership is cracking down on.) Everyone else scavenges for cash to start companies, operate factories or build buildings. They turn to “shadow banking,” alternative financial networks and lending practices through which the ordinary or desperate can tap funds.
Despite its name, there is nothing inherently nefarious about shadow banking. These diverse forms of financing activities have arisen in response to market forces, linking businesspeople who need money with those who have it. Most are legal and conducted by financial institutions, like trusts. But other types are informal and sometimes exist between what’s lawful and what isn’t—widely practiced but on shaky legal footing. Companies raise money directly from the communities in which they do business or other private pools of cash, often at exorbitant rates of interest. It was in this netherworld of financial cloak-and-dagger that Zeng, seeking capital, dived into.
In recent years, as the funding demands of Chinese businesses have grown and the government has attempted to control debt by reining in the banks, shadow banking has escalated in size and scope. JPMorgan Chase estimates that shadow banking in China, broadly defined, nearly doubled between 2010 and 2012, to about $6 trillion, or almost 70% of the gross domestic product. The rapid expansion of this often risky and poorly regulated financial arena has sparked concern that China could be vulnerable to a crisis as devastating as the meltdown that enveloped Wall Street in 2008—sending shock waves through the global economy.

Beijing now sees the danger. Regulators aim to limit the risks from shadow banking and strengthen oversight. But, as ratings agency Fitch says, the changes “have a long way to run.” The Zeng case matters because it shows how difficult a task China’s leaders face reforming an economy entangled in shadowy webs of money, saturated with unknown debts and managed by bureaucrats prone to abusing their authority. Policymakers need to step back from the allocation of money, allow the market to do its job and force officials throughout the sprawling bureaucracy to implement laws impartially and consistently. Otherwise, China’s entrepreneurs will remain vulnerable to a system that forces them to take risks with their money, ideas, property—even their lives.

Follow the Money
The road is just a gravel track, winding along a mountainside and barely wide enough for a single car to squeeze past decrepit brick-and-concrete homes. But to the residents of Yangshi village, Zeng’s hometown, it is a memorial to a poor local farm boy who made it big. A plaque proudly proclaims that Zeng donated the money to construct the road through this tiny hamlet in Hunan province. That gift was only a part of the charity Zeng lavished upon his poor former neighbors. Every Chinese New Year, he would return and offer relief to the needy, sick and elderly. In his honor, the appreciative town calls the lane he built Chengjie Happiness Road.
The villagers also recall much happier times for Zeng. Liu Jinlian, a neighbor who grew up with him, describes him as a “naughty but kindhearted boy” who spent his days swimming in ponds and climbing the craggy mountains that encircle Yangshi. “He was a local leader,” she says. “All of the other kids would follow him around.” But Zeng’s childhood was also mired in poverty. His parents were farmers and had little money, so after graduating from high school, he took a job as a construction worker at a local firm. Then, in 1986, he left his small hometown in search of better prospects.

Zeng settled in Jishou, a city of 295,000 people nestled amid pine-encrusted mountains in Hunan. Jishou is far removed from the glitz of Shanghai or the grandeur of Beijing, with their towering skyscrapers, Starbucks cafés and Louis Vuitton stores. Here, the architecture is decidedly communist—boxy and utilitarian—and the shops markedly down-market. Zeng undertook construction projects for a state real estate company, but he had bigger ambitions. China was experiencing an explosion of prosperity, and Zeng wanted his own slice of it. There were fortunes to be made for those bold enough to grab them. In 2004, he formed his own company, Hunan Sanguan, determined to develop property on his own.

The biggest problem facing Zeng was finding the money. A farm boy from rural China trying to put up buildings in a small town is not the type of businessman who gets much attention from state banks. “I needed a huge amount of money,” Zeng said in the 2009 letter written while imprisoned. “However, at that time the banks were not willing to give me loans.” That left him no choice: he became embroiled in shadow banking.
Zeng began to borrow directly from the residents of Jishou. Even in relatively poorer cities like Jishou, there is no shortage of cash sitting around. The Chinese are famously big savers, but the state-controlled financial system gives them few investment opportunities. Everyone from rich business owners to humble street sweepers are constantly on the lookout for more lucrative options. In such an environment, Zeng’s offer was practically irresistible. He promised returns of as much as 10% a month, a huge payout compared with regular bank deposits, whose interest rates are capped at about 3% a year. Many rushed to lend to Zeng and others engaged in similar practices, sometimes handing over a large portion of their savings. Government figures show that Zeng attracted more than 24,000 citizen lenders over the more than four years he raised money.
Flush with cash, Zeng went on a building spree. He completed an upscale hotel in the city of Shaoyang, close to his home village, and began constructing a commercial building near Jishou’s train station. The most ambitious development was a gargantuan complex in downtown Jishou boasting high-rise apartment towers and a shopping mall. In all, Zeng invested in some 32 projects in Jishou and elsewhere.

Zeng’s financing was technically illegal. Chinese companies require government permission to raise funds from the public on such a large scale, and Zeng never received such approval. Borrowing from local residents in the way he did also forced Zeng into a practice that regulators most anywhere would frown upon—like Madoff, he was paying back some people with cash raised from others. The structure of his investments left him no other choice. The terms of the microloans he took from Jishou locals were as short as three months, and often no more than a year, but his real estate developments took much longer to come to fruition. That meant he had to keep paying out to his citizen creditors before his projects could generate sufficient returns on his investments. So Zeng split the incoming money into two pools. One was channeled into his construction programs, the other held as a reserve of liquid cash that could be tapped to pay creditors when they were owed money.

In a part of the country that is still under­developed, Zeng was mobilizing local resources to build up Jishou. He claimed that he routinely disclosed the extent of his fundraising to officials at the municipal administration and the prefecture government, and was never told to cease. “All the fundraising activities of my company are open to the public,” Zeng wrote in the 2009 letter. “The relevant departments and people know it thoroughly. The leaders in the prefecture and the municipal government know it too. The officials acquiesced to it.” Many Jishou citizens believe that too. “The local government encouraged us” to lend to the shadow bankers, says retiree Wang Zumin, who used to work in a state hardware company. Still, without official sanction, Zeng was operating in a corner of the economy where the line between illegal and legal is blurred. As Zeng would discover, what China’s bureaucrats might tolerate at one point, they can oppose the next—with dire consequences.

Trial by Jail
The beginning of the end for zeng came when officials in Jishou had a drastic change of heart about shadow banking. Suddenly, in 2008, they decided to rein in Zeng and others engaged in public fundraising. Perhaps the bureaucrats were concerned about how pervasive the practice had become. The first salvo of the crackdown was an edict prohibiting civil servants from participating in shadow-banking schemes run by Zeng and others. The order also caused an immediate stampede of withdrawals from the funds managed by Zeng and other entrepreneurs, seriously destabilizing their finances and forcing them to raise replacement cash from the citizenry even more aggressively. Shortly afterward, one company engaged in public fundraising admitted it couldn’t pay back its creditors. That sparked a panic in Jishou in early September. Fearing the loss of their hard-earned savings, an angry mob massed in central Jishou to demand payment, flooding into the train station and blocking rail traffic. Jishou authorities had to call in riot police.

The unrest seemed to have further convinced Jishou’s cadres that shadow banking had to be quashed. On Oct. 2, 2008, Zeng was called into a meeting with Jishou officials—and then vanished. “My father was summoned to a meeting, and he never came back,” his daughter Zeng Shan recalls. For two months, Zeng’s family had no idea what had happened to him. They eventually found out that he had been arrested. Local authorities scooped up Zeng and executives at 21 other businesses allegedly engaged in shadow banking all on the same day, according to state media reports.

In public court documents, prosecutors said Zeng invested only a fraction of the some $560 million he raised from the public and that he owed creditors about $130 million. Nearly $45 million was improperly transferred from the company by Zeng and his family, the prosecutors contended, including about $2.5 million that Zeng hid for himself. By the prosecutors’ reckoning, Zeng not only raised funds illegally from the public but also committed fraud by misrepresenting his business. (He was convicted on both counts.) Rather than the promising company he marketed to Jishou’s citizens, the prosecutors asserted, Zeng was running a Ponzi scheme, luring unsophisticated local residents into lending him money by promising high rates of return, then passing the incoming cash to other creditors. “His activities have violated China’s financial order, caused damage to citizens’ property rights and had a serious effect on local social stability,” the Supreme People’s Court in Beijing explained in its decision approving Zeng’s execution. “His crime is very severe.”

Peter Wang, Zeng’s lawyer, disputes the charges against his client. Wang says Zeng intended to pay back all of his creditors and was unable to do so because he was arrested before his major projects were completed. The lawyer contends that the assets of Zeng’s company were worth nearly $400 million, more than sufficient to cover any outstanding claims. The courts, Wang argues, did not have a proper assessment of the value of Zeng’s property developments when reaching their verdict. Wang also insists that Zeng was not running a Ponzi scheme, but operating “like a bank,” by utilizing some funds to meet his commitments while employing the rest into his investments. Nor did Zeng pocket any of the creditors’ funds for himself, Wang says. “I did not transfer or illegally take money,” Zeng wrote in one letter from his jail cell. “Except to pay back the investors, all the money I raised was used in the [real estate] projects.” Wang also contests Zeng’s death sentence. Even if Zeng were found guilty of illegal fundraising, that alone, he says, is not sufficient to warrant capital punishment under Chinese law. According to Wang, there was no fraud in Zeng’s case, so, he says, the courts should not have condemned him to death.

Zeng wasn’t given a chance to make good on his promises. Jishou authorities confiscated his company’s assets and sold them to a state-owned enterprise for about $54 million, according to a court document provided by Wang. Zeng’s many creditors lost millions. They were only partly compensated for the money they lent him. Zeng’s wife Deng Youyun, chairwoman of his company, was sentenced to 51⁄2 years in prison, and his elder daughter Zeng Zheng, one of the firm’s accountants, to seven. They both remain in prison today. (TIME requested interviews with the Jishou city government office responsible for dealing with illegal financial activities and with the propaganda department of the Changsha court to discuss Zeng’s case, but they did not respond.)
Throughout the trial and subsequent appeal, Zeng rotted in prison. He was not allowed visits from his family, though Chinese law permits them, according to Wang. Zeng complained of his poor treatment in a 2013 letter from prison to his lawyer. “The guards launch crackdowns on the jailhouse bullies from time to time; otherwise, I might have been beaten to death by them,” he wrote. “My hands and feet are shackled, and I do not have enough exercise and nutrition. I have suffered constant chronic illness for a long time. I have deep concern that I will die of the diseases in prison one day.” But Zeng tried to keep his spirits up. Given that he had so far survived, “perhaps God has been blessing me.”

The last time Wang saw Zeng was last year in late May. The Beijing lawyer says he found Zeng with his hands and feet chained together, leaving him unable to stand, and weak from lack of food. Wang had come with good news—he figured he had new evidence that could help Zeng’s case. But Zeng was grim. He told Wang that his guards had warned him his execution was imminent. Wang assured Zeng that was impossible: the death sentence, the lawyer told his client, could not be carried out so long as he was submitting evidence to the court. But Zeng had lost hope. “It is too late,” he told his lawyer despondently. “You can’t save me.”

Into Darkness
Zeng was right. just weeks later he was dead. Wang says he was not informed that the Supreme People’s Court had signed off on Zeng’s execution. According to Wang, Chinese law mandates that the court should have formally notified him of that decision, but he never got a copy of the final judgment. In November, four months after the execution, the court posted the document on the Internet, a highly unusual move that, Wang speculates, was an attempt to justify Zeng’s death to a skeptical public.

Why was Zeng prosecuted for financial practices that are common in China? How could officials tolerate these business dealings one moment, and execute a man for them the next? Maybe the reason was Zeng’s defiance. By professing his innocence to the bitter end and refusing to repent, he may have angered those in authority. Perhaps he was killed as a warning to others who dabble in the financial underground. Or maybe the scale of Zeng’s activities was simply too great, in the minds of officials, to allow for leniency.
In Yangshi village, the residents have no doubt about Zeng’s innocence. In their eyes, he remains nothing more than the local boy with big dreams. More than 1,000 people attended his funeral in his family house along Chengjie Happiness Road to pay their final respects before his ashes were buried on a nearby mountainside. “A good man died,” says Liu, his former neighbor. In Jishou, the many who participated in Zeng’s scheme blame their local government for what happened, not Zeng. “We don’t hate Zeng,” says Li Songquan, an ex-official in the local business chamber who says he lost about $190,000 in the city’s shadow-banking fiasco. “If he weren’t arrested, he would have had enough money to pay the creditors back.” To retiree Yang Zhongshun, another Zeng creditor in Jishou, the businessman’s ordeal reflects the core of injustice in China today: “Officials are more powerful than the law.”

That may be the key truth to emerge from Zeng’s story. “We should say no to those law-enforcement departments that infringe upon law, property and life,” Wang Shi, the founder of Vanke, one of China’s largest private real estate developers, boldly protested on social-media site Sina Weibo in response to the Zeng case. Yang Jinzhu, a Changsha lawyer who wrote on his blog that Zeng’s execution was “against humanity and totally unacceptable,” hits the point home. “If we do not speak for Zeng today,” he warned, “no one will speak when what happened to him falls upon us.”

with reporting by Gu Yongqiang / Beijing

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