CHINESE companies are borrowing record amounts from Hong Kong's banks as the central government tries to bring the inflation rate down from a three-year high by reducing access to credit.

Financial institutions' claims on Chinese mainland companies rose fourfold to 1.6 trillion yuan (US$250 billion) between mid-2009 and the end of May, Hong Kong Monetary Authority data show. They will provide another 700 billion yuan to 1 trillion yuan of loans to mainland firms in the second half of 2011, according to Fitch Ratings. The money isn't included in the central bank's estimate of total lending in the economy. Chinese mainland's loans fell to their lowest level in a year in July.

Chinese policy makers have introduced loan quotas and higher reserve requirements in their bid to curb inflation, which quickened to 6.5 percent in July, compared with 3.6 percent in the United States and 2.5 percent in the euro region. While the All-China Federation of Industry & Commerce said in June that smaller businesses are more short on cash than during the 2008 financial crisis, companies that have access to international financing are still able to get the money through banks.

Overseas financing

"If you borrow in Hong Kong it's a hell of a lot cheaper than in the mainland," Jim Antos, a banking analyst at Mizuho Securities Asia, said in a telephone interview from Hong Kong on August 10. "The money is easily repatriated or sent to China."

Taiyuan Iron & Steel Group Co said in an April bond prospectus that its average yuan borrowing rate is 10 percent below China's benchmark lending rate. The one-year lending rate is at 6.56 percent. The company can borrow funds in foreign currencies for about 200 basis points, or 2 percentage points, more than the London interbank offered rate, according to the prospectus. Morgan Stanley and Deutsche Bank AG cut their estimates for China's economic growth to less than 9 percent this year, as the debt burdens of developed nations threaten demand for exports. The government is also trying to battle the effects of a credit boom that has seen local governments borrow 10.7 trillion yuan, and lending from Hong Kong banks could hinder those efforts.

China's preference for loan quotas and administrative controls is "becoming ineffective," Charlene Chu, a senior director at Fitch in Beijing, said in a telephone interview last Wednesday. "There are more and more ways around the rules and this is another example of a new channel that's opened up."

New loans in Hong Kong grew by HK$940 billion (US$121 billion) last year, up 29 percent from the year before, according to an April 11 letter from Norman Chan, the chief executive of the Hong Kong Monetary Authority. A total of HK$440 billion was lent to mainland non-bank customers, an increase of 47 percent. In comparison, property lending in Hong Kong rose 19 percent, Chan wrote.

Most of the mainland borrowers were state-owned enterprises or "companies owned by provincial or municipal governments," he said in the letter. Sixty-percent of the lending was either fully collateralized by bank deposits on the mainland or backed by guarantees by major mainland lenders.

"It is clear that the same rapid pace of credit growth is unsustainable," Chan wrote.

China will allow Hong Kong companies to invest in the country using yuan raised in the city, Vice Premier Li Keqiang said at a seminar last Wednesday.

Foreign direct investment into China rose 19.8 percent in July to US$8.3 billion from a year earlier, the Commerce Ministry said on last Tuesday.

Of Hong Kong banks' liabilities on the mainland, a total of 74 percent are recorded as claims on Chinese mainland banks and included in Hong Kong banks' interbank portfolio, not their loan holdings, Fitch said. This is because most of these are loans to Chinese companies and the borrower often has a guarantee or letter of credit from a mainland bank, Fitch's Chu said.

Hong Kong banks' claims on mainland lenders accounted for 17 percent of their total interbank assets by the end of March, up from 5 percent in mid-2009, according to Fitch. Exposure to Chinese mainland now amounts to about 20 percent of Hong Kong bank assets, Royal Bank of Scotland Group Plc said in a June 22 research note.

Wing Lung Bank Ltd, which was bought by China Merchants Bank Co in 2008, said in its 2010 annual report that the company had lent HK$3.37 billion to companies that had made a deposit in the mainland and borrowed in Hong Kong.

Bank of China Ltd said on May 19 it had signed a 5 billion-yuan financing agreement with Zhejiang Hengyi Group Co, a maker of chemicals, which included depositing in yuan and borrowing offshore, according to a notice on its website.

"This isn't just interbank lending, a lot of these deals are loans to Chinese companies. They just have a guarantee of some sort behind them and the Hong Kong banks are saying the ultimate risk is to a mainland bank, not to a mainland corporate," Chu said. "The true ability of the regulators to impact this non-loan based flow of finance is very limited."

Chinese corporate bond costs are rising at the fastest pace this year, reaching a record on August 15 compared with interest rates on government debt. The spread between top-rated 10-year corporate bonds and similar-maturity government bonds rose to a record 198 basis points on August 15. China's 10-year domestic bonds yielded 3.95 percent last Wednesday.

The yuan traded near a 17-year high after policymakers fixed the currency's reference rate at a stronger level. The yuan was little changed at 6.3877 in Shanghai last Thursday, compared with 6.3871 the day before, according to the China Foreign Exchange Trade System. The currency reached 6.3820 last Tuesday, the highest level since the country unified official and market exchange rates at the end of 1993.

Guarantees offer

Twelve-month non-deliverable forwards dropped 0.12 percent to 6.2873 in Hong Kong last Thursday, according to Bloomberg News data. The contracts reached 6.2585 last Tuesday, the strongest level since March 2008.

Gree Electric Appliances Inc, a manufacturer of air conditioners in Zhuhai in southern China, said in March that domestic banks have started to provide guarantees to Chinese companies' overseas subsidiaries which they can use to apply for financing from offshore banks. "Domestic companies can use yuan deposits as a counter-guarantee," it said.

Five-year credit default swaps for China's debt touched 116 basis points on August 11, the highest level since May 2009, according to data provider CMA, which is owned by CME Group Inc and compiles prices quoted by dealers in the privately negotiated market. Contracts on China's debt rose nine basis points to 112 basis points last Thursday, CMA data show.

It is unclear how much of the money raised in Hong Kong by mainland entities is returning to the mainland, Mike Werner, an analyst at Sanford C. Bernstein & Co in Hong Kong, said last Thursday.

"What this does call into question is the lending practices of the Hong Kong banks, because we don't have a good idea how well collateralized some of these loans are," Werner said. "If what they're doing is receiving collateral or pledges in Chinese mainland and extending credit in Hong Kong the question is what the recovery rate is going to be in the event of a default."