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Creating a level playing field for SMEs in China

Kanika Saigal
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Beijing may have introduced incentives to state banks to lend to marginalized small and medium-sized enterprises, but the government needs to do much more to enable SME's access to funding. Creating a level playing field with their state-owned counterparts could be critical to achieving this goal.

Last October, hundreds of owners of small and medium-sized enterprises fled the country and some committed suicide as a downturn in the economy of Wenzhou and its region left them unable to pay back their debts to private lenders.  Following this, the Chinese Communist Party (CCP) has finally taken concrete action as political and social instability began to threat the Party’s legitimate rule in the region and beyond.

“Wenzhou is a good case study of what can happen when alternative, non-banking finance systems break down,” says John Armstrong, a senior analyst at Pacific Epoch, an investment research firm based in Shanghai. The private sector in Wenzhou, and the rest of Zhejiang province, is the most developed in China. But the downsides of this are becoming more apparent. Starved of attention from state-run banks, private businesses are often forced to turn to alternative channels of funding, such as friends, families and other businesses. Cue the shadow banking system.

 Wenzhou, Zhejiang province
And it’s not just the shadow banking system in Wenzhou that’s under pressure. By the end of May, the non-performing loan ratio of the orthodox banking industry in Wenzhou had risen for 11 straight months to 2.43%. When compared with the average level of 0.9% for the country as a whole by the end of the first quarter of this year, there is something clearly wrong in the city.

“Small to medium-sized enterprises are high-risk,” explains Wang Sunan, general manager of SMEs at Shanghai Pudong Development Bank. Banks such as Shanghai Pudong Development Bank see lending to SMEs as a gamble. To offset the risks, SMEs are charged higher interest rates than their state-owned counterparts, which has discouraging effects.

When the People’s Bank of China (PBoC) drastically cut interest rates in June and July it would have been natural to assume that SMEs would be able to borrow at improved rates. But it’s not just interest rates that turn SMEs off banks. “The problem is that many SMEs just don’t have the right fundamentals and the risk is too high so we chose not to lend to them,” says a senior banker at a Shanghai-based commercial bank. The average interest rate for lending by banks to SMEs is about 10% a year. Alternative sources of lending, such as the shadow banking system, are more expensive for SMEs. SMEs can be charged 25% or even more in interest depending on the size and tenor of the loan. Less obvious is the moral hazard attached to SME lending. “if you lend to SMEs, people will second-guess your intentions and perhaps even your own fundamentals as a bank,” explains a senior banker at an international bank based in Shanghai. According to figures from Ernst & Young, only 3% of China's 42 million SMEs secure bank loans. So for a lot of SMEs, including those in Wenzhou, there is little other choice than accessing the shadow banking system.

Part of the revolution has moved online. There are more than 2,000 websites offering private lending activities in China and loans brokered online increased 300 times to Rmb6 billion ($942 million) in the first half of 2011 compared to the full-year 2007. Some websites offer up to six times the benchmark lending rate of the central bank, which in turn attracts investors willing to gamble their money in risky businesses for colossal returns. “Key to the development of SMEs in China is the continued improvement in levels of transparency around business platforms and robustness in corporate governance to keep up with patterns globally. But perhaps most importantly, SMEs require clear access to legitimate financing channels,” says Jamie Spence, principal of Asian Link, a Hong Kong-based company focused on strategic partnership opportunities in north Asia.

Beijing has started to heed this advice. In April, Beijing introduced measures to tackle the problems related to SME financing in Wenzhou, culminating in the recent opening of the city’s SME financing service centre. The centre will ensure that privately owned businesses can get low-interest loans from legal platforms. Additionally, some shadow banking finance channels are transforming into local banking businesses in villages and towns to make the process transparent. Some internet-based businesses have similarly been allowed to transform in this way. Beijing, it seems, is bringing such shadow banking finance channels to the surface. But is this enough?

SMEs are a vibrant part of China’s economy and more needs to be done to regulate SME lending. According to Spence, China's SMEs are the “powerhouses underpinning the domestic economy and offer a lifeline for consolidating foreign businesses looking for partners in north Asia over the next decade”. As China moves away from its status as a manufacturing hub in Asia into a global economic power, creating these international links will prove invaluable. Moreover, SMEs in China account for approximately 60% of China's economic output and 75% of its jobs, helping to spur domestic consumption as part of Beijing’s long-term economic plans. “Over the past three decades, the growth of SMEs has been three times that of SOEs [state-owned enterprises]. There is huge potential for growth in this sector,” says Li Wei, economist at Standard Chartered in Shanghai.