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Creating a level playing field for SMEs in China

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.

Restructuring shadow banking channels by bringing them to the surface has been coupled with myriad incentives by the government, the central bank and the China Banking Regulatory Commission to encourage state banks to open up to SMEs. For instance, loans to small businesses of less than Rmb5 million are excluded from the calculation of the banks' loan-to-deposit ratios and the tolerance level of SMEs’ NPL ratios has been relaxed compared with their state-owned counterparts.

At Shanghai Pudong Development Bank, lending to SMEs has been evolving over the past couple of years in line with Beijing’s incentives. “We made one of the biggest structural changes to bank lending last year when we set aside a separate quota of loans to SMEs," says Wang. Naturally, state-owned businesses with secure assets and collateral were the first to be served by the banks, leaving SMEs on the periphery, but this has changed. “Excluding SOEs, SPD Bank categorizes companies as tiny-sized companies, small-sized companies, and medium-sized companies,” says Wang. As well as this, loan officers’ performance-related remuneration at SPD Bank is in part based on the work they do for SMEs. “Payment to customer relationship managers, or sales managers, is closely related to their performance of SME business. Throughout the year, sales managers who give more importance to SME customers can earn bonuses. This is a major incentive introduced by the bank to encourage SME lending,” says Wang.

At SPD Bank, nearly 30% of allocated loans – around Rmb50 billion – has to go to non-state-owned enterprises of varying sizes and the bank is allowed to issue Rmb30 billion-worth of bonds to SMEs as a way for them to raise capital, not included in the loan to deposit ratio.

But these incentives are not always going to be enough. “At the end of the day, banks are businesses. Giving them incentives to lend to SMEs will not be enough. They need to see real profits on their balance sheets,” says Li. “Moreover, if SMEs default on their loans, but they have been dealing with alternative lenders, away from the banking sector, banks are not affected – they keep clean balance sheets and NPLs are kept to a minimum.”

All in all, the relationship between banks and SMEs is still murky and government numbers are biased on the upside. “The PBoC says that around 25% of all bank loans are provided to SMEs, which is a huge number,” says Stephen Green, regional head of research, greater China, at Standard Chartered. Moreover, banks have varying and often generous ideas of what an SME actually is. Criteria including size, profit and number of employees can be inflated and deflated by banks and government bodies alike when assessing what constitutes an SME. With such fluid criteria, all SMEs of different shapes, sizes and fundamentals are considered one homogenous sector. Inevitably, some SMEs will continue to be excluded from the formal banking sector.

For SMEs and SOEs to receive the same banking treatment, the government needs to make sure that the rules are fair for all parties. “Having the prefix ‘state’ attached to the type of organization you have holds a lot of weight for banks,” explains Li. “If there was a way to detach SOEs from their state-owned status, to separate them from government backing, the credit risk attached to them would automatically rise. This would put SMEs and SOEs on a level playing field – in effect SOEs would cease to exist.” For Li, equal competition between businesses of similar size would result. And eventually, the whole lending process would become a lot more transparent. “But policymakers take the view that right now this process is a lot more trouble than it’s worth. Introducing individual incentives to banks on a case-by-case basis is a lot easier to do,” he continues.

Wenzhou is an extreme example of what can happen when shadow banking spirals out of control, but SMEs nationally face similar problems when it comes to lending from big banks. Policymakers in Beijing need to create a level playing field between SMEs and SOEs for smaller, privately owned businesses to have any sort of meaningful relationship with the formal banking sector. Bringing shadow banking to the surface is a step in the right direction, but regulation needs to focus on how enterprises in China can be put on an equal footing.

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