Small firms see salvation from loan
sharks By Sue Anne Tay
In spite of the continuing controversy
within the Chinese government over the sale of
state-owned bank shares to foreign financial
institutions, penetration by foreign banks has
been broadly recognized as beneficial to China's
banking reforms. To prepare for the end of 2006,
when foreign banks will be able to compete on a
level playing field in China, domestic banks have
been frantically improving themselves using
government capital injections, stricter regulation
and supervision.
Since China has little
history of practiced risk management and corporate
governance, it has chosen to outsource some of the
banking reforms to foreigners, where working
together through
consultations, stake sales and
cooperative projects such as joint credit-card
platforms allows for the necessary technology and
expertise transfer.
With the weaker banks
weeded out and stronger banks forced to innovate
according to market trends, not only will Chinese
consumers benefit from enhanced efficiency and
competition, they will gain greater overall access
to credit, helping to drive economic growth by
boosting consumer spending. Hence the impact of
foreign-bank penetration, while providing
undesired competition to local banks, is
ultimately recognized to be positive.
Recently, however, the International
Monetary Fund (IMF) released a report disputing
this conventional wisdom. It argues that foreign
penetration in the banking sector of developing
countries may benefit a certain stratum of
customers but could also hurt other segments of
the population. While the authors of the report do
not deny that foreign banks can achieve better
economies of scale and risk diversification than
domestic banks, through use of more advanced
technology and better services, the IMF's
empirical research demonstrates that the private
sector may not necessarily benefit from foreign
penetration, but instead paradoxically receive
less credit.
According to the report, the
experience of developing countries such as Mexico,
Pakistan and India has shown that upon entry,
foreign banks mainly secure customers among larger
and more profitable firms and multinational
corporations operating in the country in question.
This is largely because the international
standards and regulations regarding accounting,
loan enforcement and collateral assessment
enforced by the parent-country headquarters of
foreign banks prevent their local subsidiaries
from lending to "informationally difficult"
clients - meaning companies that have inadequate
credentials to access loans. Small and
medium-sized enterprises (SMEs) usually fall into
this category.
SMEs, especially those in
the private sector, have traditionally received
little support and attention from Beijing compared
with large state-owned enterprises. Deng Xiaoping,
while encouraging private enterprises to develop,
had aimed to attract foreign direct investment.
Private firms in China do not enjoy the privileges
granted to foreign investors. Foreign companies
still enjoy a special tax exemption as an
incentive to invest in China, whereas private
firms have been subjected to a 33% income tax plus
a 20% individual adjustment tax. It was only in
1998 that domestic companies were granted the same
constitutional protections that foreign businesses
have enjoyed since the early 1980s.
Since
the mid-1990s, the government has redirected
attention to the SME sector. An SME department was
created in the then State Economic and Trade
Commission. Credit guarantee schemes (CGSs) for
SMEs were introduced in 1994 and have grown to
cover more than 30 provinces, municipalities and
autonomous regions. In 2000, these CGSs had a fund
of 10 billion yuan (US$1.25 billion) for SMEs. A
series of well-intentioned measures were
introduced, one of which was the 2000 SME
Technology Innovation Fund to increase financial
support for SMEs. The 2002 SME Promotion Law was
enacted to promote fair treatment and a more level
playing field for SMEs. Still, there were times
when such measures were criticized as ill-defined
and insufficient, with little program monitoring
and enforcement.
Overall, China's SMEs are
to a considerable degree "unbanked", meaning they
simply do not use traditional financial services.
As of late 2005, there were about 12 million
non-state-owned SMEs, which contributed more than
60% of gross domestic product (GDP) but only made
up 16% of the loan portfolio of Chinese banks.
According to a survey of more than 600
enterprises in Sichuan province
conducted by the China Project Development
Facility (CPDF), a multi-donor facility managed by
the International Financial Corp aimed at helping
SMEs, it was discovered that banks supply less
than 10% of the investment capital needed by
enterprises. In comparison, a 2003 World Bank
survey on China's investment climate discovered
that Chinese SMEs received 12% of their working
capital from banks. The corresponding figure in
Malaysia was 21%, 24% in Indonesia and 26% in
South Korea and Thailand.
Many obstacles
prevent banks from entering the SME lending
sector, the first and foremost being the
perception of risk attached to smaller
enterprises. State-owned commercial banks
traditionally lend to large state-owned
enterprises, which are implicitly guaranteed by
government authorities. Private firms are regarded
as considerably riskier as a result of
rudimentary, often unreliable accounting standards
and doctored financial records. For example, to
avoid penalties when operating outside a very
strict registered business scope, companies
sometimes resort to misrepresenting their
financial statements, the number of employees, and
the value of stocks and assets, as well as falsely
reporting tax information.
Second, adding
to the risk factor, most SMEs lack usable
collateral to secure loans. Inventory, equipment
or accounts receivable are acceptable collateral
in developed countries. In China's case, the often
outdated operating equipment and the stated
concerns over accounting and asset valuations
debilitate the loan-assessment process.
Legislation for property rights and bankruptcy
laws necessary for evaluating collateral are not
up to date and remain ensnared in debate.
Enforcement mechanisms are either untested or
inconsistent. Few banks are willing to risk
potential unpaid loans by relying on such
intangibles as an entrepreneur's business acumen
and trustworthiness.
Third, without a
complete credit reporting system, there is an
asymmetry of information between borrowers and
lenders. Credit information such as past lending
activities of enterprises and general business
performance information (if not compromised by
unreliable financial disclosure) is mostly absent,
thus SMEs are often not rated and unsurprisingly
fail to qualify for loans.
Last but not
least, the underdeveloped capital market further
limits funding options for SMEs. With stock-market
listings mostly limited to state firms for
political reasons, and only a small percentage of
household deposits invested in the domestic
market, the lack of liquidity to absorb
outstanding shares combined with insufficient
institutional investment makes the stock market a
dismal option for SMEs as a source of funds. SMEs
themselves have great difficulty listing on the
domestic stock exchanges; hence private firms
remain a minority.
With these obstacles to
access to formal credit channels, SMEs often
obtain loans from an informal circle of family and
friends. When this option runs out, they turn to
underground borrowing and pawnshops, particularly
prevalent in vibrant enterprise hubs in Guangdong, Zhejiang and Jiangsu. It has been
acknowledged that without the informal lending
sector in entrepreneurial cities, SMEs would never
have flourished the way they did.
China's
central bank estimates that annual underground
lending, in particular loan-sharking, has reached
$118 billion, or an approximate 6-7% of all
lending in China. Pawnshops are growing in
popularity, since they provide the quickest option
for short-term loans. Most entrepreneurs complain
they have a hard time borrowing less than a
million yuan. Understandably given the lack of
alternatives, the high interest rates pawnshops
charge fail to deter SMEs (Beijing pawnshops charge
3.2% per month on loans secured by property and
4.7% per month on other loans, keeping in mind the
benchmark bank lending rate is 5.58% per year).
Enterprises are able to secure a loan in a matter
of days and with less hassle compared with the
several-months-long process of borrowing from a
bank.
Nevertheless, this does little for
actual financial deepening in China. The
government recognizes the need to boost credit
access for SMEs given their vital role to the
economy. SMEs have absorbed 75% of the labor
force, many of whom had been laid off during state
industry reform - a major factor in preserving
social stability. With some 25 million young
people looking for 11 million available jobs in
2006, SMEs can help ease this burden. Boosting
SMEs will also help the country to build a strong
and healthy enterprise base that can compete with
foreign firms.
To address the deficient
financial infrastructure for SMEs, a
credit-information databank targeting enterprises
has launched operation on a trial basis and should
begin full operation in mid-2006. With more SMEs
being professionally rated, access to credit will
be easier. The government has also increased the
number of credit guarantee institutions to assist
SME financing, dispensing more than 23 million
yuan in 2004. A special SME board focusing on
technology companies has also been created within
the stock exchange to expand the direct financing
channels for SMEs. SME financing is now a major
priority.
With growing government
initiatives encouraging SME development, will
foreign banks tap into the lucrative business of
SME lending? Will we see more competitive lending
services in this area and an increase in overall
credit access?
The IMF working paper
posits that unlike domestic banks, foreign banks
are better at monitoring "hard" information, such
as accounting information or collateral values but
not "soft" information, such as a borrower's
entrepreneurial ability or trustworthiness.
Without the history of local networks and
relationships and intimate knowledge of the
entrepreneurial environment that influence a loan
assessment for small businesses, foreign banks do
not make concessions according to different
classes of business borrowers. There are fears
that when foreign banks enter the banking sector
as equal players, domestic banks will be
marginalized. In the worst-case scenario, the
report suggests, SMEs may find that their credit
options shrink, possibly leading to an overall
decline in credit lending to that sector.
The empirical model established by the IMF
working paper may be plausible; however, it seems
unlikely in the Chinese context for several
reasons. Foreign investors currently are allowed
only minority shares of up to 25% in banks, and
attempts to relax this limit have been
controversial, as demonstrated by the flap over
Citigroup's bid to buy 75% of Guangdong
Development Bank. In fact, analysts have seen the
improvement and innovation of city commercial
banks in the past two years that have neatly
captured the SME lending market, though not as
aggressively as one would imagine. Their deep
relations with the local market and their small
size make them flexible and responsive to the
needs of SMEs and therefore highly competitive in
lower-margin syndicated lending.
According
to a Moody's Credit Research report on Chinese
city commercial banks released in February, the
SME exposure for top-performing city commercial
banks is very significant. The Bank of Beijing has
a clientele of 130,000 local SMEs, accounting for
43% of the SMEs in Beijing; SME loans make up to
50-60% of loans in Hangzhou City Commercial Bank,
and 70% of the corporate banking business in Wuxi
City Commercial Bank is related to local SMEs.
These particular banks have been singled out for
undertaking important reforms to improve solvency
and operations while trying to expand beyond their
regional focus.
Because of increased
competition within the banking sector, many banks
have developed streamlined strategies for their
SME clientele. Dong Wenbiao, the chief executive
officer of Minsheng Bank, Shanghai's
second-largest lender, spoke of his bank's market
shift to SMEs, explaining, "We're going to leave
the state-owned-enterprise market to the Big Four
state banks ... we can't compete with them in this
area."
Large state and non-state banks
alike have begun tapping into the SME lending
sector. According to the Asian Banker Journal, the
Jiangsu branch of the Industrial and Commercial
Bank of China (ICBC) is developing innovative
methods to counter the lack of accuracy in
financial statements. It will take time before
foreign banks can effectively reach beyond the
major cities where they are currently located,
giving the domestic banks time to corner the SME
sector.
In conclusion, foreign-bank
penetration may be welcomed for its overall
contribution to competition and efficiency, but
where SMEs are concerned, formal access to credit
will be better provided for by domestic banks.
There is much to be done regarding the undeveloped
state of SME financing, such as improving the
necessary financial infrastructure to help SMEs
gain credit access, encourage and educate domestic
banks of the lucrative business of SME lending,
and, most important, promote good business
practices among SMEs. Enterprises should seek
formal channels of credit rather than informal
ones.
Nonetheless, the SME financing
sector is still in need of further reforms such as
enforcing stricter accounting and auditing
standards, easing restrictions and penalties for
business development and creating more incentives
for the creation of private enterprise. Together,
these factors will be a boost to the development
of the SME sector, fulfilling the potential
offered by China's dynamic entrepreneurs.
Sue Anne Tay is a researcher
with Hills Stern & Morley LLP focusing on
Chinese politics, finance and economics. All views
expressed above are those of the author and do not
represent the views of the firm. She can be
reached at satay@hillsandstern.com.
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