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    China Business
     Feb 21, 2009
China's family firms test home market
By Benjamin A Shobert

WENZHOU, China - What their business does is simple enough: it assembles many of the hairbrushes, bathroom scrubbers, and floor mops ubiquitous in the West and which few pause to wonder where the products come from or who makes them.

But in many ways, the family that owns this company embodies the Chinese dream. As owners of a small manufacturing business they started over 10 years ago, they have seen their standard of living improve every year. Before their business began, the family eked out survival as shopkeepers. Limited savings meant they got started on the simplest of products which required the smallest of capital investments, a small scrub brush. Now, their business occupies three floors of a modern factory, with equipment capable


of complex molding, assembly and fabrication.

A meeting during a trade show several years ago led them to become one of Wal-Mart's many Chinese suppliers. In concert with the growing demands put on them by Wal-Mart and their other North American customers, the family invested in new capacity. During peak production times, the company employs approximately 200 employees, most of whom are rural migrants from China's interior.

The family's two sons have recently returned to the business after completing university education, with aspirations to see the business develop its own portfolio of branded products for sale within the domestic Chinese market. From anyone's perspective, they are the essence of China's success: entrepreneurs who came from nothing to build a business which employs fellow nationals, ongoing investments in industrial technology, all while they take good care of demanding customers.

Up until the last quarter of 2008, the business had grown consistently, largely reliant on exports. But with the global slowdown, this small company in Wenzhou, Zhejiang province, may not have access to the capital it needs in order to survive. At a minimum, it is unlikely it will be able to make the transition from being a captive export manufacturer to a stand-alone business with its own brand and distribution channels inside its home markets. But worst case is that the slowdown in orders and credit freeze will cause this family to shutter the factory and lose everything it has built, forcing it not only to begin again, but to question what part of the original dream is worth keeping.

It is not alone in this struggle: the National Development and Reform Commission estimates that the first half of 2008 was marked by the closure of more than 67,000 small and medium-sized enterprises (SMEs). Chen Naixing, Director of the Research Center for SMEs at the Chinese Academy of Social Sciences, has stated that the first half of 2008 saw a 50% reduction in the number of SMEs specializing in the manufacturing of eyeglasses, shoes and lighters. It can be easy to trivialize these losses, since many of the companies in question are very low tech manufacturers of goods with high labor content and little in the way of value added. In many cases, these are the types of jobs Beijing is happy to see either move further West within China or leave the country entirely.

Because the SME sector is highly fragmented and historically transitory their economic, social and political influence can be easy to overlook. China officially recognizes five SME sectors: industrial, construction, retail, transportation and hotels/restaurants. To fit within this official designation, sales must range from 30 million yuan (US$4.4 million) to 400 million yuan and employment from 500 to 3,000 (certain sectors have revenue or employment limits within these ranges). About 95% of the estimated 4.32 million SMEs in China are privately owned by 38 million businesspeople.

Yet SMEs account for more than 68% of China's exports and 75% of the new jobs created within China every year. And while it might be easy to only see the immediate economic influence of SMEs, according to the Chinese government, they also account for more than 65% of China's patents, which suggests they are pivotal as the country begins to emphasize innovation over low-cost manufacturing.

Cumulatively, the difficulties SMEs are facing have an obvious negative economic impact, but they also have a corrosive effect on the hope embodied in China's growing entrepreneurial class. After years of seeing their businesses grow, and learning how to participate in China's somewhat convoluted relationship between business and government, these company owners are now looking for help from Beijing in order to keep their dream alive.

Their frustrations are, at times, compounded by a cynicism that if only they were better connected to the Communist Party they might have an easier time finding capital. When critics of China's rapid ascent look for potential sources of instability, many have believed political tension was most likely to come from the countryside and disaffected peasants. And while SME owners are unlikely to take to the streets any time soon, Beijing is becoming increasingly aware that the owners of SMEs represent the foundation of China's economic renaissance, and as such, need to be supported during this critical time.

Regardless of time or place, credit for entrepreneurs has always been problematic, and in many ways the SME's lack of access to capital from within China's banking system is not unique. What makes China's SME banking needs different is that these small companies must compete with state-owned enterprises (SOEs) that are slowing their moves towards privatization and shouldering others aside in their demand for bank credit.

In China, as in any country that privatizes formerly government-owned assets, the implicit understanding on the part of banks is that the Chinese government stands behind the credit needs of the SOEs. Banks need not be overly predatory to see the risk of a newly formed SME, which may better embody the entrepreneurial spirit the financial system normally wishes to reward, as greater than a SOE whose ongoing operation and cash flow has the weight of government behind it.

Consequently, banks in China have reluctantly - and, from the vantage point of most SMEs, expensively - extended credit to the SME sector. In addition and perhaps understandably, banks' desire to process fewer transactions with larger values has meant the underlying commercial needs of most SMEs continue to be overlooked. But Beijing is not wholly insensitive to the needs of its SMEs.

During the late 1990s, China made an effort to develop a network of loan guarantee agencies, which by now number around 2,000. Late last December, Minister of Industry and Information Technology Li Yizhong announced that the SME loan guarantee business was expected to reach US$146 billion in 2009, and that the government was introducing tax cuts and other incentives to banks specializing in the SME sector with the hopes that such moves would help SMEs find and access the capital necessary for their businesses to continue operating and expanding. Additionally, in January the China Association of Small and Medium Enterprises started a 3 billion yuan "venture investment fund" in an attempt to introduce more opportunities for SMEs who need capital.

But access to capital is not the only support mechanism China has for its SMEs. Beijing's value added tax (VAT) policy has unquestionably had a significant effect on many business owners. Not entirely appreciated by some critics of China's policy towards SMEs is the paradox the country's policymakers are trapped in: their export markets are demanding VAT reform as part of trade negotiations, but eliminating or reducing VAT will put many Chinese companies out of business. Whatever the original intentions behind discontinuing certain VAT rebates, the consequence for many SMEs was that losing this meant going out of business. The higher the labor content of the SMEs production, the more reliant they are on VAT.

In most cases, the companies in question counted on VAT as their profit margin, a somewhat perverse relationship between government and business that while not unique to China may never have been practiced on the scale China has. While Beijing may have done them no favor when the VAT policies were changed, it is hardly a sustainable business model to have your company's profitability entirely represented by your VAT rebate. Three increases in the VAT percentages in the last half of 2008 show Beijing's sensitivity to this concern, but it is unlikely the SMEs most affected by this policy change have much in the way of a long-term future.

For the family in Wenzhou, in the occasional moments they can think beyond the end of the month, two concerns are foremost. First, as the cost of credit continues to increase, their profit margins will further erode. Even though they have poured everything they have into the business, they know a large export customer such as Wal-Mart views them as a name on a bill of lading and no more.

The family knows its customers can easily price shop and in today's environment may find lower prices from companies creating short-term, very low prices in the interest of obtaining cash flow, not profitability. The family knows it is very unlikely it can get a cost increase through, especially as the competition gets increasingly desperate. Closing its doors is certainly an option, but before it does this, it is going to make a concerted effort to do something most Chinese SMEs have been able to overlook: it is going to redirect every resource it has back into the domestic market. This is the family's second concern - whether it has enough time to develop a market which, while all around, the family has not ever needed.

The trauma of the last year has taught the family one thing more clearly than anything else: that its business is too reliant on North America. Yes, the family will continue to support its export business, and may look more aggressively at export opportunities in under-developed economies such as those in Africa or Indonesia. But to survive, it needs to develop products and distribution channels within its home country. In that, it is not unlike tens of thousands of other SME owners across China who today are shifting resources back into their own country, and thinking more carefully about product development needs unique to their tastes.

In 1937 Carl Crow, one of the original expat explorers of China from the American West, wrote a seminal book, 400 Million Customers, in which he laid out the preferences of Chinese consumers, tantalizing his readers with the sheer size of the untapped market in China. Crow could not know what lay in front of China and the world, the many traps and pitfalls that would ensnare those 400 million customers from ever materializing.

We now stand at another such point, where unless China's SMEs survive and innovate, the grand possibility of China's markets may again slip through the world's fingers; again untapped and unexplored, with the fundamental question of why China struggles so mightily to become a consumer economy again going unanswered.

Benjamin A Shobert is the managing director of Teleos Inc (www.teleos-inc.com), a consulting firm dedicated to helping Asian businesses bring innovative technologies into the North American market.

Copyright 2009 Benjamin A Shobert

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