Description
Study Reports on Financing Obstacles for Small and medium sized enterprises (SMEs) in China, SME finance is the funding of small and medium sized enterprises, and represents a major function of the general business finance market – in which capital for different types of firms are supplied, acquired, and costed or priced.
Study Reports on Financing Obstacles for Small and medium sized enterprises (SMEs) in China
Small and medium sized enterprises (SMEs) in China have experienced significant obstacles obtaining access to loans and financing. According to Wang (2004, 39), only 30 percent of SMEs that apply for loans will actually receive them, which has forced many SMEs to rely on other sources (Garcia-Fontes 2005).1 Despite government efforts to improve SME financing, SMEs continue to face difficulties (Wang 2004, 44; Chen and Wang 2009, 132; Garcia-Fontes 2005, 4).2 It is important for the government to find an effective solution, because SMEs have a significant contribution to the Chinese economy, responsible for 55.6 percent of GDP, 62.3 percent of exports and 75 percent of employment (Wu 2011). At first glance, the financing difficulties that Chinese SMEs have experienced appear to be because of their high risk of loan default and low credit rating (Chen et al. 2010, 301). However, a closer examination reveals that the root of SME financing difficulties is related to larger weaknesses within the Chinese financial system. Specifically, there is an information asymmetry between banks and borrowers, insufficient regulation of the financial system, and inappropriate government intervention in the financial system. Because this problem is larger than SME credit rating and performance, improved credit risk assessment and monitoring systems are an insufficient solution.3 To improve financing for SMEs as well as help them to improve their performance in general, it is necessary for banks and borrowers to improve communication and information sharing, China must transition to a credit-based financial system and reduce government intervention, and improve regulation of the financial system to ensure adherence to a credit-based financial rules. First, I will provide some background information on the specific financing difficulties that Chinese SMEs are experiencing. I will then elaborate on the root of these challenges in relation to the three weaknesses in China's financial system mentioned above. Following this discussion, I defend my policy recommendations. Background: SME Financing Difficulties SMEs face three main obstacles to obtaining financing: 1) high credit risk, 2) a lack of appropriate collateral, and 3) a lack of information. Credit risk refers to the risk of loss for a bank as a result of a borrower's inability to pay back a loan or other form of credit (Chen et al. 2010, 301). In general, SMEs are associated with high credit risk, because most are in highly competitive industries, with lower average profits and are highly influenced by the business environment. In addition, SMEs generally have poor management quality due to the fact that they have only been established for a short period of time, have limited management experience, and have not yet established standardized financial management practices (Chen et al. 2010, 201; Li 2003, 267; Ayadi 2005; Thai and Xu 2009, 6). Consequently, SMEs have a high rate of insolvency and limited capacity to recover after experiencing losses (Wang 2004; Li
1
According to the 2003 World Bank survey, only 12 percent of SMEs obtain their primary source of financing from bank loans, and most rely on self-accumulated capital (55 percent), private borrowing (31.6 percent) or rural credit corporate loans (23.4 percent)(Dollar et al. 2003; Garcia-Fontes 2005). 2 For example, the government introduced a ceiling rate for lending to SMEs, which had perverse effects and decreased incentives for banks to loan to SMEs. The ceiling was raised in 2000 (Garcia-Fontes 2005, 4). A full map of the various efforts pursued by the Chinese government can be found in Subacchi et al. (2012, 7). 3 Chen et al. (2010) proposed improved credit monitoring methods as a means by which SME financing could be improved in China.
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2003).4 This means that banks will bear the losses in the event of loan default. Because of the higher probability of default and higher loss implications on the bank, they are usually less willing to issue loans to SMEs, and will give SMEs a lower credit rating. While a borrower's credit rating is used as the primary basis for issuing loans, banks will also consider the borrower's collateral assets if his credit rating does not provide sufficient assurances.5 However, SMEs in general do not have sufficient collateral assets to provide sufficient assurances against loss. SMEs in developing countries face particular challenges because of the overall lack of capital assets (Li 2003, 267). Therefore, SMEs can provide little assurance to banks in their ability to fulfill loan obligations. Finally, borrowers can help provide assurances about their ability to fulfill loan obligations by providing relevant information to the bank about the business' operations. Information about a firm's reputation, business plan, and management structure can help provide assurances despite a low credit rating and low collateral. Not only does this information help the bank assess the borrower's abilities or credit risk, information sharing helps build confidence between the borrower and the bank.6 Information sharing is the basis of a successful financing relationship, because it allows banks to detect and address any problems before they become unmanageable, and it helps firms improve their credit rating and performance by working on areas that are relevant to credit assessment (Ayadi 2005; Thai and Xu 2009, 6). However, SMEs in general have difficulty providing reliable information due to their un-systematic bookkeeping, financial management practices, and general business organization (Ikasari et al. 2012, 468). Chinese SMEs have a particularly poor record for providing accurate information. Firms will often show faulty information on financial reports for tax or other purposes, creating an information asymmetry between borrowers and banks.7 This creates difficulty for banks to evaluate the abilities of firms, which makes banks unwilling to provide loans (Li 2003, 267; Garcia-Fontes 2005, 3).
4 5
Wang (2004, 46) estimates that approximately 50 percent of SMEs go bankrupt over a period of 3 to 5 years. In China, eligible collateral assets are specified in Article 34 of the Guarantee Law (1995), and include: buildings and objects fixed on land that are owned by the mortgager, or that he has been given rights to dispose of by the State; machines, transportation or other property that are owned by the mortgager, or that he has been given rights to dispose of by the State; other property that may be mortgaged according to law (see Garcia-Fontes 2005, 2; PRC 1995). 6 Ayadi (2005) explains that general credit rating process involves analysis of historical, quantitative and qualitative information about the borrower. Specifically, the credit rating process involves 4 stages: 1) general analysis of historical, quantitative and qualitative information about the firm; 2) analysis of individual factors; 3) specification and estimation of credit risk using different models; 4) determination of the credit rating and the probability of default. He continues to elaborate on the information that is considered in the analysis. Quantitative information is based primarily on financial statements, and includes: 1) the firm's performance; 2) leverage; 3) debt coverage; 4) liquidity; 5) growth; 6) productivity; 7) size; 8) other macroeconomic or political factors; 9) a detailed business plan. Qualitative information includes: 1) a profile of the enterprise; 2) development prospects of the industry; 3) reputation, experience and ability of the firm; 4) past credit history; 5) the firm's ownership and governance structure; 6) management quality of accounts receivable; 7) the availability of collateral and guarantees. 7 Firms have incentives to misrepresent financial flows, number of employees, stocks of assets, and other aspects of accounting and financial structure to avoid paying higher taxes, or to make their firm appear more attractive to banks (Garcia-Fontes 2005, 3).
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The Root of the Problem: Government Influence A closer examination of the causes of information asymmetry between banks and borrowers reveals that borrowers have little incentive to provide accurate information and build up a credit reputation, because it will not affect their future prospects for borrowing (Garcia-Fontes 2005, 3; Thai and Xu 2009, 12). The Chinese government controls the four largest banks8 and has extensive influence over the rest of the financial sector through the People's Bank of China (PCB) and China Banking Regulation Commission (CBRC). It also owns a number of major companies in the country. Consequently, the majority of bank assets are allocated to these organizations regardless of their credit rating or performance (China Knowledge 2012; Thai and Xu 2009).9 The government influences the Chinese financial system to such an extent that the words and decisions of government officials at different levels are decisive in the administration of funds, rendering the allocation of loans a governmentinfluenced system rather than a credit-based system (Chen and Wang 2009, 133). Although China has taken steps to commercialize its banks, they are still largely being made to serve political goals (Subacchi et al. 2012, 33). The information asymmetry between borrowers and banks was also caused because of ineffective regulation over the financial system to ensure that accurate information is being reported and that all rules are being followed (Garcia-Fontes 2005, 3). China has experienced major problems with bad debt because of ambiguous bankruptcy procedures, failing to properly monitor outstanding loans, disregarding regulations, erroneous accounting and misrepresentation of the true value of bad loans (Thai and Xu 2009, 13; CBRC 2007; Fu 2009). These problems could have been avoided with more effective regulation and remedial measured by the China Banking Regulatory Commission. Government involvement in the financial system has also affected the credit risk of SMEs. As mentioned above, banks prefer lending to state-owned enterprises regardless of their credit rating, because banks have assurance that the government will cover any losses that may occur in the event of a loan default. The risk of loss involved in issuing loans to SMEs becomes even higher when compared against state-owned enterprises by the fact that SME loans are not covered by the government. In addition, government involvement has stifled competition between banks, which has resulted in higher rates for SMEs (Ayadi 2005, 20; Garcia-Fontes 2005, 3).10 These higher rates created added difficulty for SMEs to maintain their debts, and thus increase the risk of default. For SMEs to have a fair chance in the market, a substantial reduction of government involvement in the economy is necessary.
8
The Chinese government established four major commercial banks in 1983: the Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB), Bank of China (BOC) and Agricultural Bank of China (ABC). The ICBC, CCB and BOC were restructured between 2003 and 2005 into joint-stock banks, but the government still retained significant control over their operations. 9 In 1999, 69% of loans were issued to state-owned enterprises (Wang 2004, 43). 10 A number of studies have confirmed the link between the level of competition between banks and lending rates. For example, Thai and Xu (2009), Berger et al. (1998), Schure et al. (2004).
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Recommendation: Credit-Based System, Improved Regulation, Improved Communication To improve SME access to finance, credit ratings and general economic performance, it is necessary for China to achieve 3 key changes: 1) adhere to a credit-based system for issuing loans, 2) improve regulatory oversight over the administration and maintenance of loans, and 3) improve communication and information sharing between borrowers and banks. A credit-based system for issuing loans is basically one within which banks will consider the financial and economic qualifications and capacity of borrowers as the basis for issuing loans (MMG 2010). Despite the fact that SMEs generally have a poor credit rating, the main difficulty they have experienced in obtaining loans is that loan decisions have been influenced by arbitrary government decisions, as mentioned above. It is important for China to adhere to a credit-based system to ensure that arbitrary government decisions do not continue to undermine the loan prospects of SMEs. A credit-based system will be more beneficial to SMEs than the current system, because it is based on a consistent and transparent set of rules. This allows SMEs to understand the requirements for credit and gives them an opportunity to improve their credit rating to improve their prospects for obtaining loans. At the same time, as credit ratings are based on the management and performance of a firm, the efforts of SMEs to improve their credit rating will also improve their economic performance and contribute to the growth of the economy as a whole. While adherence to a credit-based system will be better for economic growth, it will ultimately require decreased government involvement in the economy. Specifically, the Chinese government would need to withdraw its influence over financial policies, its ownership over banks and large enterprises, and allow market forces to determine the fate of these institutions. The Chinese government may not yet be ready to make these changes. Moreover, the institutional changes needed to achieve this goal require a significant amount of time and should not be rushed. Therefore, adherence to a credit-based system must be considered as a recommendation for the longer-term. Ideally, China should work towards adopting a system for credit assessment that is internationally recognized, such as the Basel I or II systems.11 However, as Herring (2005, 281) points out, the attempt to adopt these systems will be extremely difficult and potentially harmful for emerging economies such as China, because they do not have the appropriate data, infrastructure, institutions or supervisory independence. Moreover, the adoption of these systems prematurely diverts resources from more fundamental ways of improving the financial system. Moreover, these systems were not designed for emerging economies and do not include analysis weighting of the most important risks that face these economies, such as risks associated with political volatility, currency inconvertibility, liquidity, funding and others. Adherence to a credit-based system will also require a shift in the way the "guanxi" system works within the financial sector. While guanxi is an important part of doing business in China, it is difficult to maintain a credit-based system for issuing loans if personal relations influence loan decisions. The relationship between banks and borrowers continues to be important within a credit-based system,
11
See Ayadi (2005) for an overview of the strengths and weaknesses of the Basel I and II systems.
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though it revolves around information sharing rather than personal influence in decision-making, discussed in further detail below. The Chinese government is aware of the weaknesses in its financial system, and has taken a various steps to reform its financial system. During the Fourth National Financial Work Conference that was held in Beijing in January 2012, China's financial officials identified eight key areas for strengthening its financial system that will move China towards a credit-based financial system.12 In addition, China has set new targets in its 12th Five-Year Plan. The government plans to complete the commercialization of its three policy banks by 2015. In addition, the government intends for its large commercial banks to adopt international standards and regulations as part of its Go Global Strategy. These steps will help improve the environment for SMEs (Subacchi et al. 2012, 33). To support the China's transition to a credit-based system, it is necessary to improve regulation over the financial sector. This will ensure that the rules of the system are followed. Specifically, improved monitoring over monitoring and reporting is needed to ensure the quality of information collected. Monitoring over the over the loan administration process is also needed to ensure that rules and procedures are being followed properly. In addition, monitoring over the repayment of outstanding loans is needed to ensure that payments are being made and to detect any problems that borrowers may experience. Improved regulation will be beneficial for SMEs by helping to ensure the benefits of a credit-based system as discussed above. In addition, improved regulation will benefit banks by improving the quality of information collected on SMEs. Not only will this provide banks with a better understanding of the capacity of individual firms that apply for loans, it makes further macro and statistical analyses possible, which will enable more accurate estimates of credit risk. Improved information, more accurate assessments and ongoing monitoring help banks avoid losses from default. This in turn helps SMEs, because it helps firms avoid losses, and may make banks more willing to provide loans.
12
The eight areas for financial reform are: 1) Financial Services: Improve the overall quality of financial services to support economic and social development (especially rural, SME and government supported sectors); 2) Financial Institutions: Deepen institutional reforms to reinforce corporate governance and effective decision making (particularly, China Development Bank continued reforms towards becoming a commercial bank); 3) Financial Regulations: Strengthen financial regulation to prevent systematic financial risks (particularly, institute comprehensive risk management systems, improve the market system, strengthen regulation, and protect investor rights); 4) Government Debt: Control debt issuing mechanism of local government, and incorporate revenue and expenditures into the budget system; 5) Capital and Insurance Market: Enhance coordination of stock and futures market, and encourage the development of a well-regulated and unified bond market; 6) Macroeconomic Policy: strengthen the coordination of monetary and fiscal policies, regulations (particularly, allow a wider float for the RMB exchange rate); 7) Financial Resources: Relax controls over the capital account to improve capital allocation, enhance the management of foreign reserves, promote closer financial cooperation and development; 8) Financial Infrastructure: Set up a unified credit information system, improve registration, depository, settlement and clearance systems, and enhance consumer protection (Subacchi et al. 2012, 6).
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Despite the benefits of regulation for both banks and SMEs, it will entail more reporting and will require greater transparency throughout China's financial system, which may prove to be difficult to achieve. The Chinese approach to governance and administration does not emphasize transparency, and China has experienced some difficulty complying with WTO transparency standards.13In addition, it is necessary that the body or agency responsible for regulating the financial system remains independent from the Chinese government and shielded from government influence in order to properly regulate the financial system and ensure that it is making progress towards a credit-based system (Chen and Wang 2009, 133). Again, this recommendation must be considered as a long-term goal. Nevertheless, China has achieved certain improvements since joining the WTO in 2001 (Biukovic 2008, 819). Continued efforts to achieve transparency to fulfill WTO commitments are largely in line with the types of reforms needed in the financial sector, which will contribute to improved regulation. At the micro level, improved communication and information sharing between banks and borrowers within a credit-based system will provide benefits to both by reducing the risk of default and associated losses. As mentioned above, communication and information sharing helps improve the quality of information that banks receive from borrowers. Improved information helps both banks and borrowers avoid losses by allowing for better assessment of the borrower's capacity. Continued information sharing during the repayment process helps banks to detect and address problems that may occur, thereby reducing the risk of default. Because of the poor reporting practices that currently used by both banks and borrowers in China, efforts to improve information analyses will not be fruitful.14 It is necessary to improve the quality of the information that is collected before improvements in analysis can be made. Efforts should concentrate on proper accounting procedures and systems for SMEs as well as the proper disclosure of financial information on the operating statement, balance sheet and cash flow statement (Garcia-Fontes 2005, 9). However, information sharing involves more than just information provided by the borrower. Banks must inform their clients about the credit rating process, and help them understand the requirements. Banks must also either provide or direct their clients to resources that will help them improve their credit rating and business operations (Ayadi 2005). In addition, it may be necessary for China to establish other organizations, programs and services to help provide the necessary information resources for SMEs to improve their credit ratings and business performance. As Wang (2004, 49) acknowledges, the poor performance of SMEs may be because of weaknesses in the provision of social
13
The concept of governance in China had been based on the idea that administrative agencies and regulators are only accountable to political or bureaucratic superiors, not the public. Moreover, the style of operation used by the Chinese Communist Party revolved around a concentration of power at the center, and a lack of involvement or information about internal operations by the public (Biukovic 2008, 819). 14 For example, Chen et al. (2010) focus on developing a statistical method for credit monitoring and assessment of SMEs in China. However, they acknowledge that the lack of sufficient data has been a major difficulty in their analysis. Specifically, it has made the "default rate" hard to estimate. They proceed by using suboptimal data.
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services for SMEs. Specialized institutions are needed to provide services to SMEs such as consultation and information, training, technology and marketing assistance.15 While an effective information sharing relationship between banks and borrowers is the foundation of a successful lending and financing relationship, this type of relationship is slightly different from the traditional "guanxi" relationships on which many Chinese business relationships are based. Guanxi relationships revolve around the exchange of favours, regardless of merit, whereas the information sharing relationships are more professional, and revolve around a bank's willingness to help a client as a means of improving the prospects of future returns (Fan 2007). Nevertheless, guanxi relationships can be used as a beginning point for building information sharing between banks and borrower. The relationship between banks and borrowers has not been acknowledged or mentioned by the Chinese government as part of their strategy to help SMEs and improve economic performance in general. This is surprising, because improving information sharing between banks and borrowers can provide extremely helpful assistance for SMEs without extensive institutional changes to the financial system. Therefore, added emphasis is placed on this recommendation as an option that can be pursued to help SMEs while the larger institutional reforms to the financial reforms to the financial system are still in progress. Concluding Remarks SMEs in China continue to experience difficulty obtaining access to loans and financing. Part of the difficulty stems from the fact that SMEs have high credit risk and a low credit rating. However, a closer examination of the problem has revealed that the difficulty SMEs have experienced is related to larger weaknesses in the financial system. I have argued that there is an information asymmetry between banks and borrowers, insufficient regulation of the financial system, and inappropriate government intervention in the financial system and I recommend that China needs to adhere to a credit-based system for assessing loans, reduce government intervention in the economy in general, improve regulation and the basic relationship between banks and borrowers to improve information sharing in order to improve the performance and financing prospects of SMEs. Moreover, I have emphasized that these changes are needed first before more sophisticated credit models or assessment systems can become useful. Finally, I emphasize that while the larger institutional changes necessary to achieve a credit-based financial system and improved regulation can only be achieved over the longer term, efforts to improve the relationship between banks and borrowers can provide extremely helpful assistance for SMEs in the short term, and should thus be incorporated into government strategies.
15
For example, Chen and Wang (2004, 134) describe the various ways that non-profit organizations in Taiwan have supported SMEs. Functions include: the execution of government policy, removal of barriers, improving the will of financial institutions towards SMEs, and enlarging the effects of assisting institutions. All qualified SMEs can seek services form these organizations. Garcia-Fontes (2005, 7-8) describes the services provided for SMEs in Korea and Japan. In Korea, special institutions and support centres have been established to provide training, offer research and information, organize expositions, promote technology transfer, assist SMEs with challenges pertaining to patents, foreign and domestic technology acquisition and adoption and assist firms with the marketing their products for export.
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Sources Cited: Ayadi, Rym, 2005. "The New Basel Capital Accord And SME Financing: SMEs And The New Rating Culture." Centre for European Policy Studies (CEPS). Berger, A. N., A. Saunders, J.M. Scalise and G.F. Udell. 1998. "The Effects of Bank Mergers and Acquisitions on Small Business Lending." Journal of Financial Economics, 50: 187-229. Biukovic, Ljiljana. 2008. "Selective Adaptation of WTO Transparency Norms and Local Practices in China and Japan." Journal of International Economic Law, 11 (4): 803-25. Chen, Xiaohong, Xiaoding Wang, Desheng Dash Wu. 2010. "Credit Risk Measurement and Early Warning of SMEs: An Empirical Study Of Listed SMEs In China." Decision Support Systems, 49: 301-310. Chen, Yurong and Weixing Wang. 2009. "On Perfecting the Credit Guarantee System of China's Small and Medium-Sized Enterprises." International Business Research, 2 (3): 132-35. China Banking Regulatory Commission (CBRC). 2007. "Annual Report." Beijing: China Banking Regulatory Commission. http://zhuanti.cbrc.gov.cn/subject/subject/nianbao2007/english/ywqb.pdf China Knowledge. 2012. "China Banking System." http://www.chinaknowledge.com/Business/CBGdetails.aspx?subchap=4&content=15 Dollar, D., M. Hallward-Driemeier, A. Shi, S. Wallsten, S. Wang, and L. C. Xu. 2003. "Improving the Investment Climate in China." Investment Climate Assessment. World Bank and International Finance Corporation. Garcia-Fontes, Walter. 2005. "Small And Medium Enterprises Financing In China." Central Bank of Malaysia Working Paper. http://www.bnm.gov.my/microsites/rcicc/papers/s6.garciafontes.pdf Fan, Ying. 2007. "Questioning Guanxi: Definition, Classification and Implications." International Business Review, 11 (5): 543-61. Fu, Xiao Qing. 2009. "The Effects of Reform on China's Bank Structure and Performance." Journal of Banking and Finance, 33 (1): 39-52. Herring, Richard. 2005. "Implementing Basel II: Is the Game Worth the Candle?" Financial Markets, Institutions and Instruments, 14 (5): 267-87. Ikasari, Novita, Fedja Hadzic and Tharam S. Dillon. 2012. "Incorporating Qualitative Information for Credit Risk Assessment through Frequent Subtree Mining for XML." In XML Data Mining: Models, Methods, and Applications, ed. Andrea Tagarelli. IGI Global. 467-503. Li, Xiao. 2003. "On Reasons of Difficulty in SME Indirect Financing and Corresponding Countermeasures. 265-70. http://www.seiofbluemountain.com/upload/product/200911/2009zxqyhy03a7.pdf MMG Capital (MMG). 2010. "Credit-Based Lending Vs. Asset-Based Lending." Free Investor Education Resources: Investor News. August 1, 2010. http://www.mmginvestors.com/resources/articlesguidesnews/21-published-articles/114toddpigott.html People's Republic of China (PRC). 1995. "Guarantee Law of the People's Republic of China." Eighth National People's Congress. Lehman, Lee and Xu. http://www.lehmanlaw.com/resourcecentre/laws-and-regulations/banking/guarantee-law-of-the-peoples-republic-of-china1995.html Schure, P., R. Wagenvoort, and D. O'Brien. 2004. "The Efficiency and Conduct of European Banks: Developments After 1992." Review of Financial Economics, 13. Subacchi, Paola, Helena Huang, Alberta Molajoni and Richard Varghese. 2012. "Shifting Capital: The Rise of Financial Centres in Greater China." Chatham House, Royal Institute of International Affairs. Thai, Linh Gia and Yun Xu. 2009. "Banking Market Competition and SME Financing in China: Case Study Across Chinese Provinces." Paper within Bachelor Thesis in Economics. Jönköping International Business School.
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http://www.europeana.eu/portal/record/9200111/E294C62F65D520C0B6B14956293CFA8D6A2 6890A.html Wang, Yanzhong. 2004. "Financing Difficulties and Structural Characteristics of SMEs in China." China and World Economy, 12 (2): 34-49. Wu, Tian Ran. 2011. "Financing Difficulties and Countermeasures of Our SMEs." International Conference on Economics, Trade and Development, 7: 119-22.
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Study Reports on Financing Obstacles for Small and medium sized enterprises (SMEs) in China, SME finance is the funding of small and medium sized enterprises, and represents a major function of the general business finance market – in which capital for different types of firms are supplied, acquired, and costed or priced.
Study Reports on Financing Obstacles for Small and medium sized enterprises (SMEs) in China
Small and medium sized enterprises (SMEs) in China have experienced significant obstacles obtaining access to loans and financing. According to Wang (2004, 39), only 30 percent of SMEs that apply for loans will actually receive them, which has forced many SMEs to rely on other sources (Garcia-Fontes 2005).1 Despite government efforts to improve SME financing, SMEs continue to face difficulties (Wang 2004, 44; Chen and Wang 2009, 132; Garcia-Fontes 2005, 4).2 It is important for the government to find an effective solution, because SMEs have a significant contribution to the Chinese economy, responsible for 55.6 percent of GDP, 62.3 percent of exports and 75 percent of employment (Wu 2011). At first glance, the financing difficulties that Chinese SMEs have experienced appear to be because of their high risk of loan default and low credit rating (Chen et al. 2010, 301). However, a closer examination reveals that the root of SME financing difficulties is related to larger weaknesses within the Chinese financial system. Specifically, there is an information asymmetry between banks and borrowers, insufficient regulation of the financial system, and inappropriate government intervention in the financial system. Because this problem is larger than SME credit rating and performance, improved credit risk assessment and monitoring systems are an insufficient solution.3 To improve financing for SMEs as well as help them to improve their performance in general, it is necessary for banks and borrowers to improve communication and information sharing, China must transition to a credit-based financial system and reduce government intervention, and improve regulation of the financial system to ensure adherence to a credit-based financial rules. First, I will provide some background information on the specific financing difficulties that Chinese SMEs are experiencing. I will then elaborate on the root of these challenges in relation to the three weaknesses in China's financial system mentioned above. Following this discussion, I defend my policy recommendations. Background: SME Financing Difficulties SMEs face three main obstacles to obtaining financing: 1) high credit risk, 2) a lack of appropriate collateral, and 3) a lack of information. Credit risk refers to the risk of loss for a bank as a result of a borrower's inability to pay back a loan or other form of credit (Chen et al. 2010, 301). In general, SMEs are associated with high credit risk, because most are in highly competitive industries, with lower average profits and are highly influenced by the business environment. In addition, SMEs generally have poor management quality due to the fact that they have only been established for a short period of time, have limited management experience, and have not yet established standardized financial management practices (Chen et al. 2010, 201; Li 2003, 267; Ayadi 2005; Thai and Xu 2009, 6). Consequently, SMEs have a high rate of insolvency and limited capacity to recover after experiencing losses (Wang 2004; Li
1
According to the 2003 World Bank survey, only 12 percent of SMEs obtain their primary source of financing from bank loans, and most rely on self-accumulated capital (55 percent), private borrowing (31.6 percent) or rural credit corporate loans (23.4 percent)(Dollar et al. 2003; Garcia-Fontes 2005). 2 For example, the government introduced a ceiling rate for lending to SMEs, which had perverse effects and decreased incentives for banks to loan to SMEs. The ceiling was raised in 2000 (Garcia-Fontes 2005, 4). A full map of the various efforts pursued by the Chinese government can be found in Subacchi et al. (2012, 7). 3 Chen et al. (2010) proposed improved credit monitoring methods as a means by which SME financing could be improved in China.
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2003).4 This means that banks will bear the losses in the event of loan default. Because of the higher probability of default and higher loss implications on the bank, they are usually less willing to issue loans to SMEs, and will give SMEs a lower credit rating. While a borrower's credit rating is used as the primary basis for issuing loans, banks will also consider the borrower's collateral assets if his credit rating does not provide sufficient assurances.5 However, SMEs in general do not have sufficient collateral assets to provide sufficient assurances against loss. SMEs in developing countries face particular challenges because of the overall lack of capital assets (Li 2003, 267). Therefore, SMEs can provide little assurance to banks in their ability to fulfill loan obligations. Finally, borrowers can help provide assurances about their ability to fulfill loan obligations by providing relevant information to the bank about the business' operations. Information about a firm's reputation, business plan, and management structure can help provide assurances despite a low credit rating and low collateral. Not only does this information help the bank assess the borrower's abilities or credit risk, information sharing helps build confidence between the borrower and the bank.6 Information sharing is the basis of a successful financing relationship, because it allows banks to detect and address any problems before they become unmanageable, and it helps firms improve their credit rating and performance by working on areas that are relevant to credit assessment (Ayadi 2005; Thai and Xu 2009, 6). However, SMEs in general have difficulty providing reliable information due to their un-systematic bookkeeping, financial management practices, and general business organization (Ikasari et al. 2012, 468). Chinese SMEs have a particularly poor record for providing accurate information. Firms will often show faulty information on financial reports for tax or other purposes, creating an information asymmetry between borrowers and banks.7 This creates difficulty for banks to evaluate the abilities of firms, which makes banks unwilling to provide loans (Li 2003, 267; Garcia-Fontes 2005, 3).
4 5
Wang (2004, 46) estimates that approximately 50 percent of SMEs go bankrupt over a period of 3 to 5 years. In China, eligible collateral assets are specified in Article 34 of the Guarantee Law (1995), and include: buildings and objects fixed on land that are owned by the mortgager, or that he has been given rights to dispose of by the State; machines, transportation or other property that are owned by the mortgager, or that he has been given rights to dispose of by the State; other property that may be mortgaged according to law (see Garcia-Fontes 2005, 2; PRC 1995). 6 Ayadi (2005) explains that general credit rating process involves analysis of historical, quantitative and qualitative information about the borrower. Specifically, the credit rating process involves 4 stages: 1) general analysis of historical, quantitative and qualitative information about the firm; 2) analysis of individual factors; 3) specification and estimation of credit risk using different models; 4) determination of the credit rating and the probability of default. He continues to elaborate on the information that is considered in the analysis. Quantitative information is based primarily on financial statements, and includes: 1) the firm's performance; 2) leverage; 3) debt coverage; 4) liquidity; 5) growth; 6) productivity; 7) size; 8) other macroeconomic or political factors; 9) a detailed business plan. Qualitative information includes: 1) a profile of the enterprise; 2) development prospects of the industry; 3) reputation, experience and ability of the firm; 4) past credit history; 5) the firm's ownership and governance structure; 6) management quality of accounts receivable; 7) the availability of collateral and guarantees. 7 Firms have incentives to misrepresent financial flows, number of employees, stocks of assets, and other aspects of accounting and financial structure to avoid paying higher taxes, or to make their firm appear more attractive to banks (Garcia-Fontes 2005, 3).
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The Root of the Problem: Government Influence A closer examination of the causes of information asymmetry between banks and borrowers reveals that borrowers have little incentive to provide accurate information and build up a credit reputation, because it will not affect their future prospects for borrowing (Garcia-Fontes 2005, 3; Thai and Xu 2009, 12). The Chinese government controls the four largest banks8 and has extensive influence over the rest of the financial sector through the People's Bank of China (PCB) and China Banking Regulation Commission (CBRC). It also owns a number of major companies in the country. Consequently, the majority of bank assets are allocated to these organizations regardless of their credit rating or performance (China Knowledge 2012; Thai and Xu 2009).9 The government influences the Chinese financial system to such an extent that the words and decisions of government officials at different levels are decisive in the administration of funds, rendering the allocation of loans a governmentinfluenced system rather than a credit-based system (Chen and Wang 2009, 133). Although China has taken steps to commercialize its banks, they are still largely being made to serve political goals (Subacchi et al. 2012, 33). The information asymmetry between borrowers and banks was also caused because of ineffective regulation over the financial system to ensure that accurate information is being reported and that all rules are being followed (Garcia-Fontes 2005, 3). China has experienced major problems with bad debt because of ambiguous bankruptcy procedures, failing to properly monitor outstanding loans, disregarding regulations, erroneous accounting and misrepresentation of the true value of bad loans (Thai and Xu 2009, 13; CBRC 2007; Fu 2009). These problems could have been avoided with more effective regulation and remedial measured by the China Banking Regulatory Commission. Government involvement in the financial system has also affected the credit risk of SMEs. As mentioned above, banks prefer lending to state-owned enterprises regardless of their credit rating, because banks have assurance that the government will cover any losses that may occur in the event of a loan default. The risk of loss involved in issuing loans to SMEs becomes even higher when compared against state-owned enterprises by the fact that SME loans are not covered by the government. In addition, government involvement has stifled competition between banks, which has resulted in higher rates for SMEs (Ayadi 2005, 20; Garcia-Fontes 2005, 3).10 These higher rates created added difficulty for SMEs to maintain their debts, and thus increase the risk of default. For SMEs to have a fair chance in the market, a substantial reduction of government involvement in the economy is necessary.
8
The Chinese government established four major commercial banks in 1983: the Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB), Bank of China (BOC) and Agricultural Bank of China (ABC). The ICBC, CCB and BOC were restructured between 2003 and 2005 into joint-stock banks, but the government still retained significant control over their operations. 9 In 1999, 69% of loans were issued to state-owned enterprises (Wang 2004, 43). 10 A number of studies have confirmed the link between the level of competition between banks and lending rates. For example, Thai and Xu (2009), Berger et al. (1998), Schure et al. (2004).
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Recommendation: Credit-Based System, Improved Regulation, Improved Communication To improve SME access to finance, credit ratings and general economic performance, it is necessary for China to achieve 3 key changes: 1) adhere to a credit-based system for issuing loans, 2) improve regulatory oversight over the administration and maintenance of loans, and 3) improve communication and information sharing between borrowers and banks. A credit-based system for issuing loans is basically one within which banks will consider the financial and economic qualifications and capacity of borrowers as the basis for issuing loans (MMG 2010). Despite the fact that SMEs generally have a poor credit rating, the main difficulty they have experienced in obtaining loans is that loan decisions have been influenced by arbitrary government decisions, as mentioned above. It is important for China to adhere to a credit-based system to ensure that arbitrary government decisions do not continue to undermine the loan prospects of SMEs. A credit-based system will be more beneficial to SMEs than the current system, because it is based on a consistent and transparent set of rules. This allows SMEs to understand the requirements for credit and gives them an opportunity to improve their credit rating to improve their prospects for obtaining loans. At the same time, as credit ratings are based on the management and performance of a firm, the efforts of SMEs to improve their credit rating will also improve their economic performance and contribute to the growth of the economy as a whole. While adherence to a credit-based system will be better for economic growth, it will ultimately require decreased government involvement in the economy. Specifically, the Chinese government would need to withdraw its influence over financial policies, its ownership over banks and large enterprises, and allow market forces to determine the fate of these institutions. The Chinese government may not yet be ready to make these changes. Moreover, the institutional changes needed to achieve this goal require a significant amount of time and should not be rushed. Therefore, adherence to a credit-based system must be considered as a recommendation for the longer-term. Ideally, China should work towards adopting a system for credit assessment that is internationally recognized, such as the Basel I or II systems.11 However, as Herring (2005, 281) points out, the attempt to adopt these systems will be extremely difficult and potentially harmful for emerging economies such as China, because they do not have the appropriate data, infrastructure, institutions or supervisory independence. Moreover, the adoption of these systems prematurely diverts resources from more fundamental ways of improving the financial system. Moreover, these systems were not designed for emerging economies and do not include analysis weighting of the most important risks that face these economies, such as risks associated with political volatility, currency inconvertibility, liquidity, funding and others. Adherence to a credit-based system will also require a shift in the way the "guanxi" system works within the financial sector. While guanxi is an important part of doing business in China, it is difficult to maintain a credit-based system for issuing loans if personal relations influence loan decisions. The relationship between banks and borrowers continues to be important within a credit-based system,
11
See Ayadi (2005) for an overview of the strengths and weaknesses of the Basel I and II systems.
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though it revolves around information sharing rather than personal influence in decision-making, discussed in further detail below. The Chinese government is aware of the weaknesses in its financial system, and has taken a various steps to reform its financial system. During the Fourth National Financial Work Conference that was held in Beijing in January 2012, China's financial officials identified eight key areas for strengthening its financial system that will move China towards a credit-based financial system.12 In addition, China has set new targets in its 12th Five-Year Plan. The government plans to complete the commercialization of its three policy banks by 2015. In addition, the government intends for its large commercial banks to adopt international standards and regulations as part of its Go Global Strategy. These steps will help improve the environment for SMEs (Subacchi et al. 2012, 33). To support the China's transition to a credit-based system, it is necessary to improve regulation over the financial sector. This will ensure that the rules of the system are followed. Specifically, improved monitoring over monitoring and reporting is needed to ensure the quality of information collected. Monitoring over the over the loan administration process is also needed to ensure that rules and procedures are being followed properly. In addition, monitoring over the repayment of outstanding loans is needed to ensure that payments are being made and to detect any problems that borrowers may experience. Improved regulation will be beneficial for SMEs by helping to ensure the benefits of a credit-based system as discussed above. In addition, improved regulation will benefit banks by improving the quality of information collected on SMEs. Not only will this provide banks with a better understanding of the capacity of individual firms that apply for loans, it makes further macro and statistical analyses possible, which will enable more accurate estimates of credit risk. Improved information, more accurate assessments and ongoing monitoring help banks avoid losses from default. This in turn helps SMEs, because it helps firms avoid losses, and may make banks more willing to provide loans.
12
The eight areas for financial reform are: 1) Financial Services: Improve the overall quality of financial services to support economic and social development (especially rural, SME and government supported sectors); 2) Financial Institutions: Deepen institutional reforms to reinforce corporate governance and effective decision making (particularly, China Development Bank continued reforms towards becoming a commercial bank); 3) Financial Regulations: Strengthen financial regulation to prevent systematic financial risks (particularly, institute comprehensive risk management systems, improve the market system, strengthen regulation, and protect investor rights); 4) Government Debt: Control debt issuing mechanism of local government, and incorporate revenue and expenditures into the budget system; 5) Capital and Insurance Market: Enhance coordination of stock and futures market, and encourage the development of a well-regulated and unified bond market; 6) Macroeconomic Policy: strengthen the coordination of monetary and fiscal policies, regulations (particularly, allow a wider float for the RMB exchange rate); 7) Financial Resources: Relax controls over the capital account to improve capital allocation, enhance the management of foreign reserves, promote closer financial cooperation and development; 8) Financial Infrastructure: Set up a unified credit information system, improve registration, depository, settlement and clearance systems, and enhance consumer protection (Subacchi et al. 2012, 6).
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Despite the benefits of regulation for both banks and SMEs, it will entail more reporting and will require greater transparency throughout China's financial system, which may prove to be difficult to achieve. The Chinese approach to governance and administration does not emphasize transparency, and China has experienced some difficulty complying with WTO transparency standards.13In addition, it is necessary that the body or agency responsible for regulating the financial system remains independent from the Chinese government and shielded from government influence in order to properly regulate the financial system and ensure that it is making progress towards a credit-based system (Chen and Wang 2009, 133). Again, this recommendation must be considered as a long-term goal. Nevertheless, China has achieved certain improvements since joining the WTO in 2001 (Biukovic 2008, 819). Continued efforts to achieve transparency to fulfill WTO commitments are largely in line with the types of reforms needed in the financial sector, which will contribute to improved regulation. At the micro level, improved communication and information sharing between banks and borrowers within a credit-based system will provide benefits to both by reducing the risk of default and associated losses. As mentioned above, communication and information sharing helps improve the quality of information that banks receive from borrowers. Improved information helps both banks and borrowers avoid losses by allowing for better assessment of the borrower's capacity. Continued information sharing during the repayment process helps banks to detect and address problems that may occur, thereby reducing the risk of default. Because of the poor reporting practices that currently used by both banks and borrowers in China, efforts to improve information analyses will not be fruitful.14 It is necessary to improve the quality of the information that is collected before improvements in analysis can be made. Efforts should concentrate on proper accounting procedures and systems for SMEs as well as the proper disclosure of financial information on the operating statement, balance sheet and cash flow statement (Garcia-Fontes 2005, 9). However, information sharing involves more than just information provided by the borrower. Banks must inform their clients about the credit rating process, and help them understand the requirements. Banks must also either provide or direct their clients to resources that will help them improve their credit rating and business operations (Ayadi 2005). In addition, it may be necessary for China to establish other organizations, programs and services to help provide the necessary information resources for SMEs to improve their credit ratings and business performance. As Wang (2004, 49) acknowledges, the poor performance of SMEs may be because of weaknesses in the provision of social
13
The concept of governance in China had been based on the idea that administrative agencies and regulators are only accountable to political or bureaucratic superiors, not the public. Moreover, the style of operation used by the Chinese Communist Party revolved around a concentration of power at the center, and a lack of involvement or information about internal operations by the public (Biukovic 2008, 819). 14 For example, Chen et al. (2010) focus on developing a statistical method for credit monitoring and assessment of SMEs in China. However, they acknowledge that the lack of sufficient data has been a major difficulty in their analysis. Specifically, it has made the "default rate" hard to estimate. They proceed by using suboptimal data.
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services for SMEs. Specialized institutions are needed to provide services to SMEs such as consultation and information, training, technology and marketing assistance.15 While an effective information sharing relationship between banks and borrowers is the foundation of a successful lending and financing relationship, this type of relationship is slightly different from the traditional "guanxi" relationships on which many Chinese business relationships are based. Guanxi relationships revolve around the exchange of favours, regardless of merit, whereas the information sharing relationships are more professional, and revolve around a bank's willingness to help a client as a means of improving the prospects of future returns (Fan 2007). Nevertheless, guanxi relationships can be used as a beginning point for building information sharing between banks and borrower. The relationship between banks and borrowers has not been acknowledged or mentioned by the Chinese government as part of their strategy to help SMEs and improve economic performance in general. This is surprising, because improving information sharing between banks and borrowers can provide extremely helpful assistance for SMEs without extensive institutional changes to the financial system. Therefore, added emphasis is placed on this recommendation as an option that can be pursued to help SMEs while the larger institutional reforms to the financial reforms to the financial system are still in progress. Concluding Remarks SMEs in China continue to experience difficulty obtaining access to loans and financing. Part of the difficulty stems from the fact that SMEs have high credit risk and a low credit rating. However, a closer examination of the problem has revealed that the difficulty SMEs have experienced is related to larger weaknesses in the financial system. I have argued that there is an information asymmetry between banks and borrowers, insufficient regulation of the financial system, and inappropriate government intervention in the financial system and I recommend that China needs to adhere to a credit-based system for assessing loans, reduce government intervention in the economy in general, improve regulation and the basic relationship between banks and borrowers to improve information sharing in order to improve the performance and financing prospects of SMEs. Moreover, I have emphasized that these changes are needed first before more sophisticated credit models or assessment systems can become useful. Finally, I emphasize that while the larger institutional changes necessary to achieve a credit-based financial system and improved regulation can only be achieved over the longer term, efforts to improve the relationship between banks and borrowers can provide extremely helpful assistance for SMEs in the short term, and should thus be incorporated into government strategies.
15
For example, Chen and Wang (2004, 134) describe the various ways that non-profit organizations in Taiwan have supported SMEs. Functions include: the execution of government policy, removal of barriers, improving the will of financial institutions towards SMEs, and enlarging the effects of assisting institutions. All qualified SMEs can seek services form these organizations. Garcia-Fontes (2005, 7-8) describes the services provided for SMEs in Korea and Japan. In Korea, special institutions and support centres have been established to provide training, offer research and information, organize expositions, promote technology transfer, assist SMEs with challenges pertaining to patents, foreign and domestic technology acquisition and adoption and assist firms with the marketing their products for export.
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Sources Cited: Ayadi, Rym, 2005. "The New Basel Capital Accord And SME Financing: SMEs And The New Rating Culture." Centre for European Policy Studies (CEPS). Berger, A. N., A. Saunders, J.M. Scalise and G.F. Udell. 1998. "The Effects of Bank Mergers and Acquisitions on Small Business Lending." Journal of Financial Economics, 50: 187-229. Biukovic, Ljiljana. 2008. "Selective Adaptation of WTO Transparency Norms and Local Practices in China and Japan." Journal of International Economic Law, 11 (4): 803-25. Chen, Xiaohong, Xiaoding Wang, Desheng Dash Wu. 2010. "Credit Risk Measurement and Early Warning of SMEs: An Empirical Study Of Listed SMEs In China." Decision Support Systems, 49: 301-310. Chen, Yurong and Weixing Wang. 2009. "On Perfecting the Credit Guarantee System of China's Small and Medium-Sized Enterprises." International Business Research, 2 (3): 132-35. China Banking Regulatory Commission (CBRC). 2007. "Annual Report." Beijing: China Banking Regulatory Commission. http://zhuanti.cbrc.gov.cn/subject/subject/nianbao2007/english/ywqb.pdf China Knowledge. 2012. "China Banking System." http://www.chinaknowledge.com/Business/CBGdetails.aspx?subchap=4&content=15 Dollar, D., M. Hallward-Driemeier, A. Shi, S. Wallsten, S. Wang, and L. C. Xu. 2003. "Improving the Investment Climate in China." Investment Climate Assessment. World Bank and International Finance Corporation. Garcia-Fontes, Walter. 2005. "Small And Medium Enterprises Financing In China." Central Bank of Malaysia Working Paper. http://www.bnm.gov.my/microsites/rcicc/papers/s6.garciafontes.pdf Fan, Ying. 2007. "Questioning Guanxi: Definition, Classification and Implications." International Business Review, 11 (5): 543-61. Fu, Xiao Qing. 2009. "The Effects of Reform on China's Bank Structure and Performance." Journal of Banking and Finance, 33 (1): 39-52. Herring, Richard. 2005. "Implementing Basel II: Is the Game Worth the Candle?" Financial Markets, Institutions and Instruments, 14 (5): 267-87. Ikasari, Novita, Fedja Hadzic and Tharam S. Dillon. 2012. "Incorporating Qualitative Information for Credit Risk Assessment through Frequent Subtree Mining for XML." In XML Data Mining: Models, Methods, and Applications, ed. Andrea Tagarelli. IGI Global. 467-503. Li, Xiao. 2003. "On Reasons of Difficulty in SME Indirect Financing and Corresponding Countermeasures. 265-70. http://www.seiofbluemountain.com/upload/product/200911/2009zxqyhy03a7.pdf MMG Capital (MMG). 2010. "Credit-Based Lending Vs. Asset-Based Lending." Free Investor Education Resources: Investor News. August 1, 2010. http://www.mmginvestors.com/resources/articlesguidesnews/21-published-articles/114toddpigott.html People's Republic of China (PRC). 1995. "Guarantee Law of the People's Republic of China." Eighth National People's Congress. Lehman, Lee and Xu. http://www.lehmanlaw.com/resourcecentre/laws-and-regulations/banking/guarantee-law-of-the-peoples-republic-of-china1995.html Schure, P., R. Wagenvoort, and D. O'Brien. 2004. "The Efficiency and Conduct of European Banks: Developments After 1992." Review of Financial Economics, 13. Subacchi, Paola, Helena Huang, Alberta Molajoni and Richard Varghese. 2012. "Shifting Capital: The Rise of Financial Centres in Greater China." Chatham House, Royal Institute of International Affairs. Thai, Linh Gia and Yun Xu. 2009. "Banking Market Competition and SME Financing in China: Case Study Across Chinese Provinces." Paper within Bachelor Thesis in Economics. Jönköping International Business School.
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http://www.europeana.eu/portal/record/9200111/E294C62F65D520C0B6B14956293CFA8D6A2 6890A.html Wang, Yanzhong. 2004. "Financing Difficulties and Structural Characteristics of SMEs in China." China and World Economy, 12 (2): 34-49. Wu, Tian Ran. 2011. "Financing Difficulties and Countermeasures of Our SMEs." International Conference on Economics, Trade and Development, 7: 119-22.
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