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SME financing in China
Université Paris X-Nanterre
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200, Avenue de la République
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Document de Travail
Working Paper
2007-29
Chen Xiang LIU
EconomiX
Université Paris X Nanterre
UMR 7166 CNRS
1
SME Financing in China
LIU Chen Xiang
Université Paris X-Nanterre
EconomiX (CNRS-UMR 7166)
Bâtiment K-115
200, Avenue de la République
92001 Nanterre Cedex
Tél : 01.40.97.59.10
Fax : 01.40.97.59.10
Courriel : 2
SME Financing in China
LIU Chen Xiang
Abstract
SMEs have a great contribution in China’s economic expansion. However, the financingpredicament currently faced by SMEs constitutes a great bottleneck for their development. Banksare reluctant to lend to them, mainly due to the lack of collateral and their poor capability inpricing risk. This is the reason why credit guarantee institutions play a key role in SME financingand the perfection of the credit guarantee system is important for promoting their access to credit.
In addition, the lifting of the ceiling on lending rates as well as other steps taken by bankingauthorities will encourage bank lending to SMEs. Finally, informal finance has a significant partin SME financing.
Résumé
Les PME ont une grande contribution à la croissance chinoise. Pourtant, leur difficulté definancement devient un grand obstacle dans leur développement. Les banques ne veulent pas leurprêter, principalement à cause de manque de collatéraux et la faible compétence des banquespour évaluer le risque de crédit. C’est la raison pour laquelle les organismes de garantie jouentun rôle indispensable dans le financement de PME et le perfectionnement du système de garantieest important pour augmenter leur accès aux crédits. En plus, l’enlèvement du plafond de tauxd’intérêt de crédits ainsi que les autres mesures prises par les autorités bancaires vontencourager les prêts bancaires aux PME. Enfin, la finance informelle a une part significativedans le financement de PME.#p#分頁標題#e#

Key Words: SME financing, credit guarantee, informal financ

1. Introduction
The scope of private ownership has become substantial, producing well over half of GDPand an overwhelming share of exports-imports. Private companies generate most new jobs and areimproving the productivity and profitability of the whole economy. The continued re-orientationof the economy towards the private sector brings considerable gains to real incomes and macroeconomicactivity. It should be noted that all companies which are controlled neither by state norby collective shareholders are considered as private companies; 98% of enterprises in non-publicsector are SMEs (small and medium sized enterprises), and 98% of SMEs are in non-public sector.
The changes in government polices explain importantly the emergence of a powerfulprivate sector in the economy. In 2005, regulations that prevented privately-owned companiesentering a number of sectors of the economy, such as infrastructure, public utilities and financialservices were abolished. However, SMEs have always limited access to credits, which hindersheavily their businesses’ expansion and thus their healthy development. Why banks are reluctantto lend to them and how they have fallen into financing difficulties? How to resolve theirfinancing problems and who can serve as their main supporters? This paper tries to respond tothese questions and to draw the best SME financing service system.
The paper begins by evaluating the position of SMEs in the real economy as a whole andhighlighting issues facing SME financing. The following section discusses formal finance’ssupport for SMEs, emphasizing the role of credit guarantee institutions. Ultimately, the paperpresents informal finance’s development and outlines its influences on SME financing.
2. The private sector—a major driving force in economic expansion
China’s private sector has become its main driver of economic growth. In 2005, there weremore than 40 million SMEs and sole industrial & commercial proprietorships (getihu enterprises),accounting for 99.6% of the total number of enterprises. They were responsible for as much as59% of GDP. They accounted for 60% of sales value and represented 68.65% of imports &exports. They paid 48.2% of taxes, and occupied more than 75% of employment in urban areas.
The regions with which SME cooperate have extended from Hong Kong & Macao to somedeveloped countries, such as United States and Italy.
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The growth in private output has been the result of the higher productivity of mostcompanies in this sector. The sharper incentives facing the private sector companies have resultedin them using less capital and labour to produce output than state companies. Overall, theaggregate productivity of private companies in the industrial sector is estimated to be almost twicethat of enterprises controlled directly by the state. The profitability of private companies has alsorisen considerably, and the rate of return on physical assets was double that of state controlledcompanies in certain provinces in 2005. Such a high level of competitiveness has resulted in theprivate sector accounting for more than two-thirds of all exports in 2005. While the bulk of theseexports are made by foreign-controlled companies, the domestically-owned private sector isincreasing its exports, as more small and medium-sized enterprises are granted export licences.#p#分頁標題#e#
(OECD, 2005).
The private sector plays a key role in a largely market-oriented economy owing to thechanges in government polices. Government authorities have recognized the importance of theprivate sector for economic growth and job creation, and have moved to reduce a number ofbarriers that limit its expansion and to promote its equal treatment with publicly-owned sectors.On February 2005, the State Council issued “Guidelines on Encouraging and Supporting the
Development of the Non Public Sector including Individual and Private Enterprises” that include36 articles for improving the operating environment for private business. The new guidelines givemuch-improved market access to private companies in many industries that were previouslyrestricted, including those that are dominated by state monopolies and heavily regulated sectorssuch as public utilities, financial services, social services and national defence. The directives alsomandate equal treatment of private and public business, calling for rescinding of rules thatdiscriminate against private companies and direct ministries and local governments to carry out
implementation of the new constitutional amendment guaranteeing private property rights. Interms of access to financing, the new guidelines direct financial regulators to expand access tobank, equity and bond financing, through pro-active treatment of private companies under theinterest rate liberalisation, and through impartial treatment of private companies in capital marketaccess. A subsequent survey by the All-China Federation of Industry and Commerce showed thatentrepreneurs cited the new market entry and financing access articles to be the most important.
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3. The difficulty of SMEs to access to credit
3.1 Structure of SME financing and their financing difficulties
According to the survey conducted by State Administration for Industry and Commerce
(SAIC) in 2002, the domestic private companies, including the very small companies, have lowratios of liabilities to equity, supporting the view that they had limited access to credit. Indeedover 40% of such companies in the sample had no debt, and financed their activities from internalfunds, while the remaining nearly 60% borrowed from banks or informal market (Table 1). Thevery smallest private industrial companies and private service sector companies rely extensivelyon informal credit. Bank credit, on the other hand, seems to be more accessible for largercompanies. The survey also indicates that over 90% of the private companies had difficulty inobtaining bank credit. Over half of the respondents named their lack of collateral as a majorbarrier to bank borrowing. Ownership discrimination was cited by one-fifth of respondents#p#分頁標題#e#
followed by insufficient amount of bank loans and too short-term lending as major problems withbank financing. Much fewer firms chose too high interest rates or stringent requirements for creditrating as top reasons for not bank borrowing. While banks tend to lend short-term, the informalmarkets provide long-term financing. The informal sector also accepts receivables as collateral,which may help explain why some larger firms rely exclusively on the informal market forexternal finance.
China International Capital Corporation Limited’s recent research (2006) indicates that
equity and retained earning represent respectively 30% and 26% of capital resources in SMEs.
Among external financing channels, equity market’s entry threshold is high, venture capitalinvestment system isn’t complete, corporate bonds’ issuance entry is difficult, so SMEs can’t raisecapital through capital market effectively. For instance, listing in the stock market in Shenzhen orShanghai is a privilege of a handful of well-established, large and profitable private companies.
Although the establishment of the second board on the Shenzhen market for high-tech SMEs mayease this need somewhat for such companies, for non-high-tech companies financing still remainsa major problem. Moreover, bond financing seems to be even less accessible for private
companies due to stringent criteria including industrial policy guidelines.
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Table 1 – Use of credit by Domestic Private Sector Companies
Size category (Sales volume, million yuan)
0-1 1-3 3-10 10-20 20-50 50+ all
Access to borrowing Per cent of firms
Per cent with no credit 54.2 43.4 39.5 36.1 28.6 42.4 41.1
Per cent with credit 45.8 56.6 60.5 63.9 71.4 57.6 58.9
Per cent of firm with bank finance only 13.8 23.3 28.3 34.8 43.7 36.1 29.3
Per cent with informal finance only 20.2 18.3 15.0 11.6 9.6 7.6 14.0
Per cent with bank and informal 11.8 15.0 17.2 17.5 18.0 13.9 15.6
Firms with any borrowing1 Per cent of equity
Manufacturing 51.8 32.3 36.5 39.9 36.5 28.9 32.5
Services 43.6 40.9 49.9 30.3 63.8 31.1 39.9
All 47.6 36.9 38.8 36.6 43.8 29.5 34.7
Share of informal borrowing in total
borrowing
Per cent of total borrowing
Manufacturing 23.3 24.3 19.5 26.4 9.4 3.9 17.6
Services 44.2 35.1 8.7 12.1 11.6 8.7 21.4
All 35.7 28.2 15.6 20.9 10.3 6.3 10.9
Pre tax rate of return on equity 6.1 10.6 11.5 15.1 16.6 15.5 14.8
Investment relative to (previous
year) equity plus debt minus
investment
11.8 19.8 24.8 29.9 32.0 30.6 29.0
Proportion of firms in each size
group
14.5 18.7 25.3 12.3 12.6 16.7 100.0
Note: Sample size is 2 460 companies.
Source: the Chinese University of Hong Kong, OECD Economic Surveys: China (2005)
With respect to banks, although lending by State Owned Commercial Banks (SOCB) andother banks to non-state enterprises has been growing rapidly, private enterprises still seem tohave less access to credit than State-owned enterprises (SOE). Small and medium sized businesses,which account for more than half of GDP, receive only 16% of total bank loans. Only 30% ofcredits demanded by SMEs with a good quality have been satisfied. (Economic Daily, 14/06/2006)#p#分頁標題#e#
Another example. According to Shanghai Branch of CBRC (China Banking RegulatoryCommission), up to the end of June 2005, 71 915 small enterprises had obtained credits, whichaccounted for 28.2% in the total number of small enterprises in Shanghai. There are at least 70%of small enterprises which have never demanded credit, in a conservative estimation. Among1 The enterprises, which have less than 1 million yuans of sales volume, have thehighest ratio of borrowing to equity, because theyhave little equity instead of much borrowing.
those which had demanded credit, only 10% of small enterprises failed due to their poormanagement, 45% were refused because they hadn’t acceptable properties as a pledge for banks.
3.2 Why banks are reluctant to grant credit?
Credit demanded by SMEs has the following characteristics: small amount, urgent andfrequent demands, in short term. The control cost of such credit is much higher than the one ofcredit to big enterprises. The smaller scale of SME loans makes banks proportionately moreexpensive to monitor. Big banks prefer to do business with big enterprises. Yet there are small &medium banks which have much less capital and which grant credits to SMEs with a good quality.
These banks are less competitive but know very well SMEs in their regions.
Likewise, poor management, complex related transactions, non transparent accounting andweak anti-risk capability have aggravated their difficulties to get credits from banks. Banks don’twant to lend to them owing to information asymmetry and high costs of transaction and control.
Banks’ efforts to avoid incurring new non-performing loans reduce the access of SMEs,
state owned and non-state, to bank credit, while larger SOEs (State Owned Enterprises) backed bycentral or local governments are able to get loans largely because of the implicit guarantee that
backing confers. Non performing loans granted by big four SOCBs (State owned commercialbanks) to SOEs can be written off or transferred to AMCs (Asset Management Corporation). The
State has infinite responsibility. But those granted to SMEs can’t benefit this advantage. Thepersonnel who grant credits are always responsible for them. Generally, SMEs are considered to
have a relatively high default risk. In 2003, average NPL ratio of lending to SMEs in principalcommercial banks was 32.11%, 15.7 points more than the average NPL ratio in commercial banks.
For this reason, the Big-Four which want to lessen NPL ratio in order to satisfy the regulatoryrules defined by CBRC (3%-5%) will be very prudent to SME lending.
Due to high risk in SME lending, banks demand SMEs to put enough properties in pledge,or to look for a guarantee as an indispensable condition to grant credit. Nonetheless, most of
SMEs haven’t enough acceptable assets as a pledge. This is a great handicap in their financing. Soa fully developed credit guarantee system is strongly needed.
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The present dependence on collateral and guarantee is indicative of the fact that banks nowhave limited capabilities to assess, process, and price loans to smaller customers. Improvement ofthese capabilities is the ultimate key to ensuring adequate access to credit for SMEs and willrequire substantial upgrading of internal systems for assessing and managing risk andconsiderable training of staff. However, it is particularly important that lenders have necessaryflexibility to charge lending rates that adequately compensate for risks and costs of their loans.#p#分頁標題#e#
The SMEs have a relatively higher business failure rate than larger borrowers. Risks of lending toSMEs are further increased by their relatively poor information systems, which makes it difficultfor banks to assess their creditworthiness. Official restrictions on bank’s flexibility in settinglending rates were an increasing impediment to SME lending as banks became more conservativein the effort to avoid further non performing loans.
Empirical analyses by MOLNAR and TANAKA (2007) show that private firms havedifficulties in obtaining financing from the formal banking system and their access to bank loansdepends on their credit history, size and rating that can’t easily be manipulated through creativeaccounting. Loan decisions irrelevant of the financial health of the company may suggest thatbanks, especially the largest ones, don’t have appropriate incentives to develop monitoring andrisk pricing skills as they mainly engage in lending to SOEs (i.e. they are not able to distinguish
between genuine and manipulated performance indicators). Firms in manufacturing sector aremore likely to get loans, probably due to the fact that manufacturing firms are more likely topossess assets that can be used as collateral compared to firms in service industries.
4. Enlarging access to credits for dynamic sectors—Formal finance’ssupport for SME
4.1 Credit guarantee Schemes (CGSs)
As described above, lack of collateral is the chief difficulty in obtaining bank loans for
SMEs. Collateral or loan guarantee, or both, have become an essential precondition for most SME
lending in China.
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Improving financing for SMEs undergoing substantial expansion has become a main
concern for government. The central government has taken many steps to improve the flow of
credits to SMEs in urban areas. Besides urging banks to penetrate that market, the government has
promoted the establishment of credit guarantee schemes for smaller firms. The largest component
of such schemes is the government-sponsored credit guarantee institutions established by
municipalities and provinces. In addition, there are a smaller number of member-SME-funded
mutual guarantee funds and private-sector invested commercial guarantee companies, both forms
of which pre-date the establishment of government credit guarantee institutions.
Nearly all provincial governments have established credit guarantee institutions.
Following a pilot programme starting in 1998, 30 provinces established credit guarantee
institutions. There were more than 20 in 1997, more than 300 in 2000, 848 in 2002 (one third
were private credit guarantee institutions), more than 3 500 in 2004 (more than 2 000 were private
credit guarantee institutions), and the number of such institutions reached more than 4 000 in 2005,
with the amount of loans carrying guarantees amounting to about 400 billion RMB. According to
the statistics, there are 1 200 credit guarantee institutions which serve especially for SMEs (for#p#分頁標題#e#
credits and shares issue), which account for 32.28% in all of credit guarantee institutions. (The
People’s Bank of China & China Finance, 23/01/2006)
The credit guarantee institutions are highly diverse: some are funded from the government
budgets, others by fees on participating businesses, or by private investors, or a mixture of these
sources. More than 70% of the funds of the institutions originate from non-government sources. In
lots of such institutions, the capital invested by private enterprises and individuals is more than
60% (Financial News, 07/09/2005). The organisational form of the institutions varies from public
service units, to state or privately controlled shareholding enterprises, to fund management
companies. Further, they can be non-profit or profit institutions and their business scope can be
limited to guaranteeing firm borrowing or can cover a wider range of activities.
The remainder of this section is organized as follows. 4.1.1 analyses guarantee business
operation; 4.1.2 presents the establishment of guarantee system; 4.1.3 discusses risk management
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and puts forward some proposals for reform; and finally, 4.1.4 outlines the importance of private
credit guarantee institutions’ development.
4.1.1 Guarantee contract
The enterprises which demand guarantee should satisfy the following conditions:
- They should register in State Administration for Industry & Commerce.
- They should have been created three years ago at least, and shown good performance
in the three previous years.
- The ratio of liabilities to assets can’t exceed 70%.
- The domain in which enterprises work should be supported by State (for example,
industrial policies, environmental protection policies, etc). If the domains are restricted
by State, credit guarantee institutions won’t accept their demands.
Generally, credit guarantee institutions charge a price less than a half of bank’s lending
interest rate2. The prices vary across different credit guarantee institutions, amounting to 0.8%-3%
of guaranteed credits. In addition to this guarantee price, SMEs should also pay a guarantee fee
which is calculated per year and is paid only once3. The guarantee fees vary with credit amounts
and the risk level of SME. Guarantee fee rate is defined on the basis of credit risk degree, and it’s
a floating rate. Guarantee fee rate is limited to 50% of banks’ lending rate in the same term at
most4.
Credit guarantee institutions often demand counter-guarantee as an essential condition for
granting the guarantee. There are various forms of counter-guarantee, such as mortgages on land
use rights and real estate; means of transportation, equipment, and other movables; cashable
2 The floor of bank’s lending interest rate is 6.12% for one year. There is no ceiling.#p#分頁標題#e#
3 For the guarantee in short term (3 months, 6 months), the guarantee fee is calculated per month (annual guarantee
fee rate/12).
4 Target lending rate (adjusted by the People’s Bank of China, effective from August 19, 2006)
Credits in short term
duration<= 6 months: 5.58%
6 months<duration<=1 year: 6.12%
Credits in medium and long term
1 year<duration<=3 years: 6.30%
3 years<duration<=5 years: 6.48%
duration>5 years: 6.84%
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saving instrument, actions, bills of exchange; pledges on transferable stocks, patents, and
trademarks; the guarantee granted by another person or institution, the enterprise chief’s unlimited
responsibility, etc.
Most of guaranteed credits are in short term (<=one year). The guarantee covers normally
the principal and the interests, eventually with loss undergone by creditors in certain guarantee
contracts. This depends on the negotiation between bank, enterprise and credit guarantee
institution. After granting the guarantee, the credit guarantee institutions should control the
enterprises continuously.
In case the enterprise can’t repay credit to bank on the maturity of contract, the bank will
hold caution deposited by credit guarantee institution, which is called “substitutive refunding”. If
the enterprise has a cash shortage, and she can refund credit later, we call it “temporary relay”. In
contrast, if the enterprise hasn’t the capability to refund it, we call it “default credit”. Normally,
credit guarantee institutions assume all of implied responsibility, i.e. they refund credits to banks,
and then they demand enterprises to refund them. Certain banks give a time limit (for example, 3
months after the expiry of credit contract). If the enterprise can’t yet repay credit, the credit
guarantee institution will repay it for the enterprise.
The substitutive refunding ratio relies on the credit guarantee institutions’ risk
management. It can be zero in certain credit guarantee institutions, with contrast that others will
go bankrupt owing to only one substitutive refunding. Most of enterprises are responsible for their
engagements, and so the substitutive refunding ratio is low.
After refunding credit to the bank, the credit guarantee institution requires the enterprise to
repay it, and all of interests (not only those paid to the bank, but also interests for the period after
substitutive refunding), eventually with loss and fees for creditor. The interest rate demanded by
credit guarantee institution for the period after repayment to bank can be the same as the one
demanded by bank, or even higher than the bank’s lending interest rate. In case of no refunding,
the credit guarantee institution will sell pledges. The pledges are sufficient for refunding credit#p#分頁標題#e#
generally, so the credit guarantee institution has little loss.
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The guarantee law (promulgated on June 30, 1995 by permanent committee National
People’s Congress and effective from October 1, 1995) and the new bankruptcy law (voted in the
23rd meeting of 10th permanent committee National People’s Congress on August 27, 2006 and
effective from June 1, 2007) protect well-functioning guarantee businesses and priority of
guaranteed credits’ repayment.
4.1.2 Guarantee system
National Development and Reform Commission is organizing to establish a SME
guarantee system. There are “one body, two wings, four levels” in this system: one body is mode
body (different resources of capital, market-oriented operation, corporate governance, support for
the best); two wings are commercial guarantee institutions and mutual guarantee institutions
which are considered as supplementary (agricultural credit guarantee institutions included). There
are four levels in credit guarantee system which have different functions-national, provincial,
prefectoral and county.
According to plan, the county and prefectoral credit guarantee institutions give guarantee
for SMEs in their proper regions. The provincial credit guarantee institutions grant re-guarantee
for these credit guarantee institutions at lower levels, and supervise them with the People’s Bank
of China. They can also grant guarantee directly to SMEs. The national credit guarantee
institutions are being established and will work as guarantors of last resort and grant re-guarantee
to the credit guarantee institutions at lower levels.
4.1.3 Risk management
In most of guarantee businesses, the credit guarantee institutions have joint obligation5, i.e.
banks transfer the whole credit risk to credit guarantee institutions. The only risk for banks is the
substitutive refunding risk which comes from credit guarantee institutions. Credit guarantee
institutions can also have an ordinary obligation6 or assume the risk proportionately with banks
5 After the expiry of the contract, the banks can demand enterprises or credit guarantee institutions to repay credits.
6 After the expiry of the contract and before trial or arbitration, credit guarantee institutions can refuse to assume guarantee
responsibility. After adjudication, banks use properties put in pledge to refund credits. The credit guarantee institutions bear loss
with banks proportionately. The proportion is negotiated by them.
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together7. In a mature credit guarantee system, credit guarantee institutions should assume the risk
proportionately with banks. The objective is to avoid moral hazard on any side. Banks or credit
guarantee institutions can collude with enterprises to damage another side’s interest.
SMEs should put their properties in pledge either in banks or in credit guarantee#p#分頁標題#e#
institutions as an indispensable condition for obtaining credits. The value of properties put in
pledge covers the principal and the interests normally.
Credit guarantee institutions should deposit a caution in banks as a basis of cooperation
with them, which is also a precaution against risk in banks. If the enterprises can’t repay their
credits at the term of the contract, banks will hold the caution. The caution rate in banks varies
from 10% to 20% of the guaranteed credit amount, i.e. the credit granted by banks can’t exceed 10
times the caution deposited by credit guarantee institutions. For example, credit guarantee
institution deposit 10 million yuans in a bank, this bank will lend a sum of 100 million yuans in
maximum guaranteed by this institution8. Certain credit guarantee institutions are demanded a
higher caution rate, at around 20%--33%. Others are demanded nothing.
Sometimes, the banks demand also the enterprises to deposit a caution, which differs from
the one deposited by credit guarantee institutions. These two cautions can coexist.
The caution deposited by enterprises in credit guarantee institutions serves as a counterguarantee.
Some credit guarantee institutions demand enterprises to pay a caution. Most don’t do
so. The caution is 2%--10% of guaranteed credit amount. If the enterprise can’t repay its credit
according to the contract, credit guarantee institutions will hold part of the caution deposited by
the enterprise. This part of the caution will increase along with time. Six months later, the credit
guarantee institution will hold the whole caution. It’s punishment for the enterprise. Enterprises
can’t require to refund the caution. This punishment differs from the substitutive refunding. The
substitutive refunding is done with credit guarantee institutions’ ownership, that is the caution
deposited in banks by credit guarantee institutions.
7 e.g. banks bear 30% of risk.
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In general, credit guarantee institutions bear different risks, such as guaranteed enterprises’
risk 9 , pledge sale risk, macro-economic risk (law, regulation and policies changes), and
operational risk. So strengthening their risk management capability is a very important condition
for cooperating with banks, developing their guarantee businesses, and especially for accelerating
SMEs’ development.
4.1.3.1 “SME credit guarantee institutions’ risk management temporary measures” (26/03/2001,
[2001], Ministry of Finance)
These measures take important precautions against risk.