China's SMEs struggle to jump the credit hurdle

Raising capital is a challenge for small and medium-sized businesses everywhere in the world. Some of these companies don’t have long track record of paying taxes, returning profits or having sufficient collateral. This problem is particularly acute in China where SMEs struggle to get access to credit in a state-controlled financial system.

This is one of many challenges confronting Beijing as it seeks to transform its economic structure. At the moment, small and medium-sized Chinese private companies are cash-starved and have to pay usurious interest rates to keep their operations going. At the same time state-owned giants are enjoying some of the cheapest capital in the world.

Let’s illustrate this issue with an example; a medium-sized construction material company needs to borrow 150 million yuan ($A26 million) this year. In theory, the repayment should be 18 million yuan at 12 per cent annualised interest rate. However, the company’s chairman says the actual repayment is about 33 million yuan because he needs to pay many so-called fees as well as loan guarantors.

Though the People’s Bank of China’s base interest rate is 6 per cent, which is already one of the highest amongst large economies, small and medium-sized enterprises would be lucky to get their loans at 12 per cent, according to Zhang Ming, a researcher from the Chinese Academy of Social Sciences, an influential state-backed think tank.

According to the latest report from the Ministry of Industry and Information technology, the cost of funding for small and medium sized-businesses increased 17.5 per cent in the first six months of 2014; some businesses are paying as much as 30 per cent interest on their loans. The Bank of Communications chief economist Lian Ping estimates that the average cost of capital for micro and small businesses in Shanghai is about 18 per cent every year.

The difficulty of raising fund from the bank-dominated financial system has partially contributed to the rise of the shadow banking sector. Businesses often have to pay 15 per cent or more in interest rate to so-called trust companies to raise funds. Traditional bank lending as a proportion of total lending in the country has declined from 73 per cent in 2008 to 55 per cent in 2013.

How can Chinese businesses afford 15 per cent or more in interest rate payments and especially when the economy is slowing down? The short answer is they can’t.

Bai Chongeng, vice-dean of School of Economics and Management at Tsinghua University, and one China’s most eminent economists, calculates the average return on capital for listed companies has declined from 15 to 16 per cent in 2007 to 11 to 12 per cent in 2012. Listed companies are mostly better managed and more profitable, it would be safe to say that many private companies don’t have the same rate of return.

Businesses who can afford these exorbitant rates are property developers and local government financing vehicles. Property prices in China have skyrocketed in recent years, developers have enjoyed many bumper years and they can afford to borrow at 15 per cent a year. But their profitability is under pressure as the sector faces sluggish demand and declining prices.

Local governments have borrowed heavily from the shadow banking sector to splurge on their pet infrastructure projects. They rely on land sales to pay off their debts as well as interest; this model is becoming increasingly untenable as property sector is facing rough time ahead.

The Chinese government has made a priority to address this issue, which is hurting the real economy at a crucial time when the economic growth is facing significant downward pressure. The State Council, the Chinese cabinet, has issued 10 directives that are designed to force the cost of borrowing down. However, Beijing shies away from cutting interest rate for the fear of making the debt problem worse.

The Chinese central bank has lowered the capital reserve ratios for commercial banks that allocate certain proportion of their lending to SMEs. However, Chinese commercial banks are reluctant to lend to smaller businesses despite Beijing’s directives.

The former chief economist of the World Bank Justin Li told China Spectator: “There is a mismatch between China’s real economy and the financial system. The country’s real economy is largely comprised of farmers, small and medium-sized businesses and yet the financial sector is dominated by big banks that prefer to deal with big companies.”

Though the cost of funding may come down a bit in the future due to Beijing’s intervention, it is unlikely to have a lasting impact. The country’s needs to develop a more sophisticated financial system that better support the dynamic private sector.

Zhang Ming from the Chinese Academy of Social Sciences suggests that Beijing should encourage the development of rural credit union, privately owned banks that cater for SMEs, venture fund and private equity industry to fill the gap in the country’s financial system.