People's Republic of China and the IMF
The Financing of Private Enterprise in China
Neil Gregory and Stoyan Tenev
A 1999 survey of more than 600 private Chinese enterprises revealed that they relied primarily on self-financing. For China's private sector to thrive, firms will need increased access to external loan and equity financing.
China's economy has undergone a fundamental change over the past decade, from complete reliance on state-owned and collective enterprises to a mixed economy where private enterprises play a strong role. By 1998, the domestic private sector had grown to about 27 percent of GDP, making it second only to the state sector in economic importance. (The other sectors are the foreign, collective, and agriculture sectors.) Despite its growing importance, at the end of 1999, the private sector accounted for only 1 percent of bank lending, and only 1 percent of the companies listed on the Shanghai and Shenzhen stock exchanges were nonstate firms. The discrepancy between the dynamism of the private sector and its limited use of intermediated financing suggests that the private sector may not be able to sustain its current rate of growth unless it can increase its access to financing.
A survey of private firms in Beijing, Chengdu, Shunde (Guangdong), and Wenzhou (Zhejang), conducted in 1999 by the International Finance Corporation (IFC), the private sector arm of the World Bank Group, revealed that about 80 percent considered their lack of access to finance to be a serious constraint. They relied heavily on self-financing for both start-up and expansion. More than 90 percent of their initial capital came from the principal owners, the start-up teams, and their families (see table). In the case of post-start-up investments, the sample firms continued to depend overwhelmingly on internal sources (Chart 1), with at least 62 percent of their financing coming from the principal owners or out of retained earnings. Among external funding sources, informal channels, credit unions, and commercial banks were about equally represented. Outside equity, including public equity, and public debt markets played an insignificant role.
The relative importance of different sources of financing among surveyed firms depends on firm size. Internal sources tend to become less important as firms grow larger. External sources for the smallest firms are mainly informal channels, but their share tends to decrease as firms grow bigger, while the share of commercial bank loans increases with firm size. Commercial banks are the second most important source of funds for the largest firms, after retained earnings. This seems to indicate that banks provide more support for larger and relatively successful private firms. But, on average, Chinese banks tend to play a relatively small role in financing private firms. Only 29 percent of surveyed firms had secured loans in the previous five years.
Chinese firms rely more on internal sources of financing than do firms in transition and developed economies. A recent World Bank survey on the business environment in transition economies finds that the share of internal funding is significantly lower in advanced reformers such as Estonia (33 percent), Poland (34 percent), and Lithuania (37 percent). In the United States, a far smaller share of financing is internal; even for small and medium-sized enterprises less than two years old, internal financing reached a maximum of 54 percent of total financing.
Factors affecting access to financing
The difficulty private Chinese firms face in obtaining financing is due partly to factors within the financial system and partly to the nature of Chinese private enterprises.
Bank incentives. Through recent reforms, China has made significant progress in reducing government interference in bank lending. However, there is ample evidence that local governments continue to encourage bank lending to state-owned enterprises by extending explicit or implicit guarantees or through other means.
Furthermore, banks still do not consider a bad loan to a state-owned enterprise to be as serious as a bad loan to a private enterprise. Expectations, reinforced by recent experience, are that when a state-owned borrower fails to service a loan, the government will almost certainly bail it out. Private borrowers do not benefit from the same kind of expectations. Until this asymmetry in the risks banks face in making loans to firms with different types of ownership is eliminated, banks will discriminate against private sector firms.
Banks therefore need added incentives to lend to private enterprises. One such incentive could be higher returns, but most banks in China are state owned and face limited competition, with the result that the profit incentive is weak. Furthermore, financial sector reforms focused on reducing the accumulation of nonperforming loans in the system are making banks more averse to risk. Banks concentrate on avoiding losses and show little interest in sharing the rewards of projects that may be riskier but have higher expected returns. Indeed, the central bank requires all banks to implement a policy known as "responsibility to individuals," which makes credit officers personally responsible for loans, thereby discouraging them from making loans for private sector projects.
In addition, there are controls on interest rates and transaction fees, although the government has been gradually relaxing some of them. Interest rates are capped. On loans to small and medium-sized enterprises, they are allowed to be 30 percent higher than prescribed rates, and rural credit cooperatives are allowed to charge interest rates up to 50 percent higher. Banks are taking advantage of this more flexible interest rate regime, but interest rates need to be liberalized further to encourage more lending to private firms. The government is expected to relax restrictions even further in preparation for China's entry into the World Trade Organization (WTO). For the time being, banks and credit unions have found creative ways to circumvent interest rate controls, such as requiring compensating balances and charging false late payment fees. As a result, according to the firms surveyed, state banks charge effective interest rates that are comparable to those in the informal market. At the same time, most of the mechanisms used to circumvent restrictions on interest rates entail additional transaction costs, discriminate against smaller firms, and are too blunt to reflect differences in the risk profiles of projects.
Bank procedures. Chinese banks often complain about the poor quality of projects seeking financing. What they consider "bankable" projects, however, depends in part on the procedures they use in screening them. The procedures, both formal and informal, rely on collateral and personal relationships rather than on project appraisal. Furthermore, they are inflexible and tailored, partly for historical reasons, to the "typical" state-owned enterprise. According to the firms surveyed, applying for a loan is a bureaucratic and costly process. About 70 percent said that paperwork was a moderate or major obstacle to their application for a formal loan. Collateral requirements, the cost of the application process, and relationship banking tend to make it especially hard for smaller firms to gain access to financing (Chart 2).
Collateral requirements. According to the surveyed firms, the inability to meet collateral requirements is the most frequent reason for not being able to obtain a bank loan. Although a number of assets qualify as acceptable collateral in theory, in practice real estate assets appear to be the most common—in some cases, the only—kind of collateral accepted. Yet, because of the legacy of public and collective ownership of land, many private firms do not have land-use rights or buildings that can be used as collateral. In addition, establishing the value of a firm's assets so they can be used as collateral is costly. The fees may amount to a percentage of the total value of the assets. Furthermore, firms must renew their asset registration yearly and pay an annual registration fee. Repeated and arbitrary fees have greatly reduced the incentive of firms to apply for loans.
Information problems. Information problems, endemic in financial markets, are especially severe for private firms in China. Having developed in an unfriendly political and economic environment that only recently put them on the same official footing as state enterprises, private firms have developed in ways that make them particularly opaque. Many had to present themselves as collectives or as foreign enterprises to be allowed to operate or to obtain better treatment from the authorities. The resulting lack of clear ownership and management structures imposes obvious constraints on borrowing. To add to the problem, banks are unable, and lack the incentive, to collect and process relevant information.
At present, the interactions between financial institutions and private firms do not encourage the use of transparent financial and accounting systems. By avoiding formal accounting systems or keeping several sets of books, firms can make it impossible to audit them. Banks are naturally reluctant to accept financial statements that cannot be trusted. Recent revisions to the accounting law, which stipulate that every business unit must have only one set of account books, testify to the severity of the problem.
Recently, the central bank made it mandatory for corporate borrowers to register in a national database. This will make the central database more comprehensive and prevent companies with poor records from getting loans or using the same collateral for multiple loans.
Policy agenda for financial sector
Improving private firms' access to external financing requires concerted efforts on the part of enterprises to improve their "bankability" by strengthening transparency and clarifying ownership, and on the part of the government to establish and maintain a level playing field and to create incentives for lending to and investing in private enterprises.
Strengthen banks' incentives to lend to private enterprises. An important step would be to strengthen profit incentives through private ownership and competition. At present, the ownership structures of the real sector are out of balance with those of the financial sector, where private ownership is practically nonexistent. The government should allow the entry of new domestic private financial institutions, especially in view of prospective WTO membership, which would open up entry opportunities to foreign financial institutions. To alleviate regulatory concerns, stricter entry and prudential requirements could be applied to new private financial institutions in the initial period.
Private financial institutions are less likely to be swayed by political considerations and more likely to be profit oriented. New banks tend naturally to focus on underserved market niches, especially younger and smaller firms, which constitute the bulk of the private sector today. They tend not to discriminate among customers on the basis of existing relationships and, in their struggle to establish themselves in the market, are more prone to trying new and innovative ways of doing business.
The big state-owned banks are likely to dominate the domestic financial landscape for the foreseeable future. Strengthening the profit incentives of these banks would therefore have a major impact on improving private firms' access to bank loans. Corporatization, listing, and strategic partnering with foreign financial institutions are some of the ways to reach this objective.
Further liberalize interest rates. Evidence suggests that further liberalization of interest rates is needed to improve private firms' access to bank loans. Such a measure is not likely to have a significant impact on the borrowing costs of these firms. Most private enterprises that are able to borrow already pay effective interest rates that are significantly higher than the ones prescribed by the central bank. Entrepreneurs also indicate that access to financing is more important than the cost of funds.
Allow banks to charge transaction fees. Banks find that lending to private companies, most of which are smaller and informationally more opaque than state-owned enterprises, carries higher unit transaction costs. If banks are not in a position to cover these costs, they are likely to discriminate against small firms. Transaction fees would therefore encourage banks to consider more proposals from small firms, develop a more service-oriented culture, and promote greater transparency and better accounting standards.
Develop alternatives to bank lending, such as leasing and factoring. Leasing and factoring are underdeveloped in China. Yet they are useful ways to deal with insufficient collateral and, in the case of leasing, with the enforcement of collateral.
However, the development of leasing faces obstacles in China: rent arrears have long been a problem; accounting standards are unclear; the regulatory environment does not provide equal treatment with other sources of capital investment financing; and funding is a perpetual concern. A welcome recent development is the chapter on finance lease contracts in China's new contract law. This is the first time either national or regional legislation has covered the fundamental principles of finance leases. However, the legislation is not a substitute for a special leasing law, which is needed to address the issues identified above.
Liquidity and arrears problems are common among private enterprises in China. Factoring—the sale of a firm's accounts receivable to a financial institution known as a factor, which is responsible for collecting the firm's accounts—is a way to improve a company's liquidity by substituting a cash balance for book debt. Provisions in the new contract law that make it possible to assign contractual rights independently of the assumption of the corresponding obligations and without the consent of the debtor may stimulate the growth of factoring.
Create a framework for the development of private equity markets. Private equity markets in China are at an embryonic stage of development. Indeed, offshore venture funds appear to be a far more important source of capital for start-ups in China than domestic ones. Recognizing the importance of private equity markets for the high-tech sector, the government has stepped up efforts to stimulate their development and is preparing legislation on venture capital and investment funds.
At present, no regulations cover the organizational structures that can be used to establish private equity funds, known in China as "industrial investment funds." As a result, fund promoters often set up limited-liability corporations as investment vehicles. These corporations must abide by the company law, which does not permit more than 50 percent of capitalization to be invested in subsidiaries or other legal entities.
Certain legal instruments must be in place before private equity funds can develop. The most important ones relate to the legal organization of such funds, the use of a fund manager, the need for trustees to protect investors from adverse actions of the fund manager, and tax treatment to avoid double taxation. The development of private equity markets also depends on the ability of investors to use a variety of financial instruments to structure investments. In China, however, the lack of provisions for the issuance of different classes of shares and quasi-equity securities seems to deny private enterprises the flexibility they need in their financial arrangements.
Improve access to public equity. The availability of exit mechanisms is a key condition for the development of private equity markets. In that sense, the evolution of private equity markets in China depends to a large extent on the state of the public equity market. The latter has been virtually closed to private firms, but in March 2000 the Chinese Securities Regulatory Commission announced that the quota system on listings would be abolished. This suggests that private firms would have greater opportunity to acquire long-term funding through the equity market. Two ways to further improve private firms' access to public equity would be to broaden the range of exit mechanisms available to investors and to relax listing requirements.
The expected establishment of the Second Trading Board in 2001 would have a profound effect on private equity markets by enhancing the exit mechanisms for pre-listing investors. Proposed listing rules for the Second Trading Board would make access easier for younger firms because companies would not have to demonstrate a history of profitability to be listed, and the capital required to obtain a listing is expected to drop from RMB 30 million ($3.6 million) to RMB 20 million ($2.4 million). This would represent progress, although the need for such a high minimum level of capital can still be questioned.
Macroeconomic and survey data suggest that the impressive growth of private enterprise in China over the last decade has been financed overwhelmingly from internal sources. International evidence suggests that this is not sustainable. As firms mature and grow larger, their need for external finance will grow.
Improving private firms' access to external financing in China requires changes by the enterprises themselves, by the local and national governments, and by financial institutions. These changes are critical if the private enterprise engine of growth is not to stall. But changes on each side would be mutually reinforcing—better borrowers and better banks in a better regulatory framework. With greater access to external finance, China's private enterprises will continue to play a larger role in the growth and transformation of the Chinese economy.