The Fix for China’s Small-Business Cash Crunch

Beijing should make it easier for new finance companies to meet the productive private sector’s credit needs.

Beijing is worried about the country’s shadow banking market and the risks it poses to the financial system. The central bank’s recent liberalization of regulations on bank lending rates was in part an attempt to address the fact that a large proportion of the economy’s financing activity happens in this grey or black market. Yet policy makers will have to go further if they want to address this growing threat to the country’s economic stability.

Shadow banking refers to illegal and unregulated lending practices through financing companies, trusts, street-side lenders or the like instead of through banks. This is mainly a phenomenon involving small-and-medium-sized enterprises (SMEs), which account for 80% of China’s jobs and 60% of its GDP and yet struggle to secure bank loans. A recent study commissioned by the State Council estimates that 62% of China’s small and micro businesses have no lending relationships at all with banks.

When small companies can’t borrow from banks, they borrow elsewhere, at much higher cost. Beijing understands this, and has tried to boost bank lending to small companies. But officials have not yet been able to overcome many of the incentives that contribute to banks’ reluctance to do so. Loans to small businesses tend to be, well, small, and loan officers shy away from making them for the simple reason that it increases their workload. Why bust a gut making 10 loans when you can make one large one, particularly if it is to a state-owned enterprise with implicit government support?

Last month, in an effort to get banks to lower their lending rates and boost lending generally, the central bank removed its floor on lending rates. But the practical effect, if any, will largely be to reduce the borrowing costs of state-owned enterprises. It won’t lead to an increase in bank lending to SMEs or reduce their reliance on the shadow banking system, because it doesn’t change the basic incentives for banks.

Authorities were much closer to the mark when, in 2009, they allowed the creation of small loan companies, or SLCs. These are privately funded entities that make quick loans to small businesses as an alternative to traditional bank loans. They are not regulated by the China Banking Regulatory Commission (CBRC) but they are overseen by provincial financial officials and follow government-approved lending standards.

These loan companies are proving to be a good funding alternative for SMEs. From my research and discussions with loan-company owners, their loans are collateralized and demand is strong, and as long as they adhere to strict loan to value ratio rules, defaults are rare.

However, current regulations limit the amounts SLCs can lend. Changes are needed for the program to make a serious dent in the funding shortfall the SME sector faces.

The first problem is that there are not enough small-loan companies. Beijing has ceased issuing new licences, effectively capping the number of SLCs. Since these tend to be smaller firms, the numerical cap also serves as a cap on available credit. This made sense when the program was in its pilot stage. But authorities should now feel confident expanding it.

Second, restrictions on capital-raising leave small-loan companies without enough cash to meet demand for loans. The lending ceiling is the amount of a loan company’s registered capital, plus borrowings from banks of up to 50% of equity. A loan company with equity of $20 million has its lending capped at $30 million, and the only way it can increase this cap is to raise more equity.

As most SLCs face the same difficulties obtaining loans from banks as other small businesses, they end up lending only the capital put into them by their owners, which is not nearly sufficient to meet demand. Small-loan companies’ collective lending is estimated at only 600 billion yuan ($98 billion) while the CBRC estimates a 2.67 trillion yuan gap between SME demand for loans and the supply. Loan-company owners are reluctant to pour too much capital into their firms because the process of adding equity capital is tied up with red tape, making it hard to make withdrawals later.

Beijing could allow small loan companies to borrow funds from their shareholders. Regulators have been justifiably cautious about this, since it would open the door to potentially large and rapid flows of capital into and out of loan companies, with destabilizing consequences for the broader industry.

But the answer to that fear should be carefully tailored regulation, not a stifling of the industry. For instance, Beijing could cap shareholder loans at an amount equal to total invested equity. This would allow small-loan company executives the flexibility to put more capital into their firms via shareholder loans, but keep them from overextending themselves.

The shadow banking issue illustrates the extent of the challenges Beijing will face in reforming the financial system. But these challenges are not insurmountable. In cases such as small-loan companies, Beijing already has the tools it needs. As reform continues, authorities should look for opportunities to expand programs that already are working even as they undertake new liberalizations in other areas.

Mr. Osborn is a partner at PricewaterhouseCoopers Hong Kong/China.

SOURCE: BY TED OSBORN  – PARTNER PWC HK – Silas Berry – AsiaConsult – http://online.wsj.com/article/SB10001424127887324809004578639011790219042.html 

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