In a speech Monday August 21, 2018, Chinese Vice Premier Liu He publicly called for increased financial support for small and medium sized enterprises (SMEs) in China, which he said was a vital push to support China’s domestic private sector. Mr. He called for efforts to increase financing opportunities and volumes for SMEs, and said China should improve and strengthen capital markets for smaller companies. The proposal was also made to implement favorable tax policies (read cuts) for SMEs, and new policy initiatives such as financing assurance. Mr. He’s remarks came at a conference of the State Council Leading Group on Promoting Development of Small and Medium Sized Enterprises. SMEs are targeted for the effort due to their fundamental economic role as part of a broader statement regarding addressing widespread difficulties for operations of SMEs.
A common refrain in media reporting about SMEs in China is the difficulty of these companies in obtaining loan financing. Typically, Chinese banks, whether large national banks or smaller provincial banks, prefer to provide loans to State Owned Enterprises (SOE), for obvious reasons. As an SOE is implicitly backed by government financing, the loan may be made on terms favorable to the bank, with a higher certainty that the loan will ultimately be paid back. In Contrast, SMEs often seek loan financing when they are in a tough spot, and even if the company is not in a hard place financially, the bank is less certain the loan will be paid back in good faith.
This has resulted generally, in a situation in which unprofitable SOEs suck up monies available for corporate loans while profitable, potentially industry disrupting SMEs cannot secure funding required for major expansions and growth. This phenomenon has been identified in news reports and academic studies since the early to mid-2000’s. The most obvious fix for the situation is to push these banks to loan more to SMEs, and this appears to be what Mr. He is indicating in his comments.
One option for SME fundraising is to raise capital via an IPO on one of China’s stock exchanges. This is problematic for many Chinese SMEs both for the costs involved in preparing for the IPO, and for the lack of guarantee of any real fundraising from the move. By the nature of the Chinese stock market, SMEs fail to attract much interest, while again, larger listed companies with well known names, attract much of the investment on the stock exchange platform.
This leaves banks and bank loans the primary source for funding for China’s SMEs. One approach China has taken recently has been to reduce the Banks’s Reserve Ratio Requirement for some banks on condition that the extra money available for loans goes to SMEs.
One of the major reasons banks don’t lend as much to SMEs in the first place is the perception of increased risk of default. China may consider either providing backstop funding or an insurance option for banks that lend to SMEs which will cover the costs of any default by SME and failure ot pay back the bank. If policy or new initiatives are able to reduce risk inherent in lending to SMEs, lending should increase.
The government may also consider stronger and more explicit policies in favor of lending to SMEs and discouraging lending to unprofitable SOEs. In China, sometimes just a speech means a lot, and officials may find that sustained called for greater lending to SMEs end up moving the needle favorably. Regulators and banks may also consider increased due diligence and testing prior to issuing corporate loans. For example, they may implement a stronger test as to profitability as a requirement to receive loan funds. This would have the effect of channeling greater loan financing to SMEs which manage to be profitable, and less to SOEs which tend to be less profitable.
As the perception regarding SOEs vs SMEs is that SOEs are more likely to be sustained and “bailed out” by the government in case of financial trouble, the government may look at equalizing moves. We already mentioned the possibility of providing greater guarantees to banks to prevent losses due to default of SMEs. However, the government may also consider changing policy by allowing some poorly managed SOEs to go bankrupt and go out of business without the benefit of state support. This will both spur other SOEs to better manage finances, but will also reduce differences between SOEs and SMEs, which will in time change the calculus of bank managers when deciding on whether a loan to a profitable SME is truly more of a risk than a loan to an unprofitable. SOE.