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Ranga Wimalasuriya                                                                    06/06/2012


REFORMING CHINA’S FINANCIAL SYSTEM: SUSTAINING PRIVATE SECTOR GROWTH



       Introduction

       The Chinese economy has been growing exponentially for over two decades with growth

rates averaging 10% since the Asian Financial Crisis of 1997. In the process, the economy has

flirted with deflation (1998-99, 02-03, 08-09), high levels of inflation (2007-08, 2010-11),

negative real interest rates (2008-9) and low lending rates averaging 5-6% (2010-11). The

negative real interest rates signify negative real rates of return on savings for depositors and the

majority of households that are responsible for a major share of China’s capital account.

          Fig.1 China’s GDP growth                                  Fig .2 Interest Rates




       China’s transition from a centrally planned to a market based economy has brought

about significant changes. However, there is a common perception that the hierarchy of China’s

financial system has not aided this change and that deep structural problems are prevalent

within the system. Mckinsey Global Institute stated that the access to credit for individuals and

SMEs in China is far below other developing countries (Mckinsey Global Institute 2009,25).

Some academics have further concurred that “China lacks [the] infrastructure of modern
Ranga Wimalasuriya                                                                   06/06/2012


consumer finance, and is years or possibly decades-away from building it to the standards of

the developed world” (WSJ, 2011).


       The existing financial institutions, however, fail to efficiently allocate domestic capital to

the private sector (Small and Medium Enterprises) is an issue which curtailed private sector

development according to existing literature. Access to finance plays an important role in

private sector development. The ability to start, expand and innovate for SMEs depends on

finance sector support. SME financing may be affected by a range of factors. These include the

actions of the banking sector which likely to be more inclined to fund State-owned Enterprises,

the size of the SMEs and stage of its growth which may have implications on its ability to

obtain financing and a lack of collateral SMEs offer for financing.


       Small enterprises- those firms that employ fewer than 300 people, earn less than 30

million yuan and have assets less than 40 million yuan and Medium enterprises- those firms that

employ 300 to 2,000 people, have annual sales of 30 to 300 million yuan and own assets worth

40 to 400 million yuan, in spite of financial constraints, SMEs are a significant component of

China’s economy. They have shown exponential growth in the last decade with over four

hundred thousand SMEs operating today ( NSB, Fig 3.). The SME sector produces 68 percent

of China’s exports, over 50% of China’s Gross Domestic Product and 80% of Chinas urban

employment ( Zhu, Wittmann, Peng, 2011). SMEs, therefore, are central for the growth and

development of a country as they expand as large corporations.
Ranga Wimalasuriya                                                                  06/06/2012




 Fig.3




         Source: National Statistics Bureau


         A study done by Standard Chartered Bank found on average, that the SME sector

accounted for 16 percent of GDP in low-income countries, 30 percent in middle-income

countries and 51 percent in high- income countries; suggesting that SMEs increase in

importance as an economy develops. A report from the Chinese Technology Innovation Beijing

center (CTIBJ) suggested that 68% of SMEs would close down in their first five years in

operation, 13% will exceed 10 years of operation (CTIBJ,2008) and 19% of SMEs faced with

bankruptcy in 2011 with 70% of SMEs facing financial constraints (British Embassy Beijing,

2011).


         This paper attempts to analyze the growth of SMEs over the last decade and track the

flow of capital and sources of capital into the private sector despite claims of capital constraints
Ranga Wimalasuriya                                                             06/06/2012


in some source of existing literature. The paper will then draw on a comparative assessment of

the China’s financial system and India’s financial system and identify how each system has

addressed the issue of capital constraints in the private sector.


Literature Review


An Overview: China’s Financial System

       Fig .4 China’s Financial Institutions




       Source: China Statistical Year Book


       China’s financial system is comprised of a state dominant banking sector and weak

capital markets. The banking system has evolved rapidly since the 1990s. In 1979, the system

was solely represented by the People’s Bank of China (PBOC) which acted both as the central

bank and was further responsible for deposits and loans (Linton, IMF). Presently, the banking
Ranga Wimalasuriya                                                               06/06/2012


system consists of the “Big Four” state owned commercial banks (SOCBs), policy lending

banks, joint stock commercial banks, city banks, rural and urban credit cooperative (RCCs) and

foreign banks (Fig 3). The big four and the joint stock commercial banks (JSCBs) remain the

dominant players and principle lenders to SOEs and are subjugated by government shareholders

and management. All major banks along with the City Commercial banks (CCB) and the Rural

Commercial Banks (RCB) have been converted into corporate entities subjected to a board of

directors and supervisors (Herd, Pigott and Hill). JSCBs, according to Naughton (2007), are

more efficient and hold considerably lower amounts of nonperforming loans (NPLs) and they

have captured 15% of the total banking-system assets as of 2008. However, their effectiveness

is constrained due to a lack of independence and experienced officials. Former government

officials still operate within senior management acting as a hindrance for efficient banking

(HPH). The policy banks were established to fund the central or local governments for

infrastructures and development projects and lend to SOEs and account for 8% of total assets as

of 2003. RCCs, once banking profitable TVEs in the countryside, fell out of favor following the

Asian Financial Crisis. Since 2006, the government has pumped capital into RCCs as a part of

the urban financial bailout (Naughton). Foreign banks, however, play a minute roll in China’s

capital markets even though the government gave access to start-up “private banks in “20

localities”. (Naughton, Linton).


       The big four account for 53.5 percent of the total assets of financial institutions

(excluding the people’s bank of China) as of 2004 with joint stock and city commercial banks

which claim 20.7 percent, RCCs claiming 8.9 percent of the assets and Policy Banks with 7.7

(Naughton). Showcasing that 90.8 percent of all assets are controlled or under the watch of the

central government with 9.2 percent belonging to foreign and private banks (fig.5).
Ranga Wimalasuriya                                                                                  06/06/2012




Fig 5. China’s major banking institutions, no of institutions, share of total Assets & share of total Loans, Dec, 2005




        Linton claims it is this lack of independence in China’s banking system that has resulted

in the banks focusing on financing needs of the government, SOEs and construction firms over

the last decade. Allen, Qian and Qian(2004), compare the financial systems of a sample of

countries (English origin, French origin, German origin and Scandinavian origin) to that of

China. They find that the ratio of total bank credit to GDP is 1.13, higher than German-origin

countries which are known to have heavy bank-dominated financial systems. However, when

they consider bank credit issued only to the private sector (individually owned or publically

traded companies) China’s ratio drops from 1.13 to 0.242 (Fig.6) reflecting the flow of capital

to the public sector (state-owned companies). The second panel of Fig.6 compares the relative

importance of financial markets against banks. “Structure activity” and “Structure size” are

relative size measures which are equal to Log (market size/ bank size), with a smaller value

indicating that the country’s financial markets are small than its banking system; China has the

lowest score suggesting that its banking system is larger than its markets. A World Bank
Ranga Wimalasuriya                                                                          06/06/2012


quarterly report cited that the recent most stimulus money is directed to benefit SOEs. This is

partly due to the method in which state ownership is distributed in the economy. Most SOEs

claim to have close relationships with the government and banks. SOEs have benefited from the

stimulus injected (The Economist, world bank.org).


Fig .6                                                      Fig.7




                                                              Source: Wall Street Journal




         While China’s banking system is dominant, its stock and bond markets remain

underdeveloped. They are smaller than most countries in terms of market capitalization and

total value traded as a percentage of GDP (AKM) and total equity market capitalization is

equivalent to 17 percent of GDP when compared to the average of 60 percent in other emerging

markets (Farrell et al. 2006).


         The equity markets are largely controlled by the government and act as a platform to

raise capital for SOEs that require privatization. Listed companies and IPOs on the stock market

are former SOEs that are affiliated to government officials. The bond market lacks confidence
Ranga Wimalasuriya                                                                  06/06/2012


due to a deficit of institutional investors or a reputed credit agency that offers the investor

confidence to buy in. Large companies, therefore, “prefer borrowing from banks rather than

issuing bonds”. Such actions could crowd out the ability for Small and Medium enterprises to

borrow (AKM).


SMEs


       Mu (2002) cites that post-Asian Financial Crisis events left the banking sector with a

signifcant number of NPLs which average 30 percent of assets. He claims that this situation

arose because loans were given out based on preferential treatment to inefficient SOEs and are

further supported by unpaid principal and interest and below- market interest rates. Lending

rates to SMEs were additionally set artificially low which led to rates not being attractive

enough to encourage banks to lend out to SMEs, particularly when banks had high NPLs. This

issue was addressed by the establishment of credit guarantee schemes (CGS) which Mu claims

were helpful in promoting SME’s access to finance since they provide acceptable collaterals and

assist in the mitigation of the poor credit analysis SMEs will otherwise face. However, CGS

face much interference from local governments making it unable to operate in “accordance with

market principles”.


       Zhao et al (2006) using a dataset from the Chengdu SME Administration (CDSMEAB)

from 2003 to 2004 identified some main factors affecting SME’s access to capital as the lack of

eligible collateral for loans or guarantees, low credit ratings or a lack of credit reporting system

for SME, firm sizes (economies of scales)- the banks prefer to lend out to larger-sized SMEs-

and political risks faced by bank staff in case of failure to repay loans.
Ranga Wimalasuriya                                                                   06/06/2012


       Prasad (2007) suggests that the banking system should be made more robust and driven

by market principles but he does not specify how his ideas maybe integrated. According to him,

the financial system should be broadened to create alternate sources of funding and investment

opportunities for individuals and SMEs.


       Wang (2004) identifies the scarcity of capital, the lack of specialized financial institutions

to serve SME reform, lack of direct financing channels and the monopoly of state owned banks

as reasons for capital constraints in the private sector. As solutions, he suggests that “China

should increase the overall volume and credit proportion for SMEs”, especially bank credit,

develop small and medium financial institutions and reform RCCs so they can be independent

and adopt a flexible interest rate system. Wang’s countermeasures are explained in detail;

however, he has not cited examples of how effectives his proposed measures will be and it is

unclear whether such policy actions will be effective if China should implement them.


       On the contrary, Lardy claims that the access to capital especially with regard to

households and the private sector has risen dramatically. In his structure of household

borrowing from banks, the total loans outstanding to households stood at RMB.11, 258.6

Billion (PBOC), 225 times higher than what it was in 1997. He claims that a majority of the

household loans extended were for business borrowing- 33.3 percent; bank loans to households

stood at 28 percent of GDP more than 45 times the share at the end of 1997. This significant

improvement in capital allocation will help family businesses expand and household

consumption increase. Lardy further states that “China is an outlier on the high side in terms of

consumer credit availability” in comparison to emerging markets. Although his account of

capital access to households is comprehensive and positive, he hardly analyzes this from an

SME perspective. He does not explicitly breakdown household business borrowing and we do
Ranga Wimalasuriya                                                                  06/06/2012


not get an account of what kinds of businesses these household seem to run. He also fails to

analyze other sources of financing such as FDI and the informal loans market that the private

sector seems to rely on.


       In addition to the question of capital constraints, existing literature has cited domestic

SMEs could also be facing a problem of consumption (WSJ 2012). This being the case, SMEs

that are not export oriented will face many difficulties operating due to lack of demand from

domestic customers, driving them out of business. China needs to reallocate capital towards

producing goods and services that Chinese consumers want to consume and this will require

banking changes, especially improving access to capital for SMEs that “make the modern

consumption-driven economy tick”.


       The aim of this paper is to identify the characteristics of capital allocation to the private

sector, specifically SMEs in China. It will attempt to track the flow of capital from its origin

(e.g. households) to China’s financial system and other financial institutions that act as

intermediaries for capital allocation to SMEs; and analyze both direct and indirect sources of

financing that have helped firms grow exponentially over the last decade a gap that is present in

current literature related to the topic.The paper will then evaluate four important reforms that

standout from the existing literature: less government control over the financial system

“breaking up the monopoly”, liberalizing interest rates, regulating the informal loans market and

a credit rating system.
Ranga Wimalasuriya                                                                 06/06/2012


Characteristics of Chinese Capital: Formal Financing

Fig .8




         A major source of capital for formal financing arise from household savings, enterprises

savings and government savings. Fig.8 Shows the gross domestic savings in China has increased

since 2000 and comprises more than 50 percent of Gross Domestic Product. Household savings

on aggregate has risen by 6 percentage points over the last 10 years (Prasad and Chan). Chinese

household’s savings rate has continued to increase over the last decade and this is despite a

negative real return rate from the banks. According to Prasad and Chan, this unstoppable

increase in savings or the target savings by households is due to declining public provisions such

as health and education; other factors include the presence of a target savings rate due to China’s

transition to a market economy. A high savings rate such as that depicted by the Chinese

economy may not be beneficial for domestic SMEs that depend on local demand and

consumption for their operations. If the trend continues, China’s economic expansion will slow

down and China’s attempts to adopt a consumer driven model by moving away from an exports

or investments driven model will suffer.
Ranga Wimalasuriya                                                                                          06/06/2012


Capital Allocation Cycle

Fig.9
                                               • Household Savings
         Government Bonds                      • Enterprise Savings
                                                                                       Corporate Bonds      Stocks
                                               • Government Savings
                                                                                       6.4%               6%
                9.5%                                    78%




                                                  Banks & share of Total Loans- formal market
                                     •        The BIG Four 50.5%
                                     •        Joint Stock Commercial banks 15.4 %
                                     •        City Commercial Banks 5.2%
                                     •        Urban Credit Cooperatives .5%
                                     •        Rural Credit Cooperatives 8.9%
                                     •        Policy Banks    15.4%
                                     •        Foreign Banks 1.6%


   Shadow banking / informal loans market                                                                Central Government
          • 30% of all loans made out




                                            Individuals,            SMEs                SOEs
                                            households


Source: China Statistical Yearbook

Fig. 8 and 9 depicts how dependent formal market financing is on the savings of the Chinese

public. Fig.9 shows the big picture of capital allocation within the Chinese economy. The high

household savings rate contributes a major share of the overall capital allocation within the rest

of the Chinese economy. Household savings, enterprise savings and government savings made

up 78% of the total formal market loans made out in 2005. Government bonds, corporate bonds

and stocks made up the remaining 22% highlighting China’s weak capital markets. The big four

banks are responsible for over 50 % of the total loans made out with foreign banks holding just

1.6%. Clearly, this divide seems to favor SOE funding given the authority the big four hold over

the rest of the financial system.


         Shadow banking and the informal loans market hold 30% of all the loans made out and is

therefore an important segment of China’s private sector financing. AKK using a data set of
Ranga Wimalasuriya                                                                   06/06/2012


twenty four hundred firms found that 43% of firms in China used alternative forms of finance

compared to an average of 9% in emerging markets and Allen, Qian and Qian claimed that the

fastest growing Chinese firms used alternative channels of finance rather than formal financing.

Fig 3 compliments these findings with the growth shown by both small and medium enterprises

over the last decade despite poor access to formal finance.


         The following sections will analyze the sources of financing and analyze both direct and

indirect sources of financing that have helped firms grow exponentially over the last decade and

the methodology will present how I went about conducting my research.




Methodology


        The aim of this paper is to identify the characteristics of capital allocation to the private

sector, specifically SMEs in China. There are different sources of funding that domestic firms use

for daily operations or expansion. In the formal market, retained earnings is the cheapest source of

capital and can be implemented without any external constraints, domestic loans from a bank is

the second cheapest source of capital and fundraising through bonds/stock market is relatively

more expensive source as equity is costlier than debt. Funding can be categorized into two types-

Informal and Formal financing. Formal financing includes bank financing through local

commercial banks and foreign commercial banks, state budget and debt financing through

China’s capital markets. Informal financing refers to “internal finance”- retained earnings, loans

from a family or friend and financing from an underground bank.

        I will use data drawn from the China statistical year book from 2000-2010, a data set

obtained from Dr.David Hall and the investment climate survey conducted by the world bank in

2006 for my analysis. Part 1 explores the macro level climate of credit allocation to the private
Ranga Wimalasuriya                                                                            06/06/2012


sector in China. Part 2 will attempt to identify the various channels of financing (both informal

and formal ) and the share of each channel regarding firms. Part 3 analyzes total investment in

fixed assets across firms; this will enable us to distinguish the types of firms that have expanded

over the last four years relative to the type of financing and part 4 analyzes capital allocation on a

regional and categorical level.




Analysis part 1


                                                Domestic Credit extended to the Private sector as a % of GDP
        Figure 1 depicts the domestic

credit extended to the private sector in

the form of formal loans as a % of GDP.

The graph gives us a general idea of

how strict capital allocation is within

the private sector with relation to

public vs. private credit allocation. This

graph also accounts for housing loans

as a part of private sector investment.
                                                 Source: The World Bank . Fig 1.

The data does not give a break down of how this credit is distributed within the private sector on

a firm level( small, medium and large enterprise), industrial level or a regional level. The

horizontally connected lines compare China to the United States, Spain, Germany and India. The

annual World Development Indicators (World Bank, 2004b) in 2002 summarized domestic

credit provided by the banking sector in middle-income countries to be 83 percent of GDP, 49

percent of GDP for low-income countries and 168 percent of GDP for high income countries.
Ranga Wimalasuriya                                                                06/06/2012


Ignoring the variables not addressed in the data, China and Germany seem to be on par at 150

and 130 percent of GDP respectively with the United States and Spain close to 230 percent and

India below 100 percent of GDP. The level of domestic credit extended to the private sector for

China being on par with Germany is an encouraging prospect ignoring the variables not

addressed by the data.


Analysis Part 2



       In Figure 2. the horizontally connected lines represent how each source of funding is

distributed amongst China’s firms with regard to investment in fixed assets. There are four

sources of funding for investment in terms of fixed assets in China: State Budget, Domestic Loans,

Foreign Investment (FI) and Self fundraising; the sources of funding can differ from country to

country. The State budget was a significant source of financing in the early 90’s with SOEs

heavily dependent on the State budget for operations and the Chinese economy following a

centrally planned system. As of 2009 the state budget accounted for only 5.1 percent of the total

and this maybe due to a result of the Chinese government refocusing spending on education,

healthcare and military defense. Foreign investment refers to foreign funds acting as a source for

domestic firms to invest in fixed assets and is not a measure of foreign investment in ownership

form. Foreign investment sources has reduced to 1.8 percent as of 2009. The two prominent

sources of funding are self-fundraising and domestic loans.


       Domestic loans in aggregate occupy 15 percent of the total financing and constitutes 30

percent of financing in large companies (Fig.5). Domestic loans since 2000 have grown at a

CAGR of 19.21%. Self-fundraising comprises of retained earnings, informal loans, funds raised

from local communities ( family and friends) and local governments. Self-fundraising is the
Ranga Wimalasuriya                                                                  06/06/2012


 largest source of financing accounts for 77 percent of the total. Self-fundraising is an important

 source of financing for many types of firms and it involves both individually owned companies

 (private sector) and interestingly state or quasi-state-owned companies as well. An interesting

 observation of the data is the downward trajectory of the state budget as a source of funding; this

 may have led to increased self-fundraising and might lead to increased foreign investment in the

 future.




            Source: China Statistical Year Book, Fig.2



Analysis part 3

Given we have an understanding of the sources of funding within China’s financial system from

part 2 it will be worthwhile to analyze the categories of firms affected by these sources. The

following figure illustrates the distribution of fixed asset investment in China across firms. Fixed

assets are long-term tangible pieces of property like buildings, real estate, equipment and

machinery that a firm may use in the production of its income. An account of fixed asset

investment across firms will help distinguish the firms that have expanded over the last four years.
Ranga Wimalasuriya                                                                      06/06/2012


The blue bars represent the total investment value in 100 million Yuan and the horizontally

connected lines show the different categories of firms. SOEs and LLCs seem to have invested the

most over the last 5- years with a CAGR of 19.95% for SOEs. The share of investment for private

enterprises has increased whilst the share for individuals have declined. Foreign firms with funds

mostly from Hong Kong, Macau and Taiwan account for about 7% of the total.


                                                              The large share of           fixed asset

                                                              investment by SOEs indicate the

                                                              expansionary path SOEs have taken

                                                              over the four year period. This could

                                                              be a result of the stimulus package

                                                              that was extended by the Chinese

                                                              government,       better     access     to

                                                              domestic loans through the banking

                                                              sector or profits raised through self-
            Source: China Statistical Year Book. Fig.3
                                                              fundraising.


However, construction (property) and infrastructure are two sectors that the Chinese government

has invested a lot of capital in over the last decade and most large construction companies, steel

and cement companies are SOEs. This is could mean that SOEs are directly benefited from this

surge in construction and are therefore served with easier access to capital.




  Source: China Statistical Year Book Fig .4
Ranga Wimalasuriya                                                                  06/06/2012




Figure.4 shows the total amount of short loans from the total loans markets given out to

township-village enterprises, enterprises with foreign funds and private enterprises and self-

employed individuals.     Freedman et. al (2006) cites that bank lending to SMEs ( private

enterprises and self-employed individuals in fig 4.) in developing economies mostly comprise of

short-term loans . This is because banks make lending decisions based largely on the value of

assets pledged by a borrow rather than a borrower’s expected revenues and cash flows. In Fig 4.

the ratio (d/a) of short term loans to private enterprises and self-employed individuals depict that

only 5% of the total short term loans are distributed to the segment. However, there seems to be

a rise in short term loans from 2% in 2005 to 5% in 2009.


Analysis Part 4

Parts one, two and three analyzed capital allocation to the private sector from a macro level ,

firm level and attempted to evaluate the distribution of short term loans for private firms and

SMEs. Part four will address the level of capital allocation across regions in China; a regional

comparison will help us determine the overall efficiency of capital allocation in China.


In Figure.5, Allen et.al (2005) and Ayagari et. al (2007) conducted studies on the types of

financing within firms across the five regions- Central, Coastal,Northeast, Northwest and

Southwest in China and Figure 5 portrays some of the patterns they inferred. Allen et. al

categorizes financing to Bank Financing and Self- Fundraising; they find that 20.63% of the

financing is drawn out of bank loans and 79.37% through self- fundraising. Ayagari et. al

further breakdown the     79.37% of self-fundraising      across regions. Central and Northwest

regions that are inland seem to have the highest percentage of self-fundraising firms. The
Ranga Wimalasuriya                                                                06/06/2012


Coastal and Southwest with better access to ports, tax arrangements and favorable policies show

a higher percentage of bank financing for firms (Ayagari et. al).




 Source: Allen et.al (2005) and Ayyagari et. Al (2007), Fig.5




Micro, small, medium, large and very large firms are categorized according to their financing

patters in Figure 6 according to Allen et al (2005) and Ayyagari et. Al (2007). Large and very

large firms (30%) seem to use more of Bank financing than the Small , Micro and Medium

enterprises (14- 15 and 22%). Internal financing (self fundraising) seems to be the largest source

of funding across all firms with even the Very large firms (majority of them SOEs) taking up

55% of the total.




Source: Allen et.al (2005) and Ayyagari et. Al (2007). Fig.6
Ranga Wimalasuriya                                                                    06/06/2012


Discussion

       Micro, small and medium enterprises are more restricted from formal financing than the

large and very large firms (fig 6.) This could be affiliated to the growth stages of the firms with

start-up firms (mainly comprising of small firms) receiving less formal financing due to the

financial system’s lack of a credit rating systems,strong relations with small enterprises or the

inability to better understand the business. Formal financing also requires collateral as fixed

assets and this is a hindrance for a start-up firm or medium enterprise in China. In addition, the

People’s Bank of China over the last three years has hiked reserve ratios and tightened loan

quotas, limiting liquidity in the loan market. The PBC also maintain a ceiling on interest rates

and strict interest rates fail to reflect risks of lending to SMEs from a lender’s standpoint, thereby

restricting banks from lending to SMEs.

       This restriction on formal lending has resulted in the increase of self fundraising (retained

earnings, informal loans, family and friends) as a source over the last decade (Fig.2) with both

SOEs and SMEs contributing to its growth in two different ways. Restrictions on capital flow in

the formal financing market has led SMEs resort to self fundraising through retained earnings,

informal loans and family with most firms taping into the informal loans market. SOEs that are

mainly large construction companies on the other hand has taken up the lending practice

(because of their access to easy capital) in the informal loans market to serve SMEs (that are

mostly small property developers) that are restricted to capital from the formal sector. This has

resulted in the expansion of informal lending institutions and evidence of this is seen in Fig.2

with self-fundraising increasing as a source from 70 percent to 80 percent over the last six years.

According to a Credit Suisse report, 60% of the informal lending has been channeled into the

property sector with the biggest borrowers being small and medium size real estate developers.

The informal loans market accounts for nearly four Trillion RMB or about 8% of the formal
Ranga Wimalasuriya                                                               06/06/2012


lending market with interest rates ranging among 14% to 70%. SOEs gain funding through high

interest rate loans offered to SMEs in the informal loans market and SMEs gain funding through

informal loans supported by SOEs; it is a cycle if not regulated could result in a credit crunch

that could significantly undermine China’s growth and investor confidence.

       Based on the evidence presented this paper will suggest four reforms that will help the

financial system address the concerns stated above: less government control over the financial

system “breaking up the monopoly”, liberalizing interest rates, regulating the informal loans

market, a credit rating system.



Suggested Financial Reforms in China

1.     Reducing government control of the financial system

Continual government intervention has restricted SMEs access to finance despite the reforms that

have taken place over the last decade.A possible solution would be to increase the PBOC’s

independence from the government to improve SME financing, privatize the four large-state

owned that control nearly 50% of total assets and reduce government control in equity markets.

Increased independence for the PBOC will restrict the authorities from interfering in lending

behavior of commercial banks especially through political appointments to high positions.

China’s equity markets have made considerable improvement over the last decade but further

liberalization to allow public companies access to equity markets and less government entities

will be beneficial to SMEs seeking funding.
Ranga Wimalasuriya                                                                    06/06/2012


2.      Liberalize interest rates

       Liberalizing interest rates is the process of replacing state-controlled interest rates with

market-based interest rates. China’s interest rates are extremely low and currently yielding

negative real rates of return to savers and hampering SMEs financing from the formal market.

China’s major state-owned banks sit on high profits and nearly 80 percent of it comes from

interest earnings. The liberalization of interest rates will help free up deposits and lending rates

and allow banks spread risk when allocating loans to high risk SMEs that are in need of formal

financing. Secondly, should China liberalize interest rates, it will allow its equity markets and

especially the bond market to develop which is an additional channel of financing for SMEs.

Hence, interest rate liberalization is an essential step for the Chinese economy if SME financing

is to improve.

3.     Regulating the informal loans market

       The Chinese Banking Regulatory Commission which regulates banks estimates the size

of the informal lending market to be between $500-$800 Billion. Informal loans market is a

significant component of “Self Fundraising” that takes up nearly 80 percent of all financing for

firms. It is an important component of the Chinese financial system and it must be standardized

and brought into the open with clear legal safeguards. The process of regulating could involve

issuing licenses to private lenders and imposing deposit collection and capital requirements and

a cap on the interest rates offered. If the informal loans market is not regulated it will continue to

“eat away at the depositor base of the big banks” (Lardy, 2007).
Ranga Wimalasuriya                                                                  06/06/2012


4.     A credit rating system

       The Chinese financial system has no credit rating system and often fail to identify a

businesses' credit worthiness; this makes financing difficult for SMEs as they are not well known

firms or maintain no close relations with the bank. Furthermore, the banking staff is also under

pressure given the amount of non-Performing loans that already exist in the banking sector.

Some innovative banks have resorted to analyzing a firm’s cash flows, import or export customs

declaration form and water meter bills to verify activity and this is an option that could be

introduced to the entire banking sector.



Conclusion

       The Chinese financial system has undergone many significant changes over the last

decade but SME financing and efficient capital allocation to the private sector remains a problem.

The recent financial crisis has increased the informal loans market and deteriorated formal

financing.    Structural problems within the financial system has restricted efficient capital

allocation;   these structural problems involve government control of the financial system,

interest rate ceilings, an unregulated informal loans market and the lack of a credit rating system.

It is essential that the Chinese government address these reforms above others if they are to

strengthen its financial system. Reducing government control from the state dominating banking

system and equity markets will require a lot of effort and may be a gradual process but it is

essential that steps are taken to regulate the informal loans market and liberalize interest rates

since China is a growing economy.
Ranga Wimalasuriya                                                                                             06/06/2012




   I.        BILIOGRAPHY:

   1. Allen, Franklin, Jun Qian, and Meijun Qian. "China's Financial System: Past, Present, and

        Future." (2004).

   2. "China Economy: Struggling SME Sector." British Embassy Beijing (2011)

   3. "Gregory, Neil, Stoyan Tenev, and Dilleep Wagle. "China's Emerging Private Enterprises:

        Prospects for the New Century." International Finance Corporation (2002).

   4. Guariglia, Alessandra, Xiaoxuan Liu, and Lina Song. "Is the Growth of Chinese Firms

        Constrained by Internal Finance." (2008).

   5. Hilgers, Lauren. "SMEs in China." Industry Outlook (2009).

   6. Huang, Yasheng. Capitalism with Chinese Characteristics: Entrepreneurship and the State.

        Cambridge: Cambridge UP, 2008.

   7. Shirai, Sayuri. "Banks' Lending Behavior and Firms' Corporate Financing Pattern in the People's

        Republic of China." ADB Institute Research Paper (2002).

   8.   Allen, Franklin, Jun Qian, and Meijun Qian. "Law, Finance, and Economic Growth." Journal of Financial Economics -.-

        (2004): -.

   9.   Khanna, Tarun. Billions of entrepreneurs: how China and India are reshaping their futures--and yours. Boston, Mass.:

        Harvard Business School Press, 2007

   10. Connor Linton, Katherine . "Access to Capital in China: Competitive Conditions for Foreign and Domestic
        Firms." Journal of International Commerce and Economics -.- (2006):

   11. Wang, Yanzhong . "Financing Difficulties and Structural Characteristics of SMEs in
        China."China & World Economy Vol. 12, No. 2,.34-49 (200): -.

   12. Garcia–Fontes, Walter . "Small and medium enterprises financing in China." Universitat
        Pompeu Fabra -.- (2005): -. Print

   13. HILGERS, LAUREN . "SMEs in China."INDUSTRY OUTLOOK -.- (2009): -. Print.
Ranga Wimalasuriya                                                                        06/06/2012


   14. Li, Guoying . "Barriers of supporting the SMEs entrepreneurs financially in China –a structural
         analysis and policy implications." 2010 International Conference on Economics, Business and

         Managementvol.2..- (2011):

   15. W. L. Fong, Michelle. "Chinese SMEs and Information Technology Adoption." Issues in
         Informing Science and Information Technologyvol.8.- (2011): -. Print.

   16. Prasad, Eswar , Marcos Chamon, and Kai Liu. "W. L. Fong, Michelle. "Chinese SMEs and
         Information Technology Adoption." Issues in Informing Science and Information Technology

         vol.8.- (2011): -. Print.."IMF Working Paper -.- (2010)

   17. S. PRASAD, Eswar . "Is the Chinese growth miracle built to last?." China Economic Review -.-
         (2009): -

   18. Bosworth, Barry , and Susan M. Collins. "Accounting for Growth: Comparing China and
         India." Journal of Economic Perspectives 22.- (2008): 45–66. Print

   19. Prasad, Eswar , and Marvin Goodfriend. "A Framework for Independent Monetary Policy in
         China." IMF Working Paper -.- (2006): -.

   20.   D. Chamon, Marcos, and Eswar S. Prasad*. "Why Are Saving Rates of Urban Households in China

         Rising."American Economic Journal: Macroeconomics -.- (2010):

   21.   HALL, CHRIS . "WHEN THE DRAGON AWAKES: INTERNATIONALISATION OF SMES IN CHINA AND

         IMPLICATIONS FOR EUROPE." CEISfo-.- (2007):

   22.   Zhu , Yanmei, Xinhua Wittmann, and Mike W. Peng. "Institution-based barriers to innovation in

         SMEs in China." Springer Science+Business Media -.- (2011): -.

   23. Ayyagari , Meghana , Asli Demirgüç-Kunt , and Vojislav Maksimovic. "Formal versus Informal
         Finance: Evidence from China."

   24. "China’s Scary Financial System - Economic Intelligence (usnews.com)."US News & World
         Report | News & Rankings | Best Colleges, Best Hospitals, and more. N.p., n.d. Web. 6 June

         2012. http://www.usnews.com/opinion/blogs/economic-intelligence/2012/05/21/chinas-scary-

         financial-system

   25. Tao, Dong. "China: Rising risk in informal lending ." Economics Research- Credit Suisse -.-
         (2011

   26. Qian, Wei , and Li Tong. "China Mulls Legalizing Informal Lending."China.org.cn -.- (2012):
Ranga Wimalasuriya                                                                 06/06/2012


   27. The Australian. N.p., n.d. Web. 6 June 2012. http://www.theaustralian.com.au/business/wall-
       street-journal/wenzhou-reforms-point-to-cleanup-of-chinas-financial-system/story-fnay3ubk-

       1226313201030>.
Ranga Wimalasuriya                                                      06/06/2012




Table 1: Definition of Financial Intermediaries/Institutions in China
Ranga Wimalasuriya                                   06/06/2012




Source: Law, Finance, and Economic Growth in China
Ranga Wimalasuriya   06/06/2012




   -

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Reforming China’s Financial System

  • 1. Ranga Wimalasuriya 06/06/2012 REFORMING CHINA’S FINANCIAL SYSTEM: SUSTAINING PRIVATE SECTOR GROWTH Introduction The Chinese economy has been growing exponentially for over two decades with growth rates averaging 10% since the Asian Financial Crisis of 1997. In the process, the economy has flirted with deflation (1998-99, 02-03, 08-09), high levels of inflation (2007-08, 2010-11), negative real interest rates (2008-9) and low lending rates averaging 5-6% (2010-11). The negative real interest rates signify negative real rates of return on savings for depositors and the majority of households that are responsible for a major share of China’s capital account. Fig.1 China’s GDP growth Fig .2 Interest Rates China’s transition from a centrally planned to a market based economy has brought about significant changes. However, there is a common perception that the hierarchy of China’s financial system has not aided this change and that deep structural problems are prevalent within the system. Mckinsey Global Institute stated that the access to credit for individuals and SMEs in China is far below other developing countries (Mckinsey Global Institute 2009,25). Some academics have further concurred that “China lacks [the] infrastructure of modern
  • 2. Ranga Wimalasuriya 06/06/2012 consumer finance, and is years or possibly decades-away from building it to the standards of the developed world” (WSJ, 2011). The existing financial institutions, however, fail to efficiently allocate domestic capital to the private sector (Small and Medium Enterprises) is an issue which curtailed private sector development according to existing literature. Access to finance plays an important role in private sector development. The ability to start, expand and innovate for SMEs depends on finance sector support. SME financing may be affected by a range of factors. These include the actions of the banking sector which likely to be more inclined to fund State-owned Enterprises, the size of the SMEs and stage of its growth which may have implications on its ability to obtain financing and a lack of collateral SMEs offer for financing. Small enterprises- those firms that employ fewer than 300 people, earn less than 30 million yuan and have assets less than 40 million yuan and Medium enterprises- those firms that employ 300 to 2,000 people, have annual sales of 30 to 300 million yuan and own assets worth 40 to 400 million yuan, in spite of financial constraints, SMEs are a significant component of China’s economy. They have shown exponential growth in the last decade with over four hundred thousand SMEs operating today ( NSB, Fig 3.). The SME sector produces 68 percent of China’s exports, over 50% of China’s Gross Domestic Product and 80% of Chinas urban employment ( Zhu, Wittmann, Peng, 2011). SMEs, therefore, are central for the growth and development of a country as they expand as large corporations.
  • 3. Ranga Wimalasuriya 06/06/2012 Fig.3 Source: National Statistics Bureau A study done by Standard Chartered Bank found on average, that the SME sector accounted for 16 percent of GDP in low-income countries, 30 percent in middle-income countries and 51 percent in high- income countries; suggesting that SMEs increase in importance as an economy develops. A report from the Chinese Technology Innovation Beijing center (CTIBJ) suggested that 68% of SMEs would close down in their first five years in operation, 13% will exceed 10 years of operation (CTIBJ,2008) and 19% of SMEs faced with bankruptcy in 2011 with 70% of SMEs facing financial constraints (British Embassy Beijing, 2011). This paper attempts to analyze the growth of SMEs over the last decade and track the flow of capital and sources of capital into the private sector despite claims of capital constraints
  • 4. Ranga Wimalasuriya 06/06/2012 in some source of existing literature. The paper will then draw on a comparative assessment of the China’s financial system and India’s financial system and identify how each system has addressed the issue of capital constraints in the private sector. Literature Review An Overview: China’s Financial System Fig .4 China’s Financial Institutions Source: China Statistical Year Book China’s financial system is comprised of a state dominant banking sector and weak capital markets. The banking system has evolved rapidly since the 1990s. In 1979, the system was solely represented by the People’s Bank of China (PBOC) which acted both as the central bank and was further responsible for deposits and loans (Linton, IMF). Presently, the banking
  • 5. Ranga Wimalasuriya 06/06/2012 system consists of the “Big Four” state owned commercial banks (SOCBs), policy lending banks, joint stock commercial banks, city banks, rural and urban credit cooperative (RCCs) and foreign banks (Fig 3). The big four and the joint stock commercial banks (JSCBs) remain the dominant players and principle lenders to SOEs and are subjugated by government shareholders and management. All major banks along with the City Commercial banks (CCB) and the Rural Commercial Banks (RCB) have been converted into corporate entities subjected to a board of directors and supervisors (Herd, Pigott and Hill). JSCBs, according to Naughton (2007), are more efficient and hold considerably lower amounts of nonperforming loans (NPLs) and they have captured 15% of the total banking-system assets as of 2008. However, their effectiveness is constrained due to a lack of independence and experienced officials. Former government officials still operate within senior management acting as a hindrance for efficient banking (HPH). The policy banks were established to fund the central or local governments for infrastructures and development projects and lend to SOEs and account for 8% of total assets as of 2003. RCCs, once banking profitable TVEs in the countryside, fell out of favor following the Asian Financial Crisis. Since 2006, the government has pumped capital into RCCs as a part of the urban financial bailout (Naughton). Foreign banks, however, play a minute roll in China’s capital markets even though the government gave access to start-up “private banks in “20 localities”. (Naughton, Linton). The big four account for 53.5 percent of the total assets of financial institutions (excluding the people’s bank of China) as of 2004 with joint stock and city commercial banks which claim 20.7 percent, RCCs claiming 8.9 percent of the assets and Policy Banks with 7.7 (Naughton). Showcasing that 90.8 percent of all assets are controlled or under the watch of the central government with 9.2 percent belonging to foreign and private banks (fig.5).
  • 6. Ranga Wimalasuriya 06/06/2012 Fig 5. China’s major banking institutions, no of institutions, share of total Assets & share of total Loans, Dec, 2005 Linton claims it is this lack of independence in China’s banking system that has resulted in the banks focusing on financing needs of the government, SOEs and construction firms over the last decade. Allen, Qian and Qian(2004), compare the financial systems of a sample of countries (English origin, French origin, German origin and Scandinavian origin) to that of China. They find that the ratio of total bank credit to GDP is 1.13, higher than German-origin countries which are known to have heavy bank-dominated financial systems. However, when they consider bank credit issued only to the private sector (individually owned or publically traded companies) China’s ratio drops from 1.13 to 0.242 (Fig.6) reflecting the flow of capital to the public sector (state-owned companies). The second panel of Fig.6 compares the relative importance of financial markets against banks. “Structure activity” and “Structure size” are relative size measures which are equal to Log (market size/ bank size), with a smaller value indicating that the country’s financial markets are small than its banking system; China has the lowest score suggesting that its banking system is larger than its markets. A World Bank
  • 7. Ranga Wimalasuriya 06/06/2012 quarterly report cited that the recent most stimulus money is directed to benefit SOEs. This is partly due to the method in which state ownership is distributed in the economy. Most SOEs claim to have close relationships with the government and banks. SOEs have benefited from the stimulus injected (The Economist, world bank.org). Fig .6 Fig.7 Source: Wall Street Journal While China’s banking system is dominant, its stock and bond markets remain underdeveloped. They are smaller than most countries in terms of market capitalization and total value traded as a percentage of GDP (AKM) and total equity market capitalization is equivalent to 17 percent of GDP when compared to the average of 60 percent in other emerging markets (Farrell et al. 2006). The equity markets are largely controlled by the government and act as a platform to raise capital for SOEs that require privatization. Listed companies and IPOs on the stock market are former SOEs that are affiliated to government officials. The bond market lacks confidence
  • 8. Ranga Wimalasuriya 06/06/2012 due to a deficit of institutional investors or a reputed credit agency that offers the investor confidence to buy in. Large companies, therefore, “prefer borrowing from banks rather than issuing bonds”. Such actions could crowd out the ability for Small and Medium enterprises to borrow (AKM). SMEs Mu (2002) cites that post-Asian Financial Crisis events left the banking sector with a signifcant number of NPLs which average 30 percent of assets. He claims that this situation arose because loans were given out based on preferential treatment to inefficient SOEs and are further supported by unpaid principal and interest and below- market interest rates. Lending rates to SMEs were additionally set artificially low which led to rates not being attractive enough to encourage banks to lend out to SMEs, particularly when banks had high NPLs. This issue was addressed by the establishment of credit guarantee schemes (CGS) which Mu claims were helpful in promoting SME’s access to finance since they provide acceptable collaterals and assist in the mitigation of the poor credit analysis SMEs will otherwise face. However, CGS face much interference from local governments making it unable to operate in “accordance with market principles”. Zhao et al (2006) using a dataset from the Chengdu SME Administration (CDSMEAB) from 2003 to 2004 identified some main factors affecting SME’s access to capital as the lack of eligible collateral for loans or guarantees, low credit ratings or a lack of credit reporting system for SME, firm sizes (economies of scales)- the banks prefer to lend out to larger-sized SMEs- and political risks faced by bank staff in case of failure to repay loans.
  • 9. Ranga Wimalasuriya 06/06/2012 Prasad (2007) suggests that the banking system should be made more robust and driven by market principles but he does not specify how his ideas maybe integrated. According to him, the financial system should be broadened to create alternate sources of funding and investment opportunities for individuals and SMEs. Wang (2004) identifies the scarcity of capital, the lack of specialized financial institutions to serve SME reform, lack of direct financing channels and the monopoly of state owned banks as reasons for capital constraints in the private sector. As solutions, he suggests that “China should increase the overall volume and credit proportion for SMEs”, especially bank credit, develop small and medium financial institutions and reform RCCs so they can be independent and adopt a flexible interest rate system. Wang’s countermeasures are explained in detail; however, he has not cited examples of how effectives his proposed measures will be and it is unclear whether such policy actions will be effective if China should implement them. On the contrary, Lardy claims that the access to capital especially with regard to households and the private sector has risen dramatically. In his structure of household borrowing from banks, the total loans outstanding to households stood at RMB.11, 258.6 Billion (PBOC), 225 times higher than what it was in 1997. He claims that a majority of the household loans extended were for business borrowing- 33.3 percent; bank loans to households stood at 28 percent of GDP more than 45 times the share at the end of 1997. This significant improvement in capital allocation will help family businesses expand and household consumption increase. Lardy further states that “China is an outlier on the high side in terms of consumer credit availability” in comparison to emerging markets. Although his account of capital access to households is comprehensive and positive, he hardly analyzes this from an SME perspective. He does not explicitly breakdown household business borrowing and we do
  • 10. Ranga Wimalasuriya 06/06/2012 not get an account of what kinds of businesses these household seem to run. He also fails to analyze other sources of financing such as FDI and the informal loans market that the private sector seems to rely on. In addition to the question of capital constraints, existing literature has cited domestic SMEs could also be facing a problem of consumption (WSJ 2012). This being the case, SMEs that are not export oriented will face many difficulties operating due to lack of demand from domestic customers, driving them out of business. China needs to reallocate capital towards producing goods and services that Chinese consumers want to consume and this will require banking changes, especially improving access to capital for SMEs that “make the modern consumption-driven economy tick”. The aim of this paper is to identify the characteristics of capital allocation to the private sector, specifically SMEs in China. It will attempt to track the flow of capital from its origin (e.g. households) to China’s financial system and other financial institutions that act as intermediaries for capital allocation to SMEs; and analyze both direct and indirect sources of financing that have helped firms grow exponentially over the last decade a gap that is present in current literature related to the topic.The paper will then evaluate four important reforms that standout from the existing literature: less government control over the financial system “breaking up the monopoly”, liberalizing interest rates, regulating the informal loans market and a credit rating system.
  • 11. Ranga Wimalasuriya 06/06/2012 Characteristics of Chinese Capital: Formal Financing Fig .8 A major source of capital for formal financing arise from household savings, enterprises savings and government savings. Fig.8 Shows the gross domestic savings in China has increased since 2000 and comprises more than 50 percent of Gross Domestic Product. Household savings on aggregate has risen by 6 percentage points over the last 10 years (Prasad and Chan). Chinese household’s savings rate has continued to increase over the last decade and this is despite a negative real return rate from the banks. According to Prasad and Chan, this unstoppable increase in savings or the target savings by households is due to declining public provisions such as health and education; other factors include the presence of a target savings rate due to China’s transition to a market economy. A high savings rate such as that depicted by the Chinese economy may not be beneficial for domestic SMEs that depend on local demand and consumption for their operations. If the trend continues, China’s economic expansion will slow down and China’s attempts to adopt a consumer driven model by moving away from an exports or investments driven model will suffer.
  • 12. Ranga Wimalasuriya 06/06/2012 Capital Allocation Cycle Fig.9 • Household Savings Government Bonds • Enterprise Savings Corporate Bonds Stocks • Government Savings 6.4% 6% 9.5% 78% Banks & share of Total Loans- formal market • The BIG Four 50.5% • Joint Stock Commercial banks 15.4 % • City Commercial Banks 5.2% • Urban Credit Cooperatives .5% • Rural Credit Cooperatives 8.9% • Policy Banks 15.4% • Foreign Banks 1.6% Shadow banking / informal loans market Central Government • 30% of all loans made out Individuals, SMEs SOEs households Source: China Statistical Yearbook Fig. 8 and 9 depicts how dependent formal market financing is on the savings of the Chinese public. Fig.9 shows the big picture of capital allocation within the Chinese economy. The high household savings rate contributes a major share of the overall capital allocation within the rest of the Chinese economy. Household savings, enterprise savings and government savings made up 78% of the total formal market loans made out in 2005. Government bonds, corporate bonds and stocks made up the remaining 22% highlighting China’s weak capital markets. The big four banks are responsible for over 50 % of the total loans made out with foreign banks holding just 1.6%. Clearly, this divide seems to favor SOE funding given the authority the big four hold over the rest of the financial system. Shadow banking and the informal loans market hold 30% of all the loans made out and is therefore an important segment of China’s private sector financing. AKK using a data set of
  • 13. Ranga Wimalasuriya 06/06/2012 twenty four hundred firms found that 43% of firms in China used alternative forms of finance compared to an average of 9% in emerging markets and Allen, Qian and Qian claimed that the fastest growing Chinese firms used alternative channels of finance rather than formal financing. Fig 3 compliments these findings with the growth shown by both small and medium enterprises over the last decade despite poor access to formal finance. The following sections will analyze the sources of financing and analyze both direct and indirect sources of financing that have helped firms grow exponentially over the last decade and the methodology will present how I went about conducting my research. Methodology The aim of this paper is to identify the characteristics of capital allocation to the private sector, specifically SMEs in China. There are different sources of funding that domestic firms use for daily operations or expansion. In the formal market, retained earnings is the cheapest source of capital and can be implemented without any external constraints, domestic loans from a bank is the second cheapest source of capital and fundraising through bonds/stock market is relatively more expensive source as equity is costlier than debt. Funding can be categorized into two types- Informal and Formal financing. Formal financing includes bank financing through local commercial banks and foreign commercial banks, state budget and debt financing through China’s capital markets. Informal financing refers to “internal finance”- retained earnings, loans from a family or friend and financing from an underground bank. I will use data drawn from the China statistical year book from 2000-2010, a data set obtained from Dr.David Hall and the investment climate survey conducted by the world bank in 2006 for my analysis. Part 1 explores the macro level climate of credit allocation to the private
  • 14. Ranga Wimalasuriya 06/06/2012 sector in China. Part 2 will attempt to identify the various channels of financing (both informal and formal ) and the share of each channel regarding firms. Part 3 analyzes total investment in fixed assets across firms; this will enable us to distinguish the types of firms that have expanded over the last four years relative to the type of financing and part 4 analyzes capital allocation on a regional and categorical level. Analysis part 1 Domestic Credit extended to the Private sector as a % of GDP Figure 1 depicts the domestic credit extended to the private sector in the form of formal loans as a % of GDP. The graph gives us a general idea of how strict capital allocation is within the private sector with relation to public vs. private credit allocation. This graph also accounts for housing loans as a part of private sector investment. Source: The World Bank . Fig 1. The data does not give a break down of how this credit is distributed within the private sector on a firm level( small, medium and large enterprise), industrial level or a regional level. The horizontally connected lines compare China to the United States, Spain, Germany and India. The annual World Development Indicators (World Bank, 2004b) in 2002 summarized domestic credit provided by the banking sector in middle-income countries to be 83 percent of GDP, 49 percent of GDP for low-income countries and 168 percent of GDP for high income countries.
  • 15. Ranga Wimalasuriya 06/06/2012 Ignoring the variables not addressed in the data, China and Germany seem to be on par at 150 and 130 percent of GDP respectively with the United States and Spain close to 230 percent and India below 100 percent of GDP. The level of domestic credit extended to the private sector for China being on par with Germany is an encouraging prospect ignoring the variables not addressed by the data. Analysis Part 2 In Figure 2. the horizontally connected lines represent how each source of funding is distributed amongst China’s firms with regard to investment in fixed assets. There are four sources of funding for investment in terms of fixed assets in China: State Budget, Domestic Loans, Foreign Investment (FI) and Self fundraising; the sources of funding can differ from country to country. The State budget was a significant source of financing in the early 90’s with SOEs heavily dependent on the State budget for operations and the Chinese economy following a centrally planned system. As of 2009 the state budget accounted for only 5.1 percent of the total and this maybe due to a result of the Chinese government refocusing spending on education, healthcare and military defense. Foreign investment refers to foreign funds acting as a source for domestic firms to invest in fixed assets and is not a measure of foreign investment in ownership form. Foreign investment sources has reduced to 1.8 percent as of 2009. The two prominent sources of funding are self-fundraising and domestic loans. Domestic loans in aggregate occupy 15 percent of the total financing and constitutes 30 percent of financing in large companies (Fig.5). Domestic loans since 2000 have grown at a CAGR of 19.21%. Self-fundraising comprises of retained earnings, informal loans, funds raised from local communities ( family and friends) and local governments. Self-fundraising is the
  • 16. Ranga Wimalasuriya 06/06/2012 largest source of financing accounts for 77 percent of the total. Self-fundraising is an important source of financing for many types of firms and it involves both individually owned companies (private sector) and interestingly state or quasi-state-owned companies as well. An interesting observation of the data is the downward trajectory of the state budget as a source of funding; this may have led to increased self-fundraising and might lead to increased foreign investment in the future. Source: China Statistical Year Book, Fig.2 Analysis part 3 Given we have an understanding of the sources of funding within China’s financial system from part 2 it will be worthwhile to analyze the categories of firms affected by these sources. The following figure illustrates the distribution of fixed asset investment in China across firms. Fixed assets are long-term tangible pieces of property like buildings, real estate, equipment and machinery that a firm may use in the production of its income. An account of fixed asset investment across firms will help distinguish the firms that have expanded over the last four years.
  • 17. Ranga Wimalasuriya 06/06/2012 The blue bars represent the total investment value in 100 million Yuan and the horizontally connected lines show the different categories of firms. SOEs and LLCs seem to have invested the most over the last 5- years with a CAGR of 19.95% for SOEs. The share of investment for private enterprises has increased whilst the share for individuals have declined. Foreign firms with funds mostly from Hong Kong, Macau and Taiwan account for about 7% of the total. The large share of fixed asset investment by SOEs indicate the expansionary path SOEs have taken over the four year period. This could be a result of the stimulus package that was extended by the Chinese government, better access to domestic loans through the banking sector or profits raised through self- Source: China Statistical Year Book. Fig.3 fundraising. However, construction (property) and infrastructure are two sectors that the Chinese government has invested a lot of capital in over the last decade and most large construction companies, steel and cement companies are SOEs. This is could mean that SOEs are directly benefited from this surge in construction and are therefore served with easier access to capital. Source: China Statistical Year Book Fig .4
  • 18. Ranga Wimalasuriya 06/06/2012 Figure.4 shows the total amount of short loans from the total loans markets given out to township-village enterprises, enterprises with foreign funds and private enterprises and self- employed individuals. Freedman et. al (2006) cites that bank lending to SMEs ( private enterprises and self-employed individuals in fig 4.) in developing economies mostly comprise of short-term loans . This is because banks make lending decisions based largely on the value of assets pledged by a borrow rather than a borrower’s expected revenues and cash flows. In Fig 4. the ratio (d/a) of short term loans to private enterprises and self-employed individuals depict that only 5% of the total short term loans are distributed to the segment. However, there seems to be a rise in short term loans from 2% in 2005 to 5% in 2009. Analysis Part 4 Parts one, two and three analyzed capital allocation to the private sector from a macro level , firm level and attempted to evaluate the distribution of short term loans for private firms and SMEs. Part four will address the level of capital allocation across regions in China; a regional comparison will help us determine the overall efficiency of capital allocation in China. In Figure.5, Allen et.al (2005) and Ayagari et. al (2007) conducted studies on the types of financing within firms across the five regions- Central, Coastal,Northeast, Northwest and Southwest in China and Figure 5 portrays some of the patterns they inferred. Allen et. al categorizes financing to Bank Financing and Self- Fundraising; they find that 20.63% of the financing is drawn out of bank loans and 79.37% through self- fundraising. Ayagari et. al further breakdown the 79.37% of self-fundraising across regions. Central and Northwest regions that are inland seem to have the highest percentage of self-fundraising firms. The
  • 19. Ranga Wimalasuriya 06/06/2012 Coastal and Southwest with better access to ports, tax arrangements and favorable policies show a higher percentage of bank financing for firms (Ayagari et. al). Source: Allen et.al (2005) and Ayyagari et. Al (2007), Fig.5 Micro, small, medium, large and very large firms are categorized according to their financing patters in Figure 6 according to Allen et al (2005) and Ayyagari et. Al (2007). Large and very large firms (30%) seem to use more of Bank financing than the Small , Micro and Medium enterprises (14- 15 and 22%). Internal financing (self fundraising) seems to be the largest source of funding across all firms with even the Very large firms (majority of them SOEs) taking up 55% of the total. Source: Allen et.al (2005) and Ayyagari et. Al (2007). Fig.6
  • 20. Ranga Wimalasuriya 06/06/2012 Discussion Micro, small and medium enterprises are more restricted from formal financing than the large and very large firms (fig 6.) This could be affiliated to the growth stages of the firms with start-up firms (mainly comprising of small firms) receiving less formal financing due to the financial system’s lack of a credit rating systems,strong relations with small enterprises or the inability to better understand the business. Formal financing also requires collateral as fixed assets and this is a hindrance for a start-up firm or medium enterprise in China. In addition, the People’s Bank of China over the last three years has hiked reserve ratios and tightened loan quotas, limiting liquidity in the loan market. The PBC also maintain a ceiling on interest rates and strict interest rates fail to reflect risks of lending to SMEs from a lender’s standpoint, thereby restricting banks from lending to SMEs. This restriction on formal lending has resulted in the increase of self fundraising (retained earnings, informal loans, family and friends) as a source over the last decade (Fig.2) with both SOEs and SMEs contributing to its growth in two different ways. Restrictions on capital flow in the formal financing market has led SMEs resort to self fundraising through retained earnings, informal loans and family with most firms taping into the informal loans market. SOEs that are mainly large construction companies on the other hand has taken up the lending practice (because of their access to easy capital) in the informal loans market to serve SMEs (that are mostly small property developers) that are restricted to capital from the formal sector. This has resulted in the expansion of informal lending institutions and evidence of this is seen in Fig.2 with self-fundraising increasing as a source from 70 percent to 80 percent over the last six years. According to a Credit Suisse report, 60% of the informal lending has been channeled into the property sector with the biggest borrowers being small and medium size real estate developers. The informal loans market accounts for nearly four Trillion RMB or about 8% of the formal
  • 21. Ranga Wimalasuriya 06/06/2012 lending market with interest rates ranging among 14% to 70%. SOEs gain funding through high interest rate loans offered to SMEs in the informal loans market and SMEs gain funding through informal loans supported by SOEs; it is a cycle if not regulated could result in a credit crunch that could significantly undermine China’s growth and investor confidence. Based on the evidence presented this paper will suggest four reforms that will help the financial system address the concerns stated above: less government control over the financial system “breaking up the monopoly”, liberalizing interest rates, regulating the informal loans market, a credit rating system. Suggested Financial Reforms in China 1. Reducing government control of the financial system Continual government intervention has restricted SMEs access to finance despite the reforms that have taken place over the last decade.A possible solution would be to increase the PBOC’s independence from the government to improve SME financing, privatize the four large-state owned that control nearly 50% of total assets and reduce government control in equity markets. Increased independence for the PBOC will restrict the authorities from interfering in lending behavior of commercial banks especially through political appointments to high positions. China’s equity markets have made considerable improvement over the last decade but further liberalization to allow public companies access to equity markets and less government entities will be beneficial to SMEs seeking funding.
  • 22. Ranga Wimalasuriya 06/06/2012 2. Liberalize interest rates Liberalizing interest rates is the process of replacing state-controlled interest rates with market-based interest rates. China’s interest rates are extremely low and currently yielding negative real rates of return to savers and hampering SMEs financing from the formal market. China’s major state-owned banks sit on high profits and nearly 80 percent of it comes from interest earnings. The liberalization of interest rates will help free up deposits and lending rates and allow banks spread risk when allocating loans to high risk SMEs that are in need of formal financing. Secondly, should China liberalize interest rates, it will allow its equity markets and especially the bond market to develop which is an additional channel of financing for SMEs. Hence, interest rate liberalization is an essential step for the Chinese economy if SME financing is to improve. 3. Regulating the informal loans market The Chinese Banking Regulatory Commission which regulates banks estimates the size of the informal lending market to be between $500-$800 Billion. Informal loans market is a significant component of “Self Fundraising” that takes up nearly 80 percent of all financing for firms. It is an important component of the Chinese financial system and it must be standardized and brought into the open with clear legal safeguards. The process of regulating could involve issuing licenses to private lenders and imposing deposit collection and capital requirements and a cap on the interest rates offered. If the informal loans market is not regulated it will continue to “eat away at the depositor base of the big banks” (Lardy, 2007).
  • 23. Ranga Wimalasuriya 06/06/2012 4. A credit rating system The Chinese financial system has no credit rating system and often fail to identify a businesses' credit worthiness; this makes financing difficult for SMEs as they are not well known firms or maintain no close relations with the bank. Furthermore, the banking staff is also under pressure given the amount of non-Performing loans that already exist in the banking sector. Some innovative banks have resorted to analyzing a firm’s cash flows, import or export customs declaration form and water meter bills to verify activity and this is an option that could be introduced to the entire banking sector. Conclusion The Chinese financial system has undergone many significant changes over the last decade but SME financing and efficient capital allocation to the private sector remains a problem. The recent financial crisis has increased the informal loans market and deteriorated formal financing. Structural problems within the financial system has restricted efficient capital allocation; these structural problems involve government control of the financial system, interest rate ceilings, an unregulated informal loans market and the lack of a credit rating system. It is essential that the Chinese government address these reforms above others if they are to strengthen its financial system. Reducing government control from the state dominating banking system and equity markets will require a lot of effort and may be a gradual process but it is essential that steps are taken to regulate the informal loans market and liberalize interest rates since China is a growing economy.
  • 24. Ranga Wimalasuriya 06/06/2012 I. BILIOGRAPHY: 1. Allen, Franklin, Jun Qian, and Meijun Qian. "China's Financial System: Past, Present, and Future." (2004). 2. "China Economy: Struggling SME Sector." British Embassy Beijing (2011) 3. "Gregory, Neil, Stoyan Tenev, and Dilleep Wagle. "China's Emerging Private Enterprises: Prospects for the New Century." International Finance Corporation (2002). 4. Guariglia, Alessandra, Xiaoxuan Liu, and Lina Song. "Is the Growth of Chinese Firms Constrained by Internal Finance." (2008). 5. Hilgers, Lauren. "SMEs in China." Industry Outlook (2009). 6. Huang, Yasheng. Capitalism with Chinese Characteristics: Entrepreneurship and the State. Cambridge: Cambridge UP, 2008. 7. Shirai, Sayuri. "Banks' Lending Behavior and Firms' Corporate Financing Pattern in the People's Republic of China." ADB Institute Research Paper (2002). 8. Allen, Franklin, Jun Qian, and Meijun Qian. "Law, Finance, and Economic Growth." Journal of Financial Economics -.- (2004): -. 9. Khanna, Tarun. Billions of entrepreneurs: how China and India are reshaping their futures--and yours. Boston, Mass.: Harvard Business School Press, 2007 10. Connor Linton, Katherine . "Access to Capital in China: Competitive Conditions for Foreign and Domestic Firms." Journal of International Commerce and Economics -.- (2006): 11. Wang, Yanzhong . "Financing Difficulties and Structural Characteristics of SMEs in China."China & World Economy Vol. 12, No. 2,.34-49 (200): -. 12. Garcia–Fontes, Walter . "Small and medium enterprises financing in China." Universitat Pompeu Fabra -.- (2005): -. Print 13. HILGERS, LAUREN . "SMEs in China."INDUSTRY OUTLOOK -.- (2009): -. Print.
  • 25. Ranga Wimalasuriya 06/06/2012 14. Li, Guoying . "Barriers of supporting the SMEs entrepreneurs financially in China –a structural analysis and policy implications." 2010 International Conference on Economics, Business and Managementvol.2..- (2011): 15. W. L. Fong, Michelle. "Chinese SMEs and Information Technology Adoption." Issues in Informing Science and Information Technologyvol.8.- (2011): -. Print. 16. Prasad, Eswar , Marcos Chamon, and Kai Liu. "W. L. Fong, Michelle. "Chinese SMEs and Information Technology Adoption." Issues in Informing Science and Information Technology vol.8.- (2011): -. Print.."IMF Working Paper -.- (2010) 17. S. PRASAD, Eswar . "Is the Chinese growth miracle built to last?." China Economic Review -.- (2009): - 18. Bosworth, Barry , and Susan M. Collins. "Accounting for Growth: Comparing China and India." Journal of Economic Perspectives 22.- (2008): 45–66. Print 19. Prasad, Eswar , and Marvin Goodfriend. "A Framework for Independent Monetary Policy in China." IMF Working Paper -.- (2006): -. 20. D. Chamon, Marcos, and Eswar S. Prasad*. "Why Are Saving Rates of Urban Households in China Rising."American Economic Journal: Macroeconomics -.- (2010): 21. HALL, CHRIS . "WHEN THE DRAGON AWAKES: INTERNATIONALISATION OF SMES IN CHINA AND IMPLICATIONS FOR EUROPE." CEISfo-.- (2007): 22. Zhu , Yanmei, Xinhua Wittmann, and Mike W. Peng. "Institution-based barriers to innovation in SMEs in China." Springer Science+Business Media -.- (2011): -. 23. Ayyagari , Meghana , Asli Demirgüç-Kunt , and Vojislav Maksimovic. "Formal versus Informal Finance: Evidence from China." 24. "China’s Scary Financial System - Economic Intelligence (usnews.com)."US News & World Report | News & Rankings | Best Colleges, Best Hospitals, and more. N.p., n.d. Web. 6 June 2012. http://www.usnews.com/opinion/blogs/economic-intelligence/2012/05/21/chinas-scary- financial-system 25. Tao, Dong. "China: Rising risk in informal lending ." Economics Research- Credit Suisse -.- (2011 26. Qian, Wei , and Li Tong. "China Mulls Legalizing Informal Lending."China.org.cn -.- (2012):
  • 26. Ranga Wimalasuriya 06/06/2012 27. The Australian. N.p., n.d. Web. 6 June 2012. http://www.theaustralian.com.au/business/wall- street-journal/wenzhou-reforms-point-to-cleanup-of-chinas-financial-system/story-fnay3ubk- 1226313201030>.
  • 27. Ranga Wimalasuriya 06/06/2012 Table 1: Definition of Financial Intermediaries/Institutions in China
  • 28. Ranga Wimalasuriya 06/06/2012 Source: Law, Finance, and Economic Growth in China
  • 29. Ranga Wimalasuriya 06/06/2012 -