Small and medium enterprises - the source of China’s economic miracle - and their financing challenges


by Dr. Wei Li
CSC academic group: Enterprise Development

Wei Li is a postdoctoral research fellow at the University of Sydney Business School and the China Studies Centre. Her research interests include China’s economic transition, Chinese investment into Australia, globalization of the state owned enterprises, common resource governance, and urban sustainability.

Small and medium enterprises (SMEs) now play a significant role in China’s economic development. The institutional environment of China was originally unfavourable for the emergence and development of SMEs. Private enterprises (which are mostly SMEs), for example, were not permitted to exist until 1988, ten years after economic reform started in 1978. However, the increasingly significant contribution of SMEs to the economic growth of the country prompted the Chinese government to improve policies and measures concerning the development of SMEs. In 2002, the central government promulgated the SME Promotion Law, signalling a major shift in attitude from the central government towards SMEs after years of market reform.

Source of China’s economic miracle

quote SMEs played an essential role in driving economic growth through investment in fixed assets, generating exports, and promoting technology assimilation. SMEs are estimated to contribute more than 60 per cent of China’s GDP.

SMEs have contributed hugely to the creation of China’s economic miracle. In particular, SMEs played an essential role in driving economic growth through investment in fixed assets, generating exports, and promoting technology assimilation. SMEs are estimated to contribute more than 60 per cent of China’s GDP. As Table 1 shows, private enterprises (overwhelmingly SMEs) have overtaken state owned enterprises (SOEs), becoming the biggest source of investment in urban fixed assets. In 2010, private enterprises accounted for over half of the total investment in urban fixed assets. Private enterprises have also surpassed SOEs in generating exports. In 2010, private enterprises’ total exports were double the value of exports from SOEs. In addition, SMEs’ role in promoting technology assimilation should not be neglected. A great number of technology-oriented SMEs are headquartered in innovation and high technology zones in cities like Beijing and Shenzhen. These SMEs, which are flexible and able to rapidly adapt to new technologies as well as to draw in and train specialized human capital, are significant in making new services and products available and facilitating the spread of technology and innovation. Let us take the development of the solar industry in Dezhou city as an example. While local large manufacturers such as Himin Group have shown strong leadership in undertaking major R&D projects, small businesses are important in forming industrial agglomeration, which has catalysed the deployment of solar innovations.


Table 1: Investment in urban fixed assets and exports, 2004-2010 (percentage by source)

Table 1: Investment in urban fixed assets and exports, 2004-2010 (percentage by source)
ª2005 figure.
Source: Huang (ed.), 2012, Annual Report of Non-state Owned Economy in China No.8 (2010-2011), Social Science Academic Press.

Furthermore, the SME sector contributes to China’s economic miracle by serving as an engine of job creation. The SME sector is a large provider of employment in China, especially new jobs. Currently, SMEs account for around 80 percent of China’s manufacturing employment and are estimated to create 80 per cent of new urban employment. More importantly, SMEs employ more low-income workers and socially vulnerable groups and sometimes are the only source of employment in poorer regions. The opportunity to work at SMEs also provides disadvantaged groups with access to knowledge which comes from working with other people, potentially generating positive externalities for improving human capital.

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The growth of SMEs also means that there are sufficient participants in the market to create competitive market pressure and expanding China’s market economy. Together with foreign investment companies, SMEs make up the bulk of China’s privately owned sector. A sufficient number of participants and transactions in the market improves overall efficiencies. Besides, SME development is also essential for simultaneously absorbing resources and workers laid-off or dispersed from the restructuring of the large enterprise sector, so that market reform can be carried through smoothly. Based on statistics from China’s Information Office of the State Council, from 1998 to 2003, nearly 19 million workers laid-off from SOEs were re-employed, and most of them went to SMEs.

Tax revenue collected from SMEs has also increased significantly in the last decade. Its average annual growth rate of around 25 per cent is well above China’s GDP growth rate. In 2010, tax revenue collected from private enterprises topped 800 billion yuan, accounting for nearly 11 per cent of the total tax take. In theory, this stream of tax revenue gives governments more leverage to roll out appropriate fiscal policies to boost growth and finance key infrastructure and social programs.

Tax revenue collected from SMEs has also increased significantly in the last decade. Its average annual growth rate of around 25 per cent is well above China’s GDP growth rate. In 2010, tax revenue collected from private enterprises topped 800 billion yuan, accounting for nearly 11 per cent of the total tax take. In theory, this stream of tax revenue gives governments more leverage to roll out appropriate fiscal policies to boost growth and finance key infrastructure and social programs.

Financing challenges

Although SMEs are a major source of China’s economic miracle, underfunding is a risk for the health and continuing growth of China’s SME sector. China Enterprise Survey System’s latest data indicates that more than 40 per cent of the 4,283 surveyed enterprises considered lack of finance to be their greatest challenge. Credit assets of state institutions are disproportionately composed of loans allocated to SOEs and large enterprises. Based on a recent survey, 66 per cent of SMEs sampled claimed that they had difficulty accessing bank finance. The situation has worsened since the global financial crisis in 2008. The monetary tightening policy adopted by the People’s Bank of China further marginalized SMEs from the formal banking system.

Economic theory suggests that credit market failure, attributed to information asymmetries, is the key cause for lack of finance for SMEs. Lenders are imperfectly informed about borrowers. Bank officers do not have ‘perfect’ information on enterprises and their proposals. This leads to insufficient credit available for sound or ‘bankable’ propositions. Enterprises in their early stages of development such as the SMEs face more acute asymmetric information problems, because information on these enterprises is limited and they sometimes lack transparency. Also, assets of start-up firms are often knowledge based and exclusively associated with the founding entrepreneurs. Take manufacturing or technology based start-up firms as an example. Entrepreneurs will be reluctant to provide full information about their knowledge of opportunity, as disclosure may help competitors. In this context, banking institutions face higher costs in obtaining information and monitoring small enterprises, and thus have less incentive to extend credit to them.

quote establishing a financial framework that fosters competition and transparency should be the long-term reform direction for China, as it will not only support SME growth, but also increase resource allocation efficiency in other economic systems and encourage investment to move towards more productive projects and entrepreneurship, facilitating broader-based growth.

In China’s case, the finance challenge is even greater for SMEs. Underlying their financing problems is the ongoing reform of China's financial system. Potential issues include the high market share of large state-owned commercial banks in deposits and loans, interest rate controls, insufficient development of the capital market, and restrictions on cross-border capital transactions. However, since financial policies and institutions are an essential part of China’s macroeconomic policies, they have always been designed to facilitate national economic development. Any reform of the financial system to promote SMEs has to be aligned with other economic policies, and be undertaken within the current context of economic reform. Nevertheless, establishing a financial framework that fosters competition and transparency should be the long-term reform direction for China, as it will not only support SME growth, but also increase resource allocation efficiency in other economic systems and encourage investment to move towards more productive projects and entrepreneurship, facilitating broader-based growth.

Another issue that hinders Chinese SMEs’ access to formal finance is that most of them lack formal corporate structures or fixed assets as collateral and their ownership and financial structures tend to be opaque. Firms keep two sets of accounting books: one for official declaration, one for internal usage. In an interview, one owner of a squid boat business in Zhejiang Province explained that there were five official shareholders on the company’s registration certificate, but behind each of official shareholders were several ‘invisible’ shareholders who provided start-up and operational funds to the business and received ownership interests. This makes it difficult for banks to evaluate their operation and financial circumstances. Moreover, China lacks an adequate credit rating system for SMEs, or the appropriate financial-service institutions. This lessens the incentives for SMEs to build a credit reputation.

Finally, to respond appropriately to SMEs’ financing challenges, it is important to note the distinct features of China’s SME financing structure. In particular, informal and semi-formal finances provide a major source of credit for China’s SMEs. Yet, rather than being regulated by formal laws, they are mainly supported by informal rules, social norms and structures, and enterprise relations, which have evolved through social and market development and vary from one locality to another. Thus, the same type of informal finance can play a different role in local economies across regions, due to the heterogeneity of local institutional support. Moreover, the boundary between formal and informal finance institutions in China is not always clear. There is a transition from informal to formal finance institutions where some finance institutions and arrangements can be either formal or semi-formal. These finance institutions operate with peculiar arrangements, some of which are not legal but are not discouraged by law enforcement agencies either, although the degree of tolerance varies from one locality to another. Therefore, policies targeting SME finance should take into consideration these variations and dynamics.

The good news is that certain reforms have already been rolling out. In March this year, the central government approved plans to set up a pilot zone in Wenzhou city to regulate semi-formal and informal financing activities. A batch of non-governmental financing institutions has received permission to be set up officially on a trial basis. Wenzhou’s experience will provide lessons for the wider and deeper level of financial reform.
In the open ceremony of China’s 18th Party Congress this month, Hu Jintao in his report stresses:

We should deepen reform of the financial system and improve the modern financial system so that it will better contribute to macroeconomic stability and support development of the real economy.

The world has its eyes on one of the world’s largest financial system undergoing reform.