By Zhang Chenghui

I. New Characteristics of Financing Difficulty of Privately-owned Enterprises

Since the mid 1990s, along with the development of the market economy in China and changes in the internal and external economic and trade environments, the slow transformation of the operation system of the State-owned economy has become more and more conspicuous. The State-owned economy has experienced considerable growth drop, and its driving role in the national economy has significantly weakened. In sharp contrast, due to the exuberant vitality and market competitiveness, the private economy has overtaken the State-owned economy to become the most active, the fastest developing and the largest contributing sector to economic growth.

Along with the rapid development of the private economy, the problem of financing difficulty that has long haunted private enterprises begins to attract the attention of the government management departments and the financial sector. Nonetheless, financing difficulty of the private enterprises remains to be a practical problem, which has demonstrated some new characteristics under the new situation.

Firstly, there is less difficulty in obtaining short-term fund but a serious shortage of long-term equity capital. In fact, thanks to the effort of local governments, the problem of financing difficulty of private enterprises has been eased. However, the current financial system has only granted short-term loans to private enterprises, while the mid-and long-term credit and equity capital are still seriously insufficient. In particular, instead of short-term lending, a large number of high-tech enterprises in the start-up stage are most in need of the mid- and long-term loans and equity investment, which are very difficult to obtain from the formal financial system.

Secondly, the problem of financing difficulty of large enterprises has been eased but that for the medium-sized and small enterprises still remains. So far, the private economy has developed into three groups. The first includes the famous enterprises, such as Haier, with over ten billion yuan of annual sales income and several ten billion yuan of intangible assets for the brands. These enterprises are the heated targets of bank loans and have no problem in raising funds from the securities market. And, therefore, they do not suffer from financing difficulty.The second covers group companies that have laid foundations through years' of development. Compared with the first group of enterprises, they do have more difficulty with the banks. However, with their production capacity, assets and reputation, they still manage to find some financing channels. In fact, some of these enterprises are preparing to list in the stock markets. The third group consists of the small and medium-sized enterprises. They are the largest in number, suffer from poor credibility or no credibility, have few assets for mortgage, with incomplete financial system as well as small but frequent capital demands. The banking sector dares not make loans to them so readily. Even when they agree to lend, the lending conditions are relatively harsh. In order to develop, these enterprises usually have to raise fund from informal financial activities.

Thirdly, the large and medium-sized cities enjoy sufficient capital supply but counties or areas below county-level suffer from capital shortage. In recent years, lending capital concentrates increasing in the cities, leaving counties and below-county-level areas without capital supply. According to reports, 88 counties in Shandong Province experienced zero or negative growth in loans in 2000, while none of the counties in Henan Province received any new loan from the State-owned commercial banks.

Fourthly, the difference among the ownership system is diminishing, but still remains. Because of the long-term influence of the planned economy, the "private ownership fear phobia" is still omnipresent among the State-owned commercial banks. In practice, the ideological problems of the law enforcement and auditing departments lead them to neglect the bad loan accounts of the State-owned enterprises, but to investigate for legal responsibilities when such accounts appear in private enterprises. As a result, the lending staff of banks usually try to avoid making loans to private enterprises, in specific lending appraisal, they tend to report higher risks assessments of private enterprises than that of the State-owned enterprises.

In general, despite a relatively sufficient social capital at present, neither the formal indirect financing system nor the capital market has ever provided sufficient capital to private enterprises. Currently, many private enterprises have taken the path of standard and rapid development. Some of them have completed capital accumulation and are heading for the second business establishment stage. In addition, many private high-tech enterprises with high starting points and more technical content are setting up their business. Capital demand of these enterprises will be more urgent. If financing difficulties remain, they will not only influence the development of the private economy, but also further intensify financing actions outside the formal financial system and affect the healthy operation of the economic system.

II. Causes of Insufficient Capital Supply to Private Enterprises under the Current Indirect Financing System

On the one hand, the commercial banks hold abundant capital but generally feel it is "difficult to lend". On the other hand, many small and medium-sized private enterprises suffer bitterly from "difficult to borrow". Indeed, the fundamental cause is the large gap between capital demand and supply.

1. Structural defects in the organisational framework of the banks

Since the reform, in order to break the high monopoly of the state banks and promote market competition, China has gradually set up over 10 share-holding commercial banks and more than 90 urban commercial banks. However, the organisational framework of the banks remains seriously distorted and far from rational. Compared with the rapid development of the small and medium-sized private enterprises, the number and capital strength of the small and medium-sized banks are too insufficient to provide satisfactory financing services. Take Minsheng Bank for example, who targets its services on private enterprises. The proportions of savings and loans of Minsheng Bank only take up 0.4 percent and 0.36 percent, respectively, of the total savings and loans of financial institutions. Even if all the urban commercial banks and urban credit co-operatives are taken into account, the proportions of their savings and loans are still as little as 5.5 percnet and 4.7 percent, respectively1. Over the past few years, the State started to attach importance to financial services for SMEs. Under the supervision and urge of the government, lending departments (committees) for small and medium-sized enterprises have been set up in all large banks. However, there have been few achievements in practice, mainly due to considerations in the operational costs of banks. Lending by large banks to small and medium-sized enterprises will inevitably generate relatively large overhead expenses, which are not conducive to banking efficiency and credit risk control. Along with the strengthening of risk-prevention awareness of the state-owned banks, minimising capital risks has become one of the leading factors in present banking operations. The lending staff naturally lack enthusiasm for the small and medium-sized enterprises with great risks and low profits. After the East Asia financial crisis, the lending rights of the branch agencies of the State-owned large commercial banks were taken back, many non-banking financial institutions were dissolved or annexed, and numerous rural credit co-operatives basically paralysed. As a result, a business blank emerged and the financing difficulty of small and medium-sized private enterprises further intensified.

2. Defects in the operational mechanism of commercial banks and non-banking financial institutions

The four largest state-owned commercial banks have the most evident defects in their operational mechanism. The problem of nominal property ownership of the state banks has never been solved since reform, leading to serious distortions in the legal person governance structure of the banks and the widespread insider control and moral hazards. On the other hand, to certain degree, the government still regards the four largest banks as its affiliating departments and policy instrument. The system under which commercial banks may operate independently, bear the responsibility for their own risks and set their operation objective of maximizing profits has not been established. Under current circumstances, it is very difficult for the four largest state-owed banks to operate according to business rules, improve their financial services and raise efficiency. In particular, with the strengthening of loan risk constraints and the lacking of the matching interest stimulating mechanism, the lending staff usually try to avoid risks in practice by stressing on the "absence of good project", which only intensifies the financing difficulty of the small and medium-sized private enterprises.

Secondly, there is a widespread governance structure defect among the share-holding commercial banks. For example, the Ever Bright Bank and Huanxia Bank have not completely adopted the share-holding enterprise system yet, the CITIC Industrial Bank is still affiliated with all its asset to CITIC, and Minsheng Bank is still largely under government interference in its operational activities and thus remains a semi-governmental bank.

Thirdly, the urban commercial banks still lack property ownership constraints after the system reform. In addition, due to the one-sided requirements in the ownership system reform of urban credit cooperatives, some of the urban commercial banks have incurred serious losses or even run into payment crisis. The incomplete banking functions and the excessive restrictions of the regulatory department on asset operations also withered the major business of some urban commercial banks and weakened their operational capacity.

Moreover, the trust investment companies and urban credit cooperatives that remain after the rectification generally suffer from problems relating to ownership system and governance structure. As such institutions usually enjoy close relationship with the government, they are free from the pressure for survival and, therefore, lack the drive to improve management and efficiency. Compared with the private enterprises that have long been following the market rules, the current financial institutions that have been developing under government protection and control can hardly provide financial services to meet specific characteristics and requirements of private enterprises.

III. Problems in the Direct Financing System

Compared with indirect financing, private enterprises have more difficulties in obtaining direct financing from capital market. As China's stock market has long targeted at supporting the State-owned enterprises, it has become a "money fishing" ground for the State-owned enterprises. Therefore, it has strong bias on listing the stocks of private enterprises in the market. By the end of October 2000, among the 1052 enterprises listed in the Shanghai and Shenzhen stock markets, there were only 94 private enterprises without state share, a mere 8.9 percent (Cao Honghui, 2001). Among the listed private companies, apart from a small number of enterprises with special background (about 1.6 percent of all the listed companies), most of them managed to get listed through complex operations by purchasing or borrowing the shells (names) of other companies. As most companies providing the shells are State-owned, during the shell purchasing or borrowing process, private enterprises must co-ordinate with various government departments and bear the huge debts and personnel burden of the state-owned enterprises. Therefore, the prices of such "shells" are indeed extremely expensive.

Due to strict planning management and strict control over the scale of corporate bond issuance, it is almost impossible for private enterprises to raise funds through issuance of corporate bonds. Raising funds with modern financial means, such as convertible bonds, long-term bills, investment funds and securities assets, is even more out of the question.

After 1993, 26 regional stock exchange markets were set up in various localities, which played certain roles in channeling private equity capital into private enterprises. However, due to relatively greater market risks and ideological problems, these markets have already been cleared and rectified, the remaining few transactions are illegal. In addition, there are presently over 200 non-securities in-kind property rights trading markets. Main transactions in such markets are complete transfers, with loss-making and hardly-profiting State-owned enterprises as the main trading commodities. Few private enterprises have ever entered these markets for fund raising. Due to problems in the operational mechanism, except a few regions such as Shanghai, most of the property rights transaction markets at present witness no transaction and generally are unable to play their role of resource allocation.

IV. System Impediments are the Main Causes

Retrospection to the development history of the private economy will reveal the helplessness of the government. In fact, the development of the private economy had to be accepted when the public economy was under heavy pressure in terms of both employment and finance. However, when the private economy entered a rapid development stage, the financing system dominated by the State-owned economy was not ready with corresponding preparations. The delay and the partial system reform are the fundamental causes of financing difficulty for private enterprises.
The present status of China's financing system demonstrates that system impediments are most evident in the following areas.

1. Private capital finds it difficult to enter the banking system.

As stated above, the current Chinese banking system is still monopolised by the State-owned banks and State-held banks, with high entry barriers for private capital. On the other hand, even if a few private capitals are lucky enough to enter the banking sector, they almost have no-say under the administrative control, and cannot practically operate according to market rules. With the absence of private capital–the vigorous and highly efficient competitor, it is very difficult for the banking sector to engage in complete competition and raise the efficiency and quality of their services.

As the formal financial system cannot meet capital needs of private enterprises, most of the private enterprises have to look for financing channels from the informal financial market during their development. In the coastal areas of Zhejiang, Guangdong and Fujian provinces, non-governmental lending markets are very active, replacing the functions of banks by certain degree. The vigorous non-governmental financing activities may be regarded as the inevitable result of the small scale of the current financial market and the lacking of small and medium-sized banks, as well as the absence of the administrative control system. As the financial market cannot meet the investment desire of the investors and the capital demand of the fund-raisers, the capital suppliers and capital demanders have to create the market by themselves. However, as such financing activities are basically carried out underground or partially underground, they are not regulated by sufficient legal and institutional means, and generate lots of illegal activities, such as usury. Meanwhile, with a low level of market development, it is difficult to develop financing activities that actually follow market rules only through operations depending on blood ties and regional relations rather than social creditability. Nevertheless, the fact that the non-governmental financing activities continued in spite of frequent prohibitions speaks for their rationality and reveals the defects in the current entry system of the banking market.

2. Capital market lacks layers.

The core function of the market is transaction. Transaction is divided into different layers according to commodities, volumes, makers and methods. Accordingly, market also needs to be multilayered. As a special market that deals with capital, capital market faces largely different enterprises and numerous investors with different expectations for risks and profits, and therefore, the capital market should have several layers. Take the United States for example. Its capital market has several layers. At least, they include the national stock exchanges, the local stock exchanges, the third market (over-the-counter trading for listed stocks), the fourth market (for direct trading between large institutions and investors), the NASDAQ national market, the NASDAQ small market, the OTCBB market (small stock listing system) and the Pink Sheets market. Among them, the last three market layers provide capital transaction services in particular to the small and medium-sized enterprises and have decreasing market entry standards. In the lowest layer of Pink Sheets market, enterprises do not have to meet any condition in principle for listing. In fact, it is with such a multi-layer market system that the capital market of the United States is able to maintain the largest scale, the strongest competitiveness and the highest market efficiency in the world.

In China, however, the government has strictly restricted securities transactions within the stock exchange markets over the past few years, so as to control financial risks. All the other over-the-counter transactions are basically illegal. This has created a unique phenomenon of almost only one trading layer for the capital market. The negative consequences resulted from such a distorted capital market are most evident in the following areas.

Firstly, the capital market mechanism can hardly play its role. Whatever its form is, a capital market always has limited transaction and management capacity. Therefore, it naturally rejects some fund-raisers and investors in favour of market entities with certain advantages, such as the large enterprises. If the capital market has only one layer, the rejected market entities will have no way to access other layers in the market. This will not only constrain the development of the capital market, but also distort the optimal resource allocation mechanism of the market, since not all the enterprises are given equal financing opportunities.

Secondly, more concentration of capital market can hardly be achieved. One of the most important features of the modern capital market is the increasingly concentrated transactions. With the economy of scale of market, the larger the market, the lower the transaction costs. In addition, concentrated transactions are also conducive to raising liquidity of securities. In a single layer market, it is very difficult to achieve concentrated transactions due to large differences among the characteristics of various commodities.

Thirdly, the overall risk of the capital market can hardly be reduced. Securities that largely differ in risks and profitability should have different transaction and management rules for listing. However, it is very difficult for one market to implement two or even more sets of rules at the same time. Putting securities with large differences into one transaction system will create difficulties in regulation and result in uneven implementation of regulation and supervision. Moreover, it will also influence the fairness of competition and affect the stability of the whole market as a result of sharp fluctuation of venture securities, thus increasing the overall risk of the capital market.

3. Lacking in various transaction means

Over the past ten years, due to the biased guiding strategies and the constraints of the economic and social environment in China, capital market structure suffered serious distortion, and the actual stocks were almost the only investment instrument in the capital market. As trading varieties were excessively scarce, the relatively abundant social capital had very limited investment channels, and channels to convert savings into investment were seriously obstructed. Meanwhile, numerous enterprises with capital needs cannot employ the capital market to raise funds in an appropriate way.

Along with the economic globalisation and China's entry into the WTO, the traditional boundaries of financial business are fainting in China. Meanwhile, relevant financial controls are becoming flexible, insurance capitals have been permitted to enter the stock market, and the variety and the number of institutional investors continue to increase. Various evidences reveal that China's capital market is facing a new development era. However, the serious shortage of trading instruments has not only become a major constraint to further development of the capital market, but also significantly confined the financing activities of enterprises.

V. Policy Proposals

The above-mentioned analysis demonstrates that superficially, the financing problem of private enterprises is caused by limited financing channels, but the system obstacles are in fact the deep roots. Without reforming the current system, the mere issuance of preferential policies will not work. For government departments, the most important tasks are to change their ideology, discard ownership system discrimination, and take into account the overall needs of the national economic and social development to speed up the financial sector reform and adjust and improve the financial system.

1. Improving the indirect financing system and vigorously developing local small and medium-sized private commercial banks

The above analysis demonstrates that to solve the financing difficulty of the small and medium-sized private enterprises, vigorous effort should be made to develop local small and medium-sized private commercial banks. As the local small and medium-sized financial institutions are familiar with local situation, it is most easy for them to learn the operational status, project prospects and credibility of the local small and medium-sized enterprises. They are thus able to overcome the obstacles of high transaction costs caused by mal-information, reduce service prices and meet the needs of both the capital suppliers and demanders (Fan Gang, 2000). On the other hand, in view of the problems of the State-owned banking system, the local small and medium-sized banks should stop implementing the State ownership system or State share-holding system, but mainly adopt the share-holding system based on non-government capitals.

In light of the institutional construction, the development of the local private small and medium-sized banks should follow the principle of "clear standards, flexible control, detailed supervision and more competition". The market entry and exit criterions, the risks management system, the competition rules and supervision measures for the small and medium-sized commercial banks should be set up and implemented as soon as possible. All investors should be given national treatment and banks may be allowed to set up if they meet the standards. Any action that violates the laws and regulations should be punished, so as to guarantee the small and medium-sized banks to compete on an equal footing in a healthy market environment.

In view of China's current situation, a step-by-step method may be adopted to develop the local private small and medium-sized banks in a steady way. For example, some urban credit cooperatives that meet the standards may be chosen first to be transformed into local commercial banks with the stock-holding system, and then extend the practice after experience and lessons are learned.

It should be stressed that although the private small and medium-sized commercial banks have strong property rights constraint, due to the leverage feature of the banking sector (operating large funds with small amount of capital), the private banks are not free from operational risks. Therefore, the relevant departments should strengthen their regulatory control. The priority for regulatory control should include the following areas:

First, formulating strict credibility criterion for investors and high-level managerial personnel, establishing the record system and making irregular inspections to prevent people with poor credibility, notorious past and gangsterdom background from entering the banking sector;

Second, strictly examining and prohibiting the excessive dividend distribution and capital flight by the shareholders, and preventing the short-term acts of the banks resulted from the interest impulse of the shareholders;

Third, setting up capital classification standards and limiting the operational scale and business fields for local banks.

2. Establishing a multi-layer small and medium-sized capital market system to provide services especially to small and medium-sized enterprises

The small and medium-sized capital market system should at least include two layers, namely the second board market and the regional small capital markets. In terms of functional division, the second board market mainly solves financing problems for small and medium-sized enterprises in their mid- or post-establishment stage, while the regional small capital markets primarily provide financial services to the small and medium-sized enterprises unqualified to enter the second board market, as well as equity capital to such enterprises in their initial establishment stage. The market entry qualifications for and regulatory control over the two layers should become stricter gradually, while the performance of enterprises gets better.

In fact, China is more in need of the latter layer of the capital market, because the envisaged second board market is still confined within the framework of the securities exchange and can hardly break away from the various problems and constraints of the current securities exchanges. Meanwhile, due to the limited capacity, listing costs are very high, so the numerous small and medium-sized enterprises can hardly enter this market to raise funds.

The regional small capital markets may be established by reforming the previous securities exchange centers, the current local property rights trading markets and the technology property rights trading markets. In light of the lessons from the previous regional securities exchange markets, the establishment of such markets should stress on standardization and regulatory control. The priorities of standardization and regulatory control include the criterion and rules for the trading of the listed stocks and their information disclosure, the settlement system for the trusted stocks, the market entry and exit rules for market intermediary agencies, the trading rules and the information disclosure rules.

3. Vigorously developing corporate bond market and long-term bill market and increasing transaction products of capital market

In light of the international practice, in the developed countries, the proportion of credit financing among capital raised by enterprises in the securities market is usually several times or even 10 times more than the proportion of equity financing. In contrast, capital markets of most developing countries are in favour of stocks and take bias against corporate bonds. Based on the research of Sass, the British Cambridge economist, the vigorous enterprise equity financing and weak bond financing of the developing countries is primarily caused by policy guidance of their governments. The excessive and overly strict control over corporate bond issuance has led to distorted method of enterprise financing. One of the major reasons for the government to exercise strict control over corporate bond issuance is to maintain the direct control over financial management and keep enterprises from disrupting the implementation of the unified interest rate policies through their excessive bond financing.

In light of China's situation, there are two major factors that constrain the development of the enterprise bond market and the long-term bill market. The first is that the interest rate system has not been marketized, and the second is that the credibility of enterprises remains low. For the former, as China is gradually implementing the interest rate system reform and has drafted an initial schedule to open up the interest rate system, so the external conditions for the development of the enterprise bond market and the long-term bills market are getting mature. For the latter, it is necessary to pool together the common efforts of the whole society to set up an effective credibility gathering, assessment and publication system, as well as a strict credibility-violation punishment system, so as to solve the credibility identification problem during the process of issuing and listing enterprise bond and bills.

Research Group on the Study of the Expansion of Financing Channels of Private Enterprises (Research Project financed by the China Reform Fund)

December 2001

Reference:

1. Small and Medium-sized Enterprise Financing, Edited by Hu Xiaoping, Economic Management Publishing House, October 2000.

2. Investment Management Reference, Issue No.14, 15 and 19, 2000, Edited by the Investment Research Institute of the State Development Planning Commission.

3. China Private Economy Year Book, 2000 edition and 1996 edition, Edited by All-China Federation of Industry and Commerce.