By Zhang Chenghui

1. Current Situation and Characteristics of the Operation of Policy-related Guarantee System in China

Since 1998, governments at all levels began exploring the possibility of helping small and medium-sized enterprises in financing difficulties through a credit guarantee regime. Statistics from the State Economic and Trade Commission indicate that by the end of June this year some 200 government-led credit guarantee institutions had been set up. The author's survey shows that this network did play a positive role in solving financing troubles for some small and medium-sized enterprises.

The characteristics of the current policy-related guarantee for small and medium-sized enterprises in operation can be summarized as follows:

(1) Corporate guarantee institutions as the main body of the current guarantee system

Most of the existing institutions are credit guarantee entities, few government or government agencies are involved in the business.

The organizational forms of guarantee institutions come into corporation aggregate, community and institution legal entities, of which, corporation aggregates constitute the overwhelming majority. Such guarantee institutions are usually funded either entirely or predominantly by the government (largely with fiscal funds), sometimes investment from enterprises. They are running under market principles, with independent accounting and operations, responsible for their own profits and losses.

(2) High dispersion as the main tendency of guarantee institutions

Under the government sponsorship at various levels, small and medium-sized credit guarantee institutions have mushroomed over the past two years in villages, townships, counties and cities. High dispersion marks their distribution due to differences in conception of government leaders, in the sponsoring departments and local economic conditions. Organs in charge of these guarantee institutions are governments or mostly special departments, such as financial bureau, township enterprise bureau, economic and trade commission or association of industry and commerce, whose rules, guarantee measures and management system also highlight divergences. Take Shanghai for example. The municipal government refrains from intervention by entrusting Shanghai Branch of the China Economic and Technological Guarantee Corporation with all the designated funds. Yet to ensure fund safety, their providers -- financial departments of village, township or district governments still examine and approve each guarantee item case by case. Therefore, dispersion even characterizes their decision-making mechanism.

(3) Small size as their general character

This has been determined by the limited financial sources of the local governments. Take the two comparatively rich provinces of Jiangsu and Zhejiang for instance. Sample surveys show that the registered capital of guarantee institutions in the 16 cities and counties of the former averaged only 3.33 million yuan and their guarantee capability was less than 20 million yuan even multiplied by five times. Things were no better for Zhejiang with 23 guarantee institutions having registered capital of 6.3 million yuan on average and that for the smallest one only 500,000 yuan. Of the 23 institutions, the largest had 10 employees, whereas the smaller ones had two or three people and mostly on a part-time basis. Full-time employees averaged only 1.6 persons.

2. Existing problems in the Current Policy-related Credit Guarantee System

Despite their positive role in demonstration and promotion for credit guarantee, these guarantee institutions are also plagued with the following noteworthy problems:

(1) Absence of risk compensation mechanism predetermined their vulnerability to risks.

At present, the funds of the guarantee institutions are mostly one lump sum from local fiscal budgets and there exist no follow-up capital or risk compensation mechanism. High risks and vulnerability landed these income-poor institutions in an awkward situation. A single case of compensation payment would swallow up insurance premiums for dozens of business items. Employees therefore exercise great caution like treading on thin ice, having no option other than raising guarantee conditions.

(2) Absence of risk-sharing mechanism with banks results in guarantee institutions exposed to concentrated credit risks.

In line with international practice, guarantee institutions generally shoulder 70 to 80 percent of the liability for compensation with the rest undertaken by related banks. But lack of clear-cut standardized system, fragile strength and weak negotiation position made it possible for most banks to shift risks involved in providing credit for small and medium-sized enterprises to the guarantee institutions, with many of them forced to undertake 100 percent credit risks. This has resulted not only the asymmetry between their responsibility and capacity, but also weakened the banks' examination and assessment of the enterprises, thus aggravating risks as a whole.

(3) Lack of standardized management and qualified personnel result in big potential operational and moral risks.

As mentioned above, at present, high dispersion seems to be the main tendency of the guarantee institutions. The lack of standardization led to their self-designated management systems, varied guarantee approaches and low business transparency. Furthermore, absence of horizontal exchange channels among guarantee institutions made it difficult to maintain necessary communication among them.

With a strong specialized character, credit guarantee requires expertise in finance, fiscal, law, auditing and project assessment. Yet the tiny scale of the guarantee institutions forced them to recruit part-time employees or retirees, but few qualified experts. In addition, they were woefully short of sound supervision and incentive mechanisms. Obviously, this management framework was in no position to control risks in operations and morality. There would likely occur partiality to big shareholders, excessive guarantee sum for a single project and other abuses.

(4) Prone to improper and unfair fund distribution

Though theoretically of public welfare and for massive small and medium-sized enterprises in fund utilization, the corporate system of most guarantee institutions caused many mal-practices. Despite their pretensions to non-profit aim upon inception, the nature of the corporate system made it difficult for these government-sponsored guarantee companies to be immune to profit temptations, which was accentuated with the participation of private shareholders. As a matter of fact, some guarantee companies were apt to prefer large enterprises and loathe the small ones in guaranteeing credit and go after excessive security and high rewards. As a shareholder, the government would face another dilemma. In case of profits, no sharing out of dividends would invite opposition from private shareholders. Doing so would run counter to its original intention. Some governments found a way out by turning all dividends into risk reserves to display fairness. But such an approach would signify government’s subsidies against risks to private shareholders, also an act of unfairness.

The above problems gave rise to widespread complaints about difficulties in obtaining credit guarantee among small and medium-sized enterprises. Apart from complicated procedures and additional examination and approval process, high charges and short guarantee period also plagued the relevant enterprises. In most cases, the current period was within six months with the longest not exceeding one year. Moreover, the guarantee institutions basically offered their services only for circulating funds, rather for equipment investments. In terms of counter guarantee, the demands were exacting on enterprises. A certain enterprise complained that for a loan of one million yuan, the guarantee institutions demanded 30% as guarantee fund, bank demanded another 15 percent as guarantee fund, the sum left over for the enterprise came only to 0.55 million yuan, which meant almost a doubling of interest rates and guarantee charges. By contrast, of the guarantees offered by the Credit Guarantee Association in the Yamagata County of Japan, 70% required no mortgage, with the proportion of funds going for equipment investments reaching 58 percent and that lasting from three to ten years hitting 61percent (see Credit Guarantee Monthly, N0. 4, 2001, published by the Yamagata County Credit Guarantee Association). Clearly, services provided by the existing guarantee institutions in China can hardly meet financing demands of the large numbers of small and medium-sized enterprises.

3. Proposals on Improving the Operation of Guarantee Mechanism

The above analysis shows that flawed operation mechanism casts a shadow over the future of credit guarantee institutions. Suggestions for improvement are as follows:

(1) Readjusting operations of guarantee funds

Foreign experience indicates that the credit guarantee system cannot possibly function well without cooperation from commercial banks. The guarantee institutions not only provide small and medium-sized enterprises with credit guarantee, but also reduce the credit risks for commercial banks, it defies all reasons for the commercial banks to hold back their support. Their lukewarm attitude is closely related to functioning methods of guarantee funds. To stimulate their incentives, the following measures may be worthy of consideration.

Firstly, direct government risk subsidies to commercial banks for their loans to small and medium-sized enterprise. The government openly recruits cooperating banks with specific terms, giving each a certain quota of guarantee fund (for instance, 0.2 billion yuan to each of the five participating banks for a guarantee fund of 1 billion yuan). Acting on government conditions, the cooperating bank then selects small and medium-sized enterprises to offer loans with each loan shared by bank and the credit fund (the total sum kept below the quota). In the event of loan failure, the bank concerned shall only be responsible for a certain proportion of loss, while success would reward the bank with all the interest involved. The government shall examine the performance of the bank annually and disqualify the failed ones.

Secondly, initiation and standardization of a system for cooperating banks within the current guarantee framework. The system should make clear the relationship between the bank and the guarantee institution as well as the proportion of risk sharing between the two. Meanwhile, the responsibility of the bank to examine and assess loans and its obligation to recover bad debts should be stressed.

(2) Standardization of the current policy-related guarantee institutions by referring to the special legal entity system abroad

Government-funded guarantee institutions are necessarily oriented to public welfare with policy considerations, and represent as special legal entities with specific goals and functions. They should not, therefore, adopt the institutional form of a limited liability company. We should standardize them by taking a leaf from special legal entities overseas. The goal, obligations, operation policies and supervision measures of these policy-related guarantee institutions should be explicitly established. Meanwhile, specific fiscal and taxation policies should also be applied to these special legal entities.

Special legal entities are entitled to make profits, but should not share out dividends (the prevailing practice abroad is to turn all the profits into risk reserves). They may take up private funds from enterprises and individuals, but they are not allowed to intervene, in their capacity of shareholders, in the business operations of these institutions. For absorbing private capital, we suggest that current practice of expected profits and preference rights of shareholders should be substituted with taxation. To be specific, the invested funds may be deducted from the tax base of payable income or taxation concessions may be given when the invested funds exceed the normal profits by a certain proportion.

(3) Establishment of a replenishment mechanism for guarantee funds

As guarantee charges are insufficient to cover compensation losses, governments at all levels should provide guarantee activities with stable capital source by listing guarantee funds on annual budgets. They should consider fostering small and medium-sized enterprises as a long-term policy, offering guarantee services. This will directly promote the development of small and medium-sized enterprises and bring about increases in government tax revenues. At the same time, governments should also adopt various measures to encourage commercial banks, enterprises and rich people to offer financial support to the guarantee funds.

(4) Establishment of a mechanism for information release and exchanges within the guarantee community

Taking into consideration of the weakness and dispersion of the current policy-related guarantee institutions, we suggest the organization of a national guarantee association, which shall not undertake any obligations to risk guarantee and regulatory control, but mainly be responsible for providing member institutions with information and exchange channels, compiling relevant data about the guarantee operations, and publishing related information to the general public through networks or publications.

Research Department of Technology Economy (With participation in discussion of Mr. Ma Zhaocheng from Zhejiang Provincial Association of Commerce and Industry)

July 2001