The Financing of Private Enterprise in China

Introduction
Chinese enterprises → relied primarily on self-financing → to Thrive → firms need increased access to → external loan and equity financing
China’s economy has undergone a fundamental change over the pas decade → from complete reliance on state-owned and collective enterprises to → mixed economy → where private enterprises play a strong role
1999 → private sector accounted only 1% of bank lending
Only 1% of private company are listed on the Capital market
Private sectors may not be able to sustain its current rate growth unless it can increase its access to financing
Financing Patterns
International Finance Corporation (IFC) → private sector arm of World Bank Group → revealed if company has 80% lack of access to finance → will be a serious problem
Chinese relied heavily on self-financing for both → start-up and expansion
More than 90% initial capital → came from → principal owners, family, start-up teams
For post-start-up investment → firms depend on internal sources → with at least 62% equity is owner’s
Public equity and public debt market → played an insignificant role
Relative importance of different sources of financing among surveyed firms → depend on firms size → Tend to become less important as firms grow larger
Share of commercial bank loans → increases with the firm size
Commercial banks → second most important source of fund → for the larger firms → but on average → Chinese banks tend to play a relatively small role
Factors affecting Access to Financing
Difficulty private Chinese firms face → financial system and the nature of Chinese private enterprise
Bank Incentives
Trough recent reforms → China has made significant progress in reducing government interference in bank lending
Bank still do not consider → a bad loan to a state-owned enterprise to be as serious as a bad loan to a private enterprise
Bank → discriminate against private sector firms → need added incentives to lend to private enterprises
Financial sector reforms focused on reducing the accumulation of nonperforming loans in the system are making banks more averse to risk
Bank concentrate on avoiding losses → show little interest in sharing of rewards of projects → that may be riskier → but have higher expected returns
Indeed → central banks requires all banks to implement → “responsibility to individuals” → credit officers personally responsible for loans → thereby discouraging them from making loans for private sector project
There are controls on interest rates and transaction fees → but still → interest rates are capped
Loans to small and m\medium-sized enterprises → allowed to be 30% higher the prescriptions rate →→ rural credit charge 50% higher
Government is expected to relax restrictions even further in preparation for China’s entry into WTO
Banks & Credit unions → creative ways → circumvent interest rate controls → requiring compensating balance and charging false late payment fees
Result → state banks charge effective interest rate
Bank Procedures
Chinese Banks → inflexible and tailored → “typical” state-owned enterprise
Applying for a loan → bureaucratic and costly process
Major obstacles to application for formal loan → Paperwork
Collateral requirement & relationship banking → make smaller firms hard to gain access to financing
Collateral Requirement
Most frequent reason for not being able to obtain a bank loan → The inability to meet collateral requirements
Legacy of public and collective ownership of land → can be a collateral → But many private firms does not have it yet
Assets can be collateral → but establishing the value of the firms → costly
Repeated and arbitrary fees → greatly reduced the incentive of small firms → to apply loans
Information Problem
Many had to present themselves as collectives or as foreign enterprises → to be allowed to operate or to obtain better treatment from the authorities
Lack of clear ownership an management structures → imposes obvius constrains on borrowing
In fact → banks are unable → to collect and process relevant information
Banks are naturally reluctant to accept financial statements → that cannot be trusted
Recently central bank → make mandatory for corporate borrowers to register in a national database
Central database more comprehensive and prevent company with poor records → getting loans

Policy Agenda for Financial Sector
Improve “bankability” → by strengthening transparency and clarifying ownership on the part of the government to establish and maintain a level playing field and to create incentives for lending to and investing in private enterprises
Strengthen Banks’ incentives to lend to private enterprises
Important step → strengthen profit incentives through private ownership and competition
The government should allow the entry of new domestic private financial institutions → which would open up entry opportunities → to foreign financial institutions
To alleviate regulatory concerns → stricter entry and prudential requirements could be applied to → new financial institutions in initial period
Private financial institutions → less likely swayed by political considerations → more likely profit oriented
New banks tend naturally focus on → younger and smaller firms
Big state-owned banks → likely to dominate the domestic financial landscape for the foreseeable future
Further Liberalize Interest Rates
Evidence suggest further liberalization of interest rates is needed to improve private firms’ access to bank loans
Most private enterprises that are able to borrow → already pay effective interest rate that → significantly higher that real one
Allow Banks to Charge Transaction Fees
Banks find → lending to private companies → carries higher unit transaction cost
Transaction fees would encourage banks to consider → more proposals from small firms, develop more service-oriented culture, promote greater transparency and better accounting standards
Develop Alternatives to Bank Lending, Such as Leasing and Factoring
Leasing and factoring → are useful ways to deal with insufficient collateral → with the enforcement of collateral
Leasing obstacles in China
Rent arrears have long been a problem
Accounting standards are unclear
Regulatory environment does not provide equal treatment with other sources of capital investment financing
Funding is a perpetual concern
Factoring is a way to improve a company’s liquidity by → substituting a cash balance for book debt →→ New contract law → make it possible
Create a Framework for the Development of Private Equity Markets
Offshore venture funds → appear to be a far more important source of capital for startups in China → than domestic
Corporations must abide by the company law → does not permit more than 50% of :Industrial Investment Funds” to be invested in subsidiaries or other legal entities
Legal instruments → must be develop
Legal organization of such funds
Use of a fund manager
Need for trustees → to protect investors from adverse actions of the fund managers
Tax treatment → to avoid double taxation
Improve Access to Public Equity
Availability of exit mechanism is → a key condition for development of private equity markets
Evolution of private equity markets → depends to a large extent on the state of the public equity market
Chinese Securities Regulatory Commission announced → quota system on listings → would be abolished
Private firms would have greater opportunity to acquire long term funding through the equity market