The Financing of Private Enterprise in China

1. Introduction
a. China’s economy → undergone fundamental change:
i. From complete reliance on state-owned and collective enterprise → mixed economy where private enterprises play strong role
b. The discrepancy between the dynamism of the private sector and its limited use of intermediated financing → private sector may not be able to sustain its current rate of growth unless it can increase its access to financing

2. Financing Patterns
a. Survey of private firms in Beijing, Chengdu, Shunde, and Wenzhou → the private sector arm of the World Bank Group → 80% considered the lack of access to finance to be a serious constraint
i. More than 90% of their initial capital came from the principal owners, the start-up teams, and their families
b. The relative importance of different sources of financing among surveyed firms → depend on firms size
i. Smallest firms → external sources are mainly informal channels
ii. Larger Firms → internal sources become less important
c. Commercial banks → the second most important source of funds for the largest firms after retained earnings
d. Banks provide more support for larger and relatively successful private firms
e. Chinese firms rely more on internal sources of financing than do firms in transition and developed economies

3. Factors Affecting Access to Financing
a. Difficulty private Chinese firms face in obtaining financing is due partly to factors within the financial system and partly to the nature of Chinese private enterprise
i. Bank incentives
§ 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 bad loan to a private enterprise
§ Expectation → State-owned enterprise is helped by government → private enterprise does not
§ Banks will discriminate against private sector firms
§ Banks need added incentives to lend to private enterprises
§ Banks concentrate to avoiding losses and show little interest in sharing the rewards of projects that might be riskier but have higher expected return
§ There are controls on interest rates and transaction fee
§ Banks are taking advantage of this more flexible interest rate regime, but interest rates need to be liberalized further to encourage more lending to private firms
§ State banks charge effective interest rates that are comparable to those in the informal market
ii. Bank procedures
§ The procedures rely on collateral and personal relationship rather than on project appraisal
§ Collateral requirements, the cost of the application process, and relationship banking tend to make it harder for smaller firms to gain access to financing
iii. Collateral requirement
§ Inability to meet collateral requirements → the most frequent reason for not being able to obtain a bank loan
§ In practice → real estate assets appear to the most common kind of collateral accepted
iv. Information problems
§ Information problem → especially severe for state firms in China
§ The resulting of clear ownership management in structures imposes obvious constraint of borrowing

4. Policy Agenda for Financial Sector
a. Improving private firms’ access to external financing requires:
i. Strengthen banks’ incentives to lend to private enterprises
§ An important step → strengthen profit incentives through private ownership and competition
§ Private financial institutions are less likely to be swayed by political considerations and more likely to be profit oriented
§ The big state owned banks → likely to dominate the domestic financial landscape for the foreseeable future
§ Strengthening the profit incentives of these banks → have a major impact on improving private firm’s access to bank loans
ii. Further liberalize interest rates
§ Further liberalization of interest rates → needed to improve private firm’s access to bank loans
§ Access to financing is more important than the cost of funds
iii. Allow banks to charge transaction fees
§ Bank finds → lending to private companies → carries higher unit transaction cost
§ Transaction fees → encourage banks to consider:
o More proposals from small firms
o Develop a more service-oriented culture
o Promote greater transparency and better accounting standards
iv. Develop alternatives to bank lending (Leasing and Factoring)
§ Leasing and factoring are underdeveloped in China
§ In China, leasing faces obstacles:
o Rent arrears have long been a problem
o Accounting standards are unclear
o The regulatory environment does not provide equal treatment with other sources of capital investment financing
o Funding is a perpetual concern
§ Factoring → the sales of firm’s account receivables to a financial institution
§ Factoring → is a way to improve a company’s liquidity by substituting a cash balance for book debt
v. Create the framework for the development of private equity markets
§ Private equity markets in China are at an embryonic stage of development
§ Industrial investment funds → No regulations cover the organizational structures that can be used to establish private equity funds
§ Structure equity funds → can be developed is:
o Legal instruments are in place
o High ability of investors to use a variety of financial instruments to structure investment
§ Private enterprises → have lack of flexibility in their financial arrangements
vi. Improve access to public equity
§ The availability of exit mechanisms is a key condition for the development of private equity markets
§ Quota system on listing → private firms would have greater opportunity to acquire long-term funding through the equity market
§ Two ways to further improve private firm’s access to public equity:
o Broaden the range of exit mechanism available to investors
o Relax listing requirements