Analysis: Forced lending to China SMEs may risk more harm than good

By Pete Sweeney and Gabriel Wildau

SHANGHAI/WENZHOU, China (Reuters) - Beijing's strategy to reroute money away from state-owned giants towards smaller firms to help fuel the economic transformation behind its reform plans is less of a success than it may seem on the surface.

Lending has increased in line with Beijing's orders. But banks have found loopholes allowing them to lend to state-owned firms and some borrowers are local-government-owned, operating in saturated sectors Beijing is trying to consolidate, aggravating the risks facing the financial sector rather than alleviating them.

Some lending is even being routed to real estate, a market Beijing is trying to cool as prices soar, one researcher said.

These factors highlight the struggle China faces in trying to reform its financial markets while preserving a dominant role for the state, a combination underlined by a 60-point reform plan to redraw China's economy and social fabric announced last week.

"Despite efforts for many years by every level of government to alleviate financing difficulties for small and medium enterprises, there hasn't been a substantive improvement," said Ye Xixi, director of the finance department at Wenzhou University City College, whose research focuses on small-and-medium enterprise (SME) financing.

"In fact, in recent years there are signs it's getting worse."

Regulators classify SMEs differently. China's bank regulator, for example, says they are companies with assets of less than 10 million yuan ($1.6 million) or annual sales of less than 30 million yuan.

Regardless, economists estimate they account for 70 percent of China's output and create 80 percent of its jobs, so many reformers say it is these companies, not China's stable of massive but inefficient state champions, that should lead China's economy in the future.

Beijing wants nimble, innovative firms focused on selling services to domestic consumers to steer the economy away from its current credit-intensive, state-driven model.

MISMATCH

In entrepreneurial Wenzhou, a coastal city of 9 million people south of Shanghai, a centre designed to meet the needs of small business is struggling to meet loan demand because banks are wary of lending.

"Demand for loans is heavy, but for a large portion of borrowers, lenders aren't willing to lend," said Xu Zhiqian, general manager of the Wenzhou Private Lending Service Centre, located in a zone testing financial reform. "They think the risk is too large."

Xu said only about half of the pool of funds made available by would-be lenders has been used for loans. Wenzhou made headlines in 2011 when a wave of local firms defaulted on informal loans, prompting local officials to warn that businesses would be decimated if the city was not thrown a credit lifeline by Beijing.

Nationwide, official data shows that lending to SMEs has increased as ordered, but still accounts for just about a fifth of all loans, small compared with the sector's economic output.

LOOPHOLES

To be fair, lending to small businesses is a banker's nightmare: they are hard to appraise, light on assets and quick to capsize when economic winds change.

Beijing has ordered state-owned banks to lend to smaller companies but bankers say there are loopholes that allow them to meet the quotas through lending to state-backed entities.

"We're government-owned. The company is state-owned; really our relationship is like that of brothers," said a loan officer at Bank of Communications, who declined to be identified.

"This is why small and medium-sized enterprises don't get financing from state-owned banks. It's not like they're good or not good. We discriminate against them because they're not one of my brothers."

Another state banker, a loan officer, said banks have depended on requiring collateral for loans rather than assessing risk. A lack of ability to assess risk prevented many banks from lending to smaller companies, he said.

The solution is to use a variety of accounting tricks to disguise loans to state-owned enterprises (SOEs) as SME loans, such as making loans to small subsidiaries or paying small suppliers on behalf of SOEs, he said.

DOWNMARKET

Unlike more market-orientated economies, in China "SME" is not synonymous with either private ownership, efficiency, or innovation; many small Chinese companies are owned or controlled by local governments, operating in sectors swamped with overcapacity - like solar power, shipping and steel.

So even if these companies are knee-deep in debt and facing dismal business prospects, banks will issue loans to them because they know ultimately the taxpayer is on the hook. Even local government financing vehicles are defined as SMEs, said Anne Stevenson-Yang, managing principal at J Capital Research.

She was referring to a type of financing vehicle associated with an explosion in local government borrowing that accompanied China's response to the global financial crisis.

She said many smaller Chinese banks, locked out of lending to premium SOEs, had moved downmarket to lend to LGFVs and SME associations that aggregate loans. But this funding rarely ends up with genuinely innovative small firms, she said.

"Generally, the associations don't pass these loans to small firms but instead lend at higher interest rates to real estate developers or other attractive targets, with the participation of member SMEs."

OTHER MARKETS

Alternative funding channels have also provided little success.

A "junk" bond market designed for SME corporate debt is virtually dormant. Outstanding volumes are less than 0.5 percent of all corporate bonds issued in China.

"Third board" over-the-counter equity markets launched around China have mostly flopped due to a lack of interest from firms wanting to list or from investors, many of whom are suspicious of such markets.

"The valuations are very low, there's no liquidity, and it gives you forever the stain of being traded on that market," said Peter Fuhrman, chairman of investment bank China First Capital. "You are clearly better off trying to do a private deal."

Furhman said investors in junk bonds and OTC markets were only interested if a state-owned firm would guarantee the issuer. Beijing stamped out a practice of SOEs selling guarantees for a fee after it became clear that the third-party guarantee system, which had been harnessed to help SMEs get bank loans, had devolved into an opaque market where guarantors frequently pledged the same collateral multiple times, while dabbling in shadow banking on the side.

CIVILISED WORK UNIT

For viable Chinese small businesses, access to capital is not the major challenge. Entrepreneurs told Reuters that getting loans was less of a problem than the policy hoops necessary to stay in business.

Wenzhou-based Kingapple Home Textile Co Ltd, which has 100 employees and makes bed sheets, blankets and pillows, has few problems getting bank loans, General Manager Su Zhonghai said. His major problem, he said, was onerous labor laws and rising costs.

Small companies also face a wider regulatory environment in which government approval, even symbolic, plays an outsized role. Kingapple, for example, is seeking to renew its certification as a "Civilized Work Unit", which requires companies to "diligently study and implement Deng Xiaoping Theory, the 'Three Represents' Important Thought, and Scientific Outlook on Development,(and) resolutely carry out the Party line."

There are no explicit benefits attached to the certification, a county propaganda official said. But certified firms would be treated favorably when seeking land or administrative permits.

(Additional reporting by Shanghai Newsroom; Editing by Tomasz Janowski and Neil Fullick)

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