CHINA'S SMALL AND MEDIUM ENTERPRISES: ROOM TO GROW WITH WTO

Summary. The Chinese government is improving the "enabling environment" for small and medium-sized enterprises (SMEs). Challenges marring this bright spot of economic reform include insufficient access to capital and local corruption that saps SMEs' dynamism. Nonetheless, flexible SMEs are generally well positioned to take advantage of opportunities created by China's entry to the WTO.

WHY SMALL AND MEDIUM ENTERPRISES MATTER

The growing significance of SMEs in China's economy is hard to ignore. Chinese and foreign experts estimate that SMEs are now responsible for about 60% of China's industrial output and employ about 75% of the workforce in China's cities and towns. SMEs are responsible for creating most new urban jobs, and they are the main destination for workers laid-off from state-owned enterprises (SOEs) that re-enter the workforce.

The Chinese government is acutely aware of the impact that SMEs as job-creators can have on forestalling potential social unrest. Chinese officials have said that SMEs would be more important for preserving social stability than the nascent social security system once increased foreign competition as a result of China's WTO entry forces more layoffs from uncompetitive state-owned firms. Local experts have offered an important caveat: many workers let go from SOEs are 40- and 50-somethings who lack the skills needed to succeed in more competitive private ventures.

IMPROVED IDEOLOGICAL CLIMATE

Chinese SMEs have flourished as ideological barriers have fallen. Many SMEs are truly private firms, started by enterprising individuals. In the early days of China's economic reforms, private firms faced an openly hostile political atmosphere and, as a result, were extremely limited in scale. The 14th Party Congress in 1992 saw the announcement of the socialist market economy, which implied that firms in the non-state sector would play an important role in national economic development. The 15th Party Congress in 1997 made this position official, openly acknowledging that the private sector was an important component of the economy. The revision of the constitution two years later equating the state and non-state sectors further improved the political environment for private entrepreneurs, as did Jiang Zemin's call last July to expand Party membership to incorporate "new elements of society," including private entrepreneurs.

In addition to private firms, some SMEs were "collectives" (i.e. operated by authorities below the county level) rented by individuals who offered to manage them and use their semi-public ownership status as protection from official harassment. These SMEs expanded considerably throughout the 1990s under the second half of the landmark "grasp the large, release the small" (zhua da fang xiao) policy for state-owned firms. Under this policy 80% of the hundreds of thousands of state-owned SMEs changed their ownership status through corporatization, shareholding, or private management through leasing the enterprise. The State Council Commission to Reform the Economic System managed the process until the 1998 government restructuring, when responsibility was shifted to the State Economic and Trade Commission's (SETC) new SME office.

WHERE WILL THE MONEY COME FROM?

SMEs still lack access to the resources lavished on larger state-owned firms, according to investment statistics. During the first three-quarters of 2001, private sector investment was US$ 30.7 billion, up 7.9% year-on-year, while public sector investment was US$ 191.7 billion, up 18.2% year-on-year. Widespread wariness by both borrowers and lenders of the higher risks accompanying private projects is a key cause of the slower growth in private sector investment. The central government is concerned about this imbalance. The State Development Planning Commission is attempting to address the slow growth in private investment by announcing incentives to "guide" private investment towards public works and high-technology projects.

Chinese officials have said that banks are "too conservative" to lend money to SMEs. Loan officers in state-owned commercial banks are not rewarded for making good loans but are penalized when they approve loans that are not repaid. Other officials are more blunt: the state-owned commercial banks will continue giving priority to large state-owned enterprises because of their implicit government guarantees. Some SMEs, usually former collectives, do in fact turn to the banking system for at least a small portion of their lending needs. In these cases, SME managers typically use their housing as collateral. As a result of the banking system's continuing preference for lending to large state-owned firms, SMEs usually raise money through indirect financing, primarily from family members or from their local communities. Retained earnings are another key source of financing.

SMEs generally do not receive central government approval to list on China's domestic stock exchanges, which are still dominated by politically connected state-owned firms. One consequence of widespread bad bookkeeping by these large listed firms is that it has delayed the launch of a second board for smaller, more dynamic firms. Prior to the suspension last October of sales of state-owned shares (which was having a negative impact on domestic markets), officials said that the second board proposal was on hold because similar stock exchanges around the world had been performing poorly.

BUREAUCRATS READ THE WRITING ON THE WALL

Chinese officialdom recognizes that vibrant SMEs are an essential part of sustained economic development and are trying to improve their "enabling environment." At the national level, the focus is on the forthcoming SME Promotion Law, which will codify the official definition of SMEs and clarify what government financial support will be made available to them. The law should help to protect SMEs, particularly former township and village enterprises (TVEs) that had become share-issuing firms, from corrupt officials. These former collectives, which had close relations with local government officials when they were TVEs, were particularly vulnerable to extortion by those same officials who are familiar with the firms' financial resources.

CREDIT GUARANTEES TO THE (EVENTUAL) RESCUE

Recognizing the limited financial opportunities available to SMEs, the central government created a network of credit guarantee agencies in the late 1990s and tasked the SETC's SME Bureau to oversee them. The bureau maintains a catalog listing what kinds of firms can apply for a guarantee. After checking on a given firm's financial background (using data provided by the State Administration for Industry and Commerce) and reviewing the proposed project, one of the more than 200 guarantee agencies nationwide uses the SETC's money to guarantee that the SME in question will repay its bank loan. The bureau presently manages guarantees worth about US$ 120 million a year.

Jiangsu Province's Zhenjiang City has been touted as a model for the credit guarantee system. Local officials have said that SME's with successful track records are the main beneficiaries, but firms that could offer convincing explanations for past failures could also participate. Existing firms receive 70% of the city's credit guarantees, while the rest has been dedicated to high-tech startups. Because the latter typically lack track records, the city relies on a panel of experts to assess their business plans and loan guarantee applications.

SOME EARLY PROBLEMS

China's nascent credit guarantee system is a step in the right direction, especially until the banking system makes lending decisions on a strictly commercial basis. Nonetheless, by SETC criteria, less than 1% of China's small and medium firms actually qualify to use this system. It is too early to tell if the SETC's vetting process will remain free from the political interference seen in other parts of China's financial system.

A study by the State Council's Development Research Center found that some credit guarantee companies preferred supporting larger firms over smaller ones, viewing the latter as too risky. The study also concluded that banks have been able to shift nearly the entire liability burden onto the credit guarantee companies, thereby undermining one of the central government's goals of strengthening the credit risk assessment ability of the country's state-owned banks.

OLD HABITS DIE HARD

Another factor limiting SME development is the mindset of their managers. Some SME proprietors respond to China's uncertain regulatory environment by not fully expanding their businesses. They know that being "too successful" could draw the attention of local government officials who then might impose high levies and fees. In this context, the long tradition of family-based businesses also works to limit the development of SMEs. Many of these firms are unwilling to transform themselves into larger corporate entities because that would require entrusting non-family members with the firm's valuable information and resources.

Not surprisingly, SMEs are not eager to shoulder more of the national tax burden, which is still primarily carried by the state-owned sector. Even in the self-declared SME heartland of Zhenjiang City, small and medium-sized firms pay a disproportionately small share of taxes. The irony for SMEs is that by not paying more taxes to the central government, they are not able to buy the center's "protection" from predatory local officials.

WTO ACCESSION SHOULD HELP

Central government officials turn giddy when describing how SMEs can take advantage of China's WTO entry. Senior Ministry of Foreign Trade and Economic Cooperation (MOFTEC) officials have said that SMEs can further integrate themselves into multinational companies' supply chains so China's "small giants" can one day become "big giants" in their own right. That said, while SMEs are better positioned than most of the state-sector to adapt to the new environment WTO membership will not immediately or painlessly improve most SME's plight because they will need time to improve their competitiveness and product quality.

Officials, frustrated by the state sector's grudging attitude towards reform, cite the principle of "national treatment" in WTO as an additional benefit because it creates new opportunities to launch businesses in industries now dominated by state companies. Moreover, existing SMEs have been disadvantaged vis-a-vis SOEs and would benefit from "national treatment." These officials maintain that China will not achieve the socialist market economy until government at all levels promotes transparency and ends direct government intervention in management. MOFTEC officials late last year said that SMEs were better positioned to adapt to the WTO economy because they lack the social, managerial, and financial baggage of most large state-owned firms.

COMMENT: THEY MIGHT BE GIANTS

The most remarkable aspect of China's small and medium enterprises is their rapid growth despite their inability to tap the official financial system. Two factors predict even faster development in the near term. One is their suitability for the post-WTO accession economy. SMEs in China will continue to thrive as more responsive partners of foreign companies than large state firms. They will also have the opportunity to move into market segments once dominated by state firms.

The other factor is that the policy environment for SMEs appears to be steadily improving. The SME Promotion Law will help, especially if it means better access to bank lending, as would improvement in, and expansion of, the credit guarantee system. An important indicator to watch will be whether the 16th Party Congress later this year builds on the progress made at the previous two Congresses in fostering an ideological framework conducive to SMEs.

Jiang Zemin's "Three Represents" concept and calls for expanded Party membership also point to a more benign political environment for SME managers. These political currents could turn into liabilities for SMEs, however, if their managers become distracted with Party activities instead of running their businesses.

SME's development will not be without difficulties. Official corruption remains the biggest threat. This phenomenon will persist as long as SMEs lack effective legal and political protection from local officials. To stay off their scopes, many SME managers will likely continue avoiding aggressively expanding their businesses, to the detriment of economic growth and job creation. In that vein, SMEs will not be a panacea for preserving social stability since many older, poorly educated state-sector workers are ill-equipped to succeed in a more competitive labor market.