Comment: Stepping out of the shadow

The importance of small  and medium-sized enterprises to an economy is a well known fact.  What’s interesting is that in the US, Europe and China, SMEs have very similar attributes to the overall economy. 

SMEs are an integral part of China’s economy. Our in-house research suggests they represent more 50 percent of the national tax revenue, 60 percent of the GDP, 80 percent of the jobs and around 99 percent of the total number of resident enterprises. Despite the significance to the economy, the lack of access to finance constantly ranks as the biggest obstacle to doing business in China, according to various surveys.

After the global financial crisis in 2008, SMEs enjoyed better growth than the market average over the ensuing years.

However they continue to have difficulty getting long term credit from banks.

On the supply side, according to the People’s Bank of China 2012 statistics, total loans to small enterprises account for only 18 percent and 25 percent of the total loans and total business loans outstanding as at 2012 year end. This suggests the bank loan allocation to small businesses is underweighted, not only considering their significant contribution to the country’s value add, but also as compared to China’s global counterparts.

Historically, in Europe, around 80 percent of SMEs have been successful in obtaining bank loans; in the US, the figure is more like 30 percent; and depending on which report one turns to, this figure can be as little as a single digit percentage point in China.

Suffice to say, banks are cautious in giving credit to SMEs, as they prefer larger customers who have better credit records and lower transaction costs to service. Additionally, the imposition of tighter monetary policies (Basel III) and stricter loan approval process further drained short-term liquidity from SMEs. 

The lack of a legitimate standard for assessment of SMEs’ risks and qualifications for loans provides a great opportunity in China’s credit market. In the aftermath of financial crisis in 2008, the government of China implemented a series of measures to increase both interest rates and reserve requirement ratios in a bid to counter inflation risk.

This policy has worsened the situation for already liquidity-strapped SMEs, pushing them to go to the shadow banking system which typically charges very high interest rates (legends have it sometimes rates can be as high as 8 percent per month, although such are loans offered on a very short term basis). 

China’s shadow banking industry is broadly divided into pawnshops, credit guarantee companies, financial leasing companies, private lending by individuals and institutional private debt funds.

As the shadow banking industry plugs a void that exists in the market, it is highly lucrative and growing demand is estimated at more than US$500 billion that remains underserved under China’s current financial industry structure.

The limitations relating to the shadow banking system are manifold. Generally these are offered to short term financing opportunities only (up to six months).

Pawnshops usually focus on shorter term financing (three months) with smaller loan size. Financial leasing companies are only allowed to finance equipment and production related assets. Credit guarantee companies cannot do direct lending and have to rely on banks’ lending decisions.

Individual private lenders lend money on a very informal basis. However, such informality works both ways (supposedly, people have fled the country or jumped off buildings due to lenders’ enforcement measures!).

Thus there is an opportunity for institutional private debt funds to provide financing to SMEs that may have capital needs for longer periods – that is, six months or more, with the comfort that these funds are professionals who are able to assist companies to grow beyond just the short term financing needs.

Barry Lau is co-founder and managing partner of Hong Kong-based Adamas Asset Management.