Hardy Zhu
Research Analyst

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"Structural constraints often channel investments into property, which has caused some areas of the market to become overheated."

Breaking Down Barriers for China's Small Businesses

On the Ground

To further examine this situation and to better understand the challenges facing the country’s smaller businesses, I traveled with three investment team colleagues earlier this year to visit to a few cities in Zhejiang Province, including the eastern city of Wenzhou, China, near Wu’s hometown.
 
Zhejiang has been at the heart of private lending activity and Wenzhou, in particular, is known as the country’s cradle of entrepreneurial activity. Wenzhou recently won approval to liberalize its financial markets, including initiatives aimed at legitimizing grey market lending to improve the flow of capital to small- and medium-sized enterprises (SMEs). The reforms could also allow those offering private capital to set up or take shares in rural banks and credit companies.

During the trip, our team met with more than a dozen entrepreneurs across several industries, including light industrials, real estate, pharmaceuticals, agriculture and alternative energy. Among them was Zhou Dewen, an influential head of the SME association in the city. Our aim was to understand how local entrepreneurs were reacting to the challenges of rising wages, an appreciating currency, rising commodity and raw material prices and the tight credit environment.

Wenzhou is home to more than 400,000 small businesses enterprises, according to Mr. Zhou, who also shared with us proposals he presented to Premier Wen Jiabao when they met last autumn. Among the proposals were suggestions for such changes as tax reforms and the establishment of a national-level regulator to better assist small businesses. While there are still some funding-related issues with these enterprises, Mr. Zhou indicated that the majority are in good health. “SMEs already endured their worst scenario last year and the overall environment seems to be getting better,” he said.

We were impressed to learn that most of these innovative entrepreneurs have gotten as far as they have with no viable access to bank loans and limited access to capital markets (only 10 companies from Wenzhou are listed on equity markets, according to Mr. Zhou). Even so, many have achieved impressive success. One apparel maker in Hangzhou told us that even when he first started his business in 1999 with just three sewing machines and less than US$2,000, he intended to build out his own brand rather than just manufacture clothes for other brand owners. He has never borrowed any money from banks and has consistently budgeted for advertising to tout his brand. Thirteen years later, his business employs 600 workers and he says he may be considering some Italian fashion acquisitions down the road. We were impressed by his ambitious temperament and the foresight he had for brand building at that early stage.

Due to the lack of access to banks, rates from the private lending market are exorbitant. During our trip we also met with bank managers who confirmed that there is little incentive for large banks to lend to SMEs, which raises the cost of capital for these businesses. China currently has no credit rating system so the process of gauging a business’s creditworthiness would be onerous on banking staff. Instead of completely avoiding lending to SMEs, some of the more innovative banks have resorted to a more practical approach of looking at a firm’s import or export customs declaration forms as well as their water meter bills to verify usage and, therefore, activity levels.

In general, what we returned with was the view that there is still much wealth creation occurring in places like Zhejiang, and many are still seeking to invest that wealth. However structural constraints often channel these investments into property, which has caused some areas of the market to become overheated. But generally, businessmen remain optimistic about the future despite the difficult credit and market environments. In the discussions, they acknowledge that there have been bankruptcies primarily as a consequence of reckless diversification and lack of focus. Indeed, following the government’s tightening in the property market as well as weak demand from developed markets, many SMEs have declared bankruptcies and a spate of entrepreneurs have resorted to taking their own lives to escape the shame and burden of not being able to repay their debts. When we spoke to those who survived the crisis, they credited their survival to having focused on their main businesses and not diversifying. These prudent enterprises are already planning for opportunities that are likely to emerge as China embarks on a challenging rebalancing of its economy.

The Road Ahead

The growing significance of small and medium-sized enterprises in China’s economy is clear. About 60% of China’s industrial output is credited to SMEs, which are also estimated to employ approximately 75% of the workforce in China’s cities and towns. And yet, there are several obstacles that SMEs have to overcome in launching new businesses—the availability of capital being one of them.



We also learned that there was no national level regulator to deal with the issues relating to small- and medium-sized businesses. In addition to these structural impediments, the cyclical headwinds arising from rapidly rising costs, and shrinking export demand are testing a broad swath of entrepreneurs in China. So it is encouraging that the government is trying to address some of the shortcomings, particularly their attempts to legitimize the flow of non-bank funding.

Following the widespread sympathy and strengthened public criticism of the death penalty that Wu Ying’s case attracted, China’s Supreme Court suspended her death sentences in late April. Recently, Wu’s lawyer told a reporter in Beijing that entrepreneurs would be paying particular attention to her case “because today’s Wu Ying could be any of them tomorrow.”

Hardy Zhu
Research Analyst
Matthews International Capital Management, LLC