Tuesday, May 28, 2019

So far, 2019 has been a key year for China's economic transition and upgrade. Amid the trade war with the US and the nation's continued push to slash overcapacity, inventories, and deleveraging, all levels of governments have no choice but to face downward pressure on the economy and employment.

This highlights the significance of small and medium-sized enterprises (SMEs) to the economy as well as the difficulty they have experienced with fundraising.

Multi-pronged, joint efforts are needed from governments, financial institutions, and businesses to take advantage of diversified capital to spur economic innovation and diffuse fundraising woes impeding small business development.

The main issue with SME fundraising does not pertain to China. Instead, it's a globalized financial challenge. Developed economies would also rack their minds to give their domestic SMEs "blood transfusions" through non-market methods including technology, industry, and employment subsidies.

This is a manifestation of economic law. As borrowers from commercial banks, SMEs face higher operational risks than government organizations and large companies. They also have to also rely on high-risk and yet high-return direct financing arrangements like equity investment to acquire capital.

Compared with European and US capital markets, China's mainland stock market is much younger, with exchanges in Shanghai and Shenzhen less than 30 years old. More than 3,000 companies are traded on the mainland market, which is accessible to large-scale businesses with healthy profit margins, while the SME fundraising needs that are vastly distributed and widely different are challenging to meet.

Due to the size of the Chinese economy, eastern coastal areas, along with central and western interior regions differ from each other in economic structure. Domestic liquid capital markets are unlikely to become the primary source for SME financing.

That's way the annual government work reports in recent years have given substantial attention to underlining development of a multi-layered capital market. The end result would serve the financing needs of businesses in different regions with various size and potential.

Such a multi-layered capital market should at least include the National Equities Exchange and Quotations in Beijing, also known as the "new third board," and regional equities markets across different provinces.

Another advantage China has in developing a multi-layered capital market is diversification within its economic development. China's consumer market upgrade is shown being pushed from central cities to rural areas. This underpins the resilience of the economy, providing room for smaller businesses to explore opportunities in niche markets.

Why does the public still reckon the financial sector fails to provide sufficient support for SMEs? Moreover, SMEs have complained that commercial banks are almost absent in serving companies in rural areas and without the ability to raise money from the new third board and regional equities exchanges.

The mismatch in financial services reveals how the commercial bank system remains the driving force behind China's financial ecosystem while similarities in operating models among commercial banks are leading them down a blind alley that only separates them further from the masses, businesses, the market, and prevents funds from circulating into the real economy.

The development of commercial banks can't focus solely on financing infrastructure projects championed by local governments, or rely on property credit policy easing and disguise risks in pursuit of expansion. The banks should "bend with" the real economy.

It boils down to the fact that commercial banks have over the past 20 years have made easy money. Property-related companies have relied on the use of land as collateral while governments have been dependent on the monetization of new assets.

As a consequence, the "land plus state-owned" economy has turned out to be the "golden client" for banks who naturally dislike SMEs that carry operational risks. However, after several rounds of fiscal stimulus and investments aimed at ensuring growth, the real estate sector, local government financing platforms, and a portion of state-owned enterprises (SOEs) have piled up a substantial amount of nonperforming loans.

In light of this, commercial banks have to replace existing loans with new loans to maintain a balance sheet, and many banks have money and assets that only circulate in the financial system, thus undermining monetary transmission efficiency.

In years to come, outside of a few commercial banks poised to exit the market due to insolvency, most commercial banks are required to mull over new services to squeeze water from assets and count on new business models to achieve upgrades.

Governments at all levels, for their part, require SMEs filled with vitality to spur local job markets. Without professional think tanks and financial services, industrial development will remain challenging.

Consequently, careless blunders have been made wherein public finances were used for fraudulent schemes that only harmed society. This means that in the rural part of economy where there's insufficient financial services, professional financial institutions are required to spur business vitality via the offerings of structural financial products.

As the China-US trade war escalates, many export-driven SMEs face financial difficulties. Provincial governments are supposed to provide services aimed at innovation and fueling the marketplace, helping businesses acquire access to a comprehensive set of financial tools such as leasing, pledging of shares, and direct financing.

Fostering vigorous SME growth is supposedly the best path for the economy experiencing downward pressure, as it urges governments to use public finances and advanced banking services that address market needs.

Author: Xu Weihong, Global Research Partner of ANBOUND, Chief Advisor for China Securities JT Fund.

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