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Cablegate: China/Smes/Rebalancing: Trying to Overcome Anti-Sme Biases

DE RUEHBJ #2952/01 2951033
P 221033Z OCT 09





E.O. 12958: N/A

Refs: A. Priscilla Hoffman-Stowe/Laura Stone email, October 9, 2009;
B. FBIS/OSC #CPP20090924308001; C. 08 Shanghai 550

1. (SBU) SUMMARY: China's largest, often State-owned companies have
benefited handsomely in recent years from overt government
favoritism aimed at quickly stimulating the economy, and in the
longer term at building strong national champions. Smaller firms
have also had to contend with a poorly developed financial sector,
barriers to entry in many sectors, an inadequately-trained
workforce, and ineffectual legal protections. The result has been
stunted growth of smaller, innovative and service-oriented
companies. To combat this trend, recent high profile policy
statements indicate the leadership seeks to re-focus attention on
advancing a more robust private sector. However, the structural
bias toward powerful State-owned enterprise (SOEs) will be hard to
reverse. Despite new policies aimed at re-orienting growth, China's
small- and medium-sized enterprises (SMEs) continue to struggle.
(Note: This cable provides information in response to Ref A. End

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SMEs a Growth Engine, But Face Obstacles

2. (SBU) Chinese data on SMEs are notoriously problematic since many
small service providers are unregistered, but according to official
statistics China has at least 10 million SMEs that make up 60
percent of China's GDP, and account for 99 percent of total
enterprises and 80 percent of urban employment. These smaller
firms and businesses, according to Dragonomics Economist Arthur
Kroeber, have created almost all Chinese job growth in the last
decade and have contributed disproportionately to GDP growth. A
Deloitte report called SMEs "powerful transformational agents" and
"innovation centers," key to China's rise as a global competitive
force. Nevertheless, SMEs have been heavily impacted by the
financial crisis, highlighting their role as employers and
exporters. Jie Yao, Professor at the School of Economy and
Management in Northeast Dianli University, told Econoff that
export-based SMEs face considerable obstacles and were adversely
impacted by the economic crisis: "Many Chinese export-oriented SMEs
closed down because of their weak vitality and weak competitive
strength." According to the Ministry of Finance, 40 percent of
China's SMEs stopped production and/or apply for bankruptcy as a
result of the economic crisis.

3. (SBU) Despite SMEs' major contributions to economic growth and
employment, they are virtually barred from participating officially
in some of China's fastest-growing sectors, which are often
monopolies dominated by the state sector. In telecoms and Internet
Services, for example, SMEs have limited access, although they could
in theory obtain licenses as service providers. In the past, the
coal industry was open to SMEs, but the Chinese government is now
enforcing large-scale consolidation and closing small mines in order
to reduce the number of mining fatalities. Infrastructure projects
go to large, typically state-owned firms, but SMEs can often get
part of the pie as subcontractors. Even where there are no formal
barriers, however, SMEs usually lack the political ties needed to
overcome opaque regulatory regimes, corruption and weak rule of law,
poor IPR protection, and a government procurement system that
rewards the companies that have political connections and resources
to lobby for contracts.

Lack of Credit

4. (SBU) SMEs also lack basic access to credit (See Refs B and C).
In a press conference earlier this year, Minister of the Ministry of
Industry and Information Technology (MIIT) Li Yizhong identified
availability of capital as the single most important culprit for
SMEs' difficulties. Zhang Qizuo of China International Economic
Research Group pointed to lack of capital as a major problem: "The
financing problems of SMEs have not yet been properly resolved."
Under recent government initiatives, loans to SMEs reached 54
percent of total outstanding corporate loans at the end of June
2009, and grew at a faster rate than overall corporate loans. While
this is an improvement over previously woeful credit access, it
still represents tight credit conditions and allows little slack for
start up businesses.

5. (SBU) SMEs' difficulties accessing capital stem from the lack of
a credit information system and the ability to charge interest rates
appropriate for the level of risk, in combination with the central
government's continued reliance on lending quotas rather than more
normal monetary tools to control excess liquidity in the economy. A
Jiangxi Chamber of Commerce official recently told Econoff that SMEs
rely heavily on China's large financial institutions, but banks

BEIJING 00002952 002 OF 003

under-serve local SMEs because the banks lack sufficient familiarity
and credit information on SME firms. As a result, according to the
official, under-ground financing is prevalent and plays a key role
fulfilling the un-met demand for loans. Underground financing
includes county governments and local businesses making informal
financing arrangements to fill the gap, as well as informal business
and illegal operations. He explained that information about credit
worthiness is often limited by region. For example, when a company
wants to expand or borrow money from financial institutions based
elsewhere, it encounters difficulty, particularly outside of large

6. (SBU) Rural Credit Cooperative (RCC) branches have had some
success where lending by large state-owned banks have fallen short.
According to the official, RCC's extensive rural branch networks
gave them knowledge about SME credit worthiness that other financial
institutions lack. However, there are indications that even credit
from the RCCs is drying up. Caijing magazine recently reported that
the RCCs have unduly favored local infrastructure and real estate
projects at the expense of lending to smaller borrowers. China has
growing private equity and venture capital industries, but private
equity firms focus on large firms ready to make initial public
offerings, and the lack of credit information prevents funding from
these channels from reaching many Chinese SMEs.

The Dearth of Talent

7. (SBU) In addition to the short-term access to credit challenges
facing SMEs, the longer-term challenge of attracting, developing,
and retaining talent serves to shackle private sector growth. SMEs
have historically lost talent to well-known multinational brands,
famous SOEs, and stable government packages because, according to
Jim Quigley and Chris Lu of Deloitte, SMEs are "weakly branded,
patriarchal, and family dominated." Beyond losing the battle to tap
into the available talent market, SMEs further lose in their ability
to develop and add value to existing employees.

But the Government Has A Plan!

8. (SBU) As China moves to promote more sustainable balanced growth,
it has given new attention to growing the economy's service sector
and promoting SME growth. In late September 2009, the China State
Council issued "Certain Opinions of the State Council on Further
Efforts to Promote the Development of Small and Medium-sized
Enterprises" (see Ref B). This document outlines a range of pro-SME
programs, including the development of a special credit fund,
improving science and technology innovation policies, preferential
tax policies, lowering market access thresholds in traditional
service monopolies as well as other areas dominated by large-scale
enterprises, giving SMEs preferences in government procurement,
encouraging SME lending, allowing a new NASDAQ-type market, and
reducing business registration and transaction fees.

9. (SBU) Some programs to stimulate SMEs are already in place, and
the State Council Opinion merely summarized ongoing efforts. For
example, measures were announced in August 2009 to help SME
exporters through export tax refunds and export credit insurance;
the China Association of Small and Medium Enterprises has set up a
venture investment fund; and a corporate bond to raise funds for a
group of SMEs Liaoning Province was issued in May 2009. Moreover,
commercial banks such as the Bank of China, China Commercial Bank,
and Minsheng Bank set up separate SME business departments to
support SMEs, and an SME board was recently established on the
Shenzhen Stock Exchange. Also, funds available for lending from
MIIT's development fund for small and medium-sized enterprises
increased from RMB 3.9 billion (571 million USD) in 2008 to RMB 9.6
billion (1.4 billion USD) in 2009. MIIT also is working to increase
technical, management, and business training for SMEs. Before the
State Council Opinion was issued, according to a RCC official in
Jiangxi Province, the provincial government directed that one third
of new lending go to SMEs. In the past, RCCs waited for SME
borrowers to come to them, but now RCCs aggressively target SME

Comment: An Uphill Struggle

10. (SBU) Beijing has had a stated goal of spurring SME development
for at least eight years, thus far to little effect. Because of the
scale and structural nature of the biases against SMEs, getting
funding to flow towards smaller firms without implicit government
guarantees will be difficult without wholesale reform of the Chinese

BEIJING 00002952 003 OF 003

economy. The State Council's SME Opinion appears to reflect the
government is taking the health of SMEs seriously; it also calls for
providing real financial and technical support to ongoing
initiatives. However, the document does not include details, which
are expected to be fleshed out in subsequent policies and
regulations. Even in the face of a newfound policy to promote SME
growth and development, challenges remain colossal and include weak
financial infrastructure in the provinces, lack of transparency and
variability in local rule of law, as well as local government
corruption and favoritism. Until China achieves real financial
reform in the form of risk-based interest rates for business loans
and control over petty corruption, plans to support SMEs will have
trouble gaining purchase. The largest short-term barrier remains a
lack of access to capital from the formal financial sector, which
forces SMEs to maintain high savings and hinders business
re-investment. In the long-term, talent recruitment, development
and retention will be crucial. Overcoming these challenges will
likely limit the reach of China's rebalancing efforts in the
foreseeable future.


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