China’s SMEs, Good And Bad, Under Threat

IOUs

By John Richardson

THE cosy relationship between the state-run banks and state-owned enterprises (SOEs) has long held back economic rebalancing, but wasn’t a critical problem for small-and-medium-sized enterprises (SMEs) when official lending tripled in 2009 (have a look at the chart on polypropylene in this post, which illustrates the impact). There was, of course, plenty of cake to go around because the overall size of the cake had been hugely increased.

But over the last three years, starting from April 2011 when it became apparent to China’s leaders that inflation was out of control, efforts have been made to rein-back official lending. As the cake shrank in size, the SMEs were left with the crumbs because the lending that was available predominantly went to the SOEs.

No matter. The SMEs could still, until this year, fuel their growth via the shadow-banking system, even if they ended up paying interest rates of 10% or more. These interest rates were affordable because everywhere you looked, China was booming.

But now, as the new government tries to fix China’s hugely flawed economic growth model, it has gone after the shadow-banking sector: In February, there was virtually no new loan growth via shadow banking compared with $160bn of growth in February.

All might eventually be fine, provided China’s leaders can break the comfortable transmission mechanism, where all that preferential finance is funnelled from the state banks to the SOEs with hardly any checks on whether a loan can be repaid.

“The problem is I am not seeing any signs of success so far,” said an executive with a Western chemicals logistics company, who is based in Shanghai.

“All we have seen to date is a big gap in trade finance for our SME customers versus the SOEs.”

Dr John Lee of Sydney University is also sceptical over whether any real progress has been made towards tackling the SOE problem.

But its not just about cosy relationships. The state-run lenders, under pressure to keep their official non-performing loan ratios to around 1% don’t want to lend to SMEs because they are worried, quite understandably, that lots of these companies might go bust.

Further, the official lenders are no longer able to as easily shift money off their balance sheets in order to speculate via the complex shadow-banking system. This money was eventually finding its way to the SMEs.

This is all part of Beijing’s plan. It wants to get rid of “low value” SMEs, including in the plastic processing sector. The government aims to tackle oversupply in some industries, wants to reduce to pollution and needs to control the bad debt problem before it gets any worse.

But, of course, it is the SOEs that are as much, if not more, to blame for all the above because of their scale and their access to voluminous amounts of indiscriminate and cheap capital.

Meanwhile for the chemicals industry the risk remains that their customers will start going bust in ever-larger numbers as the reform process accelerates. Last week’s mini-stimulus package didn’t change anything.

There are no guarantees that only the good companies will fail during this process because of long and complex supply chains.

For example, you might be a multi-layer plastic film producer in China – exactly the kind of high-value converter the government likes. But what happens if you end with a worthless IOU (see the above chart from this WSJ article about the growing role of IOUs in the Chinese economy) from one of your customers or suppliers?

Unless the government “blinks” and pumps more indiscriminate cash into the SME system then good and bad bankruptcies might ensue.

The danger, though, of indiscriminate cash is that it will end up finding its way to those bad companies.

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