The Real Trouble with SME Lending in China
China’s latest burst of bank lending, much of it apparently directed at government-sponsored projects and large state-owned enterprises, has refocused attention on the chronic difficulty many promising entrepreneurial enterprises have in obtaining similar loans from China’s state-run banking system. The problem is usually framed in public policy terms, as the need to push for more lending to the Small and Medium Enterprise (SME) sector. In June, China’s “big four” state banks proudly trumpeted how vigorously they were addressing this issue by issuing billions of yuan in new loans to SMEs.
I used to work for an SME-focused private equity fund in Sichuan, and later for a mezzanine fund engaged in subordinated lending to Chinese companies. I’ve spent a lot of time with Chinese management teams talking over their financial statements and funding options, and more evenings than I’d like to remember helping them wine and dine local bank officials in order to secure loans. Based on my experiences, I believe the conventional diagnosis is wrong. China’s problem is not SME lending, per se. It is collateral-based lending. And efforts to push more SME loans as part of China’s stimulus will not only be ineffective (except in the very, very short run), but also counterproductive.
When a Western commercial bank considers making a business loan, it starts by looking at the company’s income and cash flow statements. Does the borrower earn enough to meet its obligations? Can it continue to do so over the life of the loan? To answer these questions, the lender often relies on metrics such as the loan amount as a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization) or the debt service coverage ratio (the ratio of cash available for interest and principal repayment). If the answer is border-line, the lender may seek additional peace of mind by establishing a secured claim on some specific asset, such as a machine or piece of land, which it could seize and sell in the event the borrower were to default. But even with a mortgage, such collateral should be a worst-case back-up, a way of mitigating losses if all else fails. The basis for making the loan is an assessment of the borrower’s ability (and its willingness) to pay.
In China, when a company requests a loan, the first thing banks look at is the borrower’s balance sheet. What hard assets does the business have, in case it fails to pay? Land is best, in the banks’ eyes, but a really big, expensive piece of machinery might suffice. The lender may or may not actually secure that asset with a lien, but the value of the collateral serves as the basis for making the loan. In 2006, an IMF study confirmed that, despite efforts at reform, Chinese banks still “do not appear to take enterprise profitability into account when making lending decisions.” The reason is that, from a technical and bureaucratic perspective, collateral lending is much easier. At least superficially, it doesn’t require any business judgment, just check-the-box procedures to make sure the bank is adequately “covered.”
Compared to other businesses, state-owned enterprises (SOEs) tend to have plenty of hard assets for use as collateral. The Chinese government spun off most of its smaller SOEs to private entrepreneurs in the 1990s, to concentrate on what it saw as the “commanding heights” of the economy: asset-heavy industries like steel, coal, automobiles, and computers. These SOEs often received choice land at special discount from their sponsoring government entity. But even private Chinese companies in asset-heavy sectors tend to have little difficulty securing loans from banks, because of the collateral they can present to loan officers.
The need to impress banks with the size of their collateral pushes Chinese companies to grossly inflate their balance sheets. Chinese accounting makes liberal use of the international accounting rule that lets companies revalue their fixed assets upwards, in excess of cost (US GAAP only recognizes impairments to such assets that make them worth less than before). Companies regularly hire appraisers to declare their machinery to be worth two or three times what they paid for it–often just months after installation. They value the land under their factory based on the going price of the nearest luxury condo development–even if that project lies uncompleted or empty. This whole charade tends to distort the value of the business in the eyes of the bankers and sometimes the managers themselves.
Of course, bank officers still have a great deal of discretion in determining which assets they will accept as collateral and at what valuation. An SOE, with the central or provincial government to back it, will obviously get what it wants with the least fuss and delay. Others must wine and dine loan officers until their new “friends” can be persuaded to see things their way. The goal, in either case, is to get the bankers to just check the box, and check it next to the biggest number possible.
There are a lot of SMEs out there that, because of their limited assets, simply have no hope of playing this game–hence the conclusion that SMEs are poorly served by the banking system. But while the problem is usually portrayed as one of institutional access, it actually goes far deeper than that.
First of all, China’s reliance on collateral, rather than profitability, as its main criteria for allocating capital distorts the country’s economic development. Asset-heavy industries receive capital to grow. Asset-light sectors–particularly services, which often have little or no fixed assets–find themselves cut off from bank financing. And we wonder why China has such a difficult time developing its service sector, and such a lopsided reliance on manufacturing.
Second, collateral-based lending has the perverse effect of punishing efficiency and rewarding inefficiency. Most people would agree that earning $1 million from a $10,000 investment is better than earning the same thing from a $1 million investment. An investor wants an enterprise not just to generate as much earnings as possible, but also use as little capital (both equity and debt) as required, in order to maximize the return. Companies that conserve (perhaps buying a second-hand machine instead of a brand new one) in order to produce a high return on assets (ROA) should be the ones to receive more capital to grow, since they use it most efficiently. But in China, the best way to secure access to future capital is to pile assets on your balance sheet. It’s survival of the fattest, not the fittest.
To be fair, Chinese banks have spent the past decade trying to improve their lending practices. Several have formed joint ventures with Western banks to train their employees in the financial and business skills necessary to evaluate loans on a more commercial astute basis. But Chinese banks–including the “big four”–have traditionally been far more centralized than many people realize. Branch managers possess a great deal of operational autonomy, and their staffs prefer the safety of “checking the box” as well as the perks associated with the old way of doing business. Still, some progress has been made, especially in Tier 1 markets.
That is why China’s stimulus lending binge threatens to hurt SMEs more than help them. True, the government can order banks to channel money towards SMEs, just as it has directed them to fund other aspects of the stimulus plan. But lending by state fiat is a step backwards, not forwards. By reverting to their previous role as mere conduits for state funds, China’s banks have abandoned the very commercial reforms that might have opened up lending to more efficient, asset-light companies on a sustained basis [see my earlier WSJ op-ed on undoing Chinese bank reform].
China’s goal should not be to throw money at SMEs as though they were just another special interest to be subsidized. It should be to develop a banking system capable of allocating capital to whoever can use it best–including good SMEs.