FINANCING DIFFICULTY OF SMALL FIRMS IN CHINA
Kevin Chow
Senior Manager
Research Department
Hong Kong Monetary Authority
9 October 2015
Why alleviating financing difficulty of small firms is important
for China?

Small and Medium-sized Enterprises (SMEs) play a pivotal role in fostering
economic growth, creating employment and driving innovations in China. They
contributed to
 60% of GDP in value-added terms,
 50% of tax income and,
 more than 70% of new jobs creation


However, credit that small firms can get is hardly matched by their economic
significance, and this has become a major obstacle for SMEs to increase
investment and expand business
To alleviate financing difficulty of small firms is important for China at this
juncture as debt overhang problem in local governments and some state-owned
sectors means that private sector investment will play a more important role
2
Financial constraints faced by SMEs: how big is the problem?

The phenomenon of financing difficulty in China manifests itself in two aspects
1. Most credit has been allocated to larger firms such as listed companies and
state-owned enterprises, little is left for small firms.
2. Small firms tend to pay much higher interest rates than their larger
counterparts in borrowing even after controlling for risk profiles
Disproportionate small amount of credit
allocated to small firms
Sources: CEIC, PBOC and staff estimates.
Proxy of borrowing costs faced by small firms
3
Listed company data show small firms tend to face higher
borrowing cost than large firms


To investigate into the issue, we studied the borrowing costs and funding
structure of non-bank corporates listed in A-share market for the period
between 2010 – 2013.
Small firms tend to pay interest rates 50 – 100 basis points higher than their
larger counterparts, depending on industry they belonged to.
=
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒑𝒂𝒚𝒎𝒆𝒏𝒕
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒃𝒆𝒂𝒓𝒊𝒏𝒈 𝒍𝒊𝒂𝒃.
=
𝑩𝒂𝒏𝒌 𝒍𝒐𝒂𝒏 + 𝑩𝒐𝒏𝒅 𝒇𝒊𝒏𝒂𝒏𝒄𝒊𝒏𝒈
𝑻𝒐𝒕𝒂𝒍 𝒍𝒊𝒂𝒃.
Borrowing cost
Reliance on external financing
(% p.a.)
(% share of total liabilities)
Small and
Small and
Large firms
medium firms
medium firms
Large firms
Infrastructure and utility
7.1
6.3
5.8
5.9
31
45
41
62
Retail and wholesale
6.0
6.0
30
32
Manufacturing
5.6
5.8
33
41
IT
5.6
5.4
4.9
5.0
20
29
24
35
Mining
Real estate and construction
Sources: Listed company data from WIND and staff estimates.
4
The differentials in borrowing cost are more prominent for
listed firms with higher leverage, poorer liquidity…


We also compare the borrowing costs between riskier and less risky firms
according to their leverage, liquidity and profitability.
It is found that for the riskier firms the borrowing costs differentials due to
firm size are more pronounced compared to the less risky firms.
Leverage – Debt to asset ratios
Sources: WIND and staff estimates.
Liquidity – Current assets to total assets
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…or weaker profitability


We also compare the borrowing costs between riskier and less risky firms
according to their leverage, liquidity and profitability.
It is found that for the riskier firms the borrowing costs differentials due to
firm size are more pronounced compared to the less risky firms.
Profitability – Return on assets
Sources: WIND and staff estimates.
6
After controlling for risk profiles, small firms still tend to face
higher borrowing cost than large firms within the same industry


To test the robustness of our findings,
we also performed a regression analysis
to control for the three risk factors (i.e.,
leverage, liquidity and profitability) at
the same time.
Holding other variables constant, a 1%
increase in firm size on average would
reduce a firm’s borrowing costs by 0.41
basis points
Coef.
Std. Err.
-0.02**
0.008
Leverage
0.026***
0.005
Liquidity
-0.433***
0.063
Ln(Size)
-0.41***
0.051
0.521
0.383
Real estate and construction
0.941**
0.446
Retail and wholesale
0.945**
0.461
Mining
1.584***
0.533
0.545
0.435
8.13***
0.591
Period: 2009 - 2013
Profitability
Industry Fixed Effects:
Manufacturing
Infrastructure and utility
Constant
No. of observations
R-squared
Sources: WIND and staff estimates.
7412
0.0253
7
The root causes of financing difficulty of small firms in China (1)

Information asymmetry on borrowers’ risk profiles between lenders and
borrowers.

The lack of tractable history of
operations and profits, limited
financial information disclosure
and inability to provide collateral
have put small firms into
disadvantage position in getting
credits.
Sources: WIND and staff estimates.
Banks usually require collateral from small
firms more than large firms
8
The root causes of financing difficulty of small firms in China (2)



Banking sector in China is dominated by the 4 state-owned commercial banks. They have been able
to secure decent profits under the interest rate rules.
They therefore can focus on lending to SOEs or large firms while have little incentive to extend
business to lending to small firms.
While financing activities conducted through the shadow banking channel have expanded notably in
recent years, they do not replace the dominant role of the traditional banking system
City and rural banks are active in SME lending
Sources: CEIC, PBOC, WIND and staff estimates.
Bank loans remain the major source of finance
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Policy measures to alleviate financing difficulty of small firms
Solution
Central credit registry & loan
guarantee schemes
Interest rate liberalisation
Contents
•
Effective tool to reduce the problem of information
asymmetry
•
Common and well established in many OECD countries
•
Catalyst for changing the lending behaviour of big banks
 Pass on the increase in funding costs to larger firms such as
SOEs, thus reduce their loan demand
 Narrowing interest margin would prompt banks to seek for
better risk return trade-off by lending to small firms
Development of a liquid
interbank market
Alternative source of finance
 Private lending / P2P loans
 Internet banking
•
As a reliable alternative funding source for small banks
•
Ease funding constraints faced by small city and rural banks
and they can channel more funds to small firms.
•
Stringent risk requirement would be important to safeguard
financial stability
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Conclusion
● There are evidences that small firms tend to pay higher interest rates than
larger counterparts, even after controlling for difference in their risk levels.
The borrowing cost differential is more pronounced for the group of firms with
higher financial risks
● Financing difficulty of small firms in China to a large extend is a structural
issue related to its financial market structure and interest rate regulations that
hinder real competition in the banking sector
● Policy efforts that reduce information asymmetry, ensure a level-playing field
for small and big banks, and introduce more competition to the banking
sector would be useful in alleviating financing difficulty faced by small firms
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