What will happen to small business as China's economy slows? The country's small and medium-sized enterprises are an important part of the economy and even more integral to employment; they account for 60 per cent of gross domestic product but a full 82 per cent of employment. With China's GDP growth dropping from over 10 per cent three years ago to 7.5 per cent or below, SMEs are going to struggle, which could have a disastrous effect on China's future. The biggest problem facing them is a shortage of capital. The five state-owned banks, which control half of all bank assets, are much happier lending to state firms because they are generally "too big to fail". Even the smaller city and commercial banks prefer local-government-backed companies to private enterprise. That forces small businesses to rely on the shadow banking sector. The shadow banks in China include a wide gamut of enterprises, ranging from family and friends and private lending groups to giant trusts. Figures vary but, according to the People's Bank of China, these lenders accounted for 30 per cent of credit issued last year. We recently conducted a study of SME bank loans in China for the Shadow Banking Working Group at Guangxi University, sponsored by Beijing's Central University of Finance and Economics. We examined data for more than 4,000 SMEs in 2007 and 2011 in two surveys conducted by China's State Administration for Industry and Commerce and collected by the Chinese University of Hong Kong. The results were dismaying. Loans from the official state and local banks, for the most part, go to the traditional sectors of the economy, including real estate, mining, manufacturing and older registered companies. The only non-traditional lending from the banks goes to firms whose net income "increases as a result of innovation". In contrast, unofficial "shadow" loans tend to go to rural borrowers or those sectors typically dominated by SMEs, including agriculture, forestry, consumer services (like barbershops and local repairmen). What does this mean for the future of SMEs? First, their capital is more expensive. On average, they pay 8.9 per cent for non-bank financial loans and a whopping 12.6 per cent for personal loans, compared with only 8.1 per cent for the official bank loans. Second - and more worrisome for the nation's macroeconomy - shadow loans are likely to be the first to disappear if liquidity tightens in China. Why would this happen? Here's where we take a step back to look at Japan's financial crisis and China's own history. Japan's crisis in the 1990s started with a shortage of liquidity that caused a deflation in asset prices. Land prices escalated, and companies increasingly issued shares collateralised by rapidly escalating land prices. This happy little game worked fine - until the funds ran out. New capital adequacy rules from the Bank for International Settlements and growing dismay at the loosely regulated credit co-operatives meant that the fire hose of money dried up. Who were the first to fail? The smaller, peripheral financial institutions - shadow banks. In 1994, the Tokyo government closed the Tokyo Kyowa Credit Co-operative and Anzen Credit Co-operative. In 1995, the Cosmo Credit Co-operative in Tokyo and the Kizu Credit Co-operative in Osaka also folded. Eventually, Japanese regulators let larger institutions go. What about China? Since the majority of the banking sector is owned by the central government in Beijing, including the state banks, they are well insulated from such liquidity shocks. But not the shadow banks. Unless they are large or well-connected enough to have direct ties to Beijing, they are not going to avail themselves of central government protection. There is a historical precedent for the failure of shadow banks in China. In 1989, regulators shuttered dozens of Wenzhou money houses or converted them to urban credit co-operative banks. Ten years later, suffering from growing bad loans, 18,000 rural co-operative foundations were either closed or taken over by a new group called Rural Credit Co-operatives, with much of the debt ending up back in the hands of the local governments. Such actions were prudent in light of weak lending controls and inadequate capital. But it also meant small business lost an important source of credit. The regulators, including the People's Bank of China and the China Banking Regulatory Commission, are aware of the risks. They are doing their best to push the official banks to lend to SMEs. In 2010, following orders from Beijing, SME loans jumped 34 per cent compared with a 20 per cent rise in total lending, according to Moody's. And last July, the authorities approved additional measures requiring state banks to lend to small businesses and provided new support for village and township banks. But all this may be in vain if China faces a new credit crunch. Like starving wheat during a drought, a crisis could lead thousands of small business to shrivel and die. It happened in Japan in the 1990s, again in the US during the mortgage crisis, and it could happen in China. Andrew Collier is a senior fellow in Hong Kong with The Mansfield Foundation. Sara Hsu is assistant professor of economics at the State University of New York at New Paltz
