One of the main themes of this year’s “two sessions” meetings of the country’s legislature and top political advisory body has been renewed support for the private sector, seen as crucial to the governments hopes of pulling the economy out if its current slump. But the private sector, which accounts for more than 60 per cent of China’s gross domestic product (GDP) growth and creates 90 per cent of new jobs, has suffered in recent years from the government’s deleveraging campaign aimed at reducing excess debt and risky lending. That campaign targeted so-called shadow banking practises – lending and other financial activities conducted by unregulated institutions like trust companies or brokerages, or unregulated off-balance-sheet operations by traditional banking institutions – that authorities said posed a threat to the stability of the entire financial system. The authorities had reason to worry as the country’s debt level rose to nearly 300 per cent of its GDP at the end of 2017, a dangerous level for any country but especially so for a developing nation like China. But there is growing recognition that the deleveraging campaign may have gone too far, eliminating legitimate funding channels as well as high risk speculative operations. “Perhaps there were places that needed to be tackled that didn’t get dealt with, yet some major shareholders of listed companies were killed off. This is the side effect of [the government’s] policy,” said Chen Yuyu, a professor of economics at Peking University’s Guanghua School of Management, referring to business owners who struggled to find funds after informal funding channels such as shadow banking had been cut. Adverse side effects A significant consequence of the deleveraging campaign was to sharply reduce lending to small- and medium-sized private businesses, who depended heavily on shadow banking for credit. Traditionally, large state-owned banks lent largely to state-owned companies due to the larger credit risk associated with lending to private companies that did not have the implicit – or at times explicit – backing of the central or local government. Small businesses turned to unregulated shadow banks, whose lending interest rates are not constrained by the rules that are applied to regular banks and which were willing to take larger credit risks. The shadow bank lending fuelled the growth of the Chinese private business sector, but the clampdown that began in 2016 had the direct effect of reducing credit to these smaller firms and sharply raising the cost of credit for those who still had access. Without adequate financing for operations or to service debt, many firms had to postpone investment and recruitment, contributing to a slowdown in the economy that started even before the trade war with the United States. There are no official figures on how much shadow banking has contributed to the financing needs of small- to medium-sized companies or the size of the China’s shadow banking market, but academics at the American Economic Association estimated that 80 per cent of privately owned Chinese firms received funds from informal channels. But financial support has fallen significantly and Fitch Ratings estimated total shadow banking assets fell to 60 per cent of China’s nominal GDP in 2018 from 70 per cent in 2017 due to the deleveraging measures. This led to China’s corporate debt falling from 134 per cent of GDP in 2017 to 128 per cent of GDP in 2018, according to estimates from Natixis. “Most of the reduction is due to private corporation’s efforts to divest assets, given the constraints in accessing credit, especially since the clampdown on shadow banking,” said Alicia Garcia Herrero, chief economist for Asia-Pacific at Natixis. Government response The government now understands the problem and is trying fix it, but it is trying to do so without unravelling the progress it made in eliminating the shadow banking practises that funded financial speculation rather than contributed to the real economy. Premier Li Keqiang pledged in his work report to the meeting of the National People’s Congress last week a series of measures to help businesses, particularly smaller private sector firms, including a cut in the value-added tax rate for many firms and a reduction in the contribution rate for social security – pensions, unemployment insurance and health care – that firms must pay the government for each employee. Li also said that one of the main goals of the government this year is to “achieve a marked improvement in providing financing for medium, small and micro enterprises, and see that there are definite reductions in overall financing costs.” He further pledged that loans to small and micro businesses by large state-owned commercial banks would increase by over 30 per cent this year. Over 85 per cent of private firms’ investment is in the manufacturing sector,” said Zhou. “We hope the government can help the private sector when it comes to financing, such as streamlining the procedure [to obtain a loan]. Zhou Qunfei, Lens Technology While Li’s annual report sought to reassure the private sector they would have access to funds at reasonable rates, not all private entrepreneurs were convinced. High funding costs and difficulties in borrowing can slow down innovation, warned Zhou Qunfei, founder and chief executive of Lens Technology, a screen supplier whose clients include Apple and Samsung. A delegate to the Chinese People’s Political Consultative Conference (CPPCC), the government top political consultative body, Zhou listed financing as a major hindrance to progress in advanced manufacturing. “Over 85 per cent of private firms’ investment is in the manufacturing sector,” said Zhou. “We hope the government can help the private sector when it comes to financing, such as streamlining the procedure [to obtain a loan]. The whole world is talking about advanced manufacturing, if you have fallen behind by a small margin in China, I believe the gap is a lot bigger, especially in the telecommunication industry that we are in. It’s about speed.” Han Jinguang, chairman of Hainan Standard Bio-Technique, said the next two years would be “winter time” for the private sector, expressing concern whether small- to medium-sized firms would be able to obtain loans from banks even with instructions from the central government. “In practise, there are often ways to skirt the rules,” Han said. “Subsidiaries set up by state-owned firms will get allocated the funds [borrowed from banks] as they disguise themselves as small- to medium-sized enterprises, so the real small- to medium-sized firms don’t get the benefits. The funding cost for private firms is often double that of state firms on average. It’s very stressful mentally for private companies.” NPC delegate Han suggested that the government encourage bank lending by setting up agencies to guarantee loans to private firms. “The government could also consider subsidising the gap between the funding costs that private firms have to pay compared to [state-owned enterprises],” he added. Despite Li’s pledge that the country’s commercial banks would increase lending to small companies this year, many banks may still not be comfortable taking the risk to lend to the private sector, in part because their income has also been squeezed after deleveraging sharply cut their off-balance-sheet operations, according to Brian Li Man-bun, deputy chief executive at Hong Kong-based Bank of East Asia, which has a corporate loan business in mainland China. “For banks, risk management always comes first,” said Li, who is also a delegate to the CPPCC. “Small- to medium-sized companies are not getting funding, and even if they can, it’s very costly. A constructive way is improve the situation is to offer some level of guarantee.” Li cited the Hong Kong government’s small- and medium-sized private businesses financing scheme, which gives banks a financial incentive to lend to small firms, with a government insurance agency guaranteeing 50 to 70 per cent of loans to an eligible enterprises. The return of shadow banking With China’s economy growing at its slowest pace in early three decades, regulators are considering making a U-turn on some portions of shadow banking. “We need to have an accurate understanding of shadow banking. For those [institutions] whose financing benefits the real economy and which have good internal risk controls, we may continue to allow them to exist and support them,” Wang Zhaoxing, vice-chairman of the China Banking and Insurance Regulatory Commission said last week. Andrew Collier, managing director at Orient Capital Research and author of Shadow Banking and the Rise of Capitalism in China, said shadow banking is “extremely important to China’s economic growth”. “The crackdown on shadow banking helped to reduce the chance of a financial crisis in China,” said Collier. “However, it starved the private sector of capital and also reduce the ability of local governments to grow their economy. Now the government is suddenly aware that although they’ve reduced financial risk, they created a potential for a sharp economic slowdown.” Going forward, Beijing will have to continue with damage control to rescue the private sector and stabilise the economy. “The Chinese government and regulators have underestimated the importance and power of shadow banking acting as an effective credit channel for private business,” Collier said. “Now they are trying to figure out a safe way to reinstitute it.”