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Banking on Small Business

Banking on Small Business
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The banking reforms of recent years have seen major Chinese banks launching on global stock markets and opening branches in global capitals around the world. The UK is now home to subsidiaries of Bank of China, China International Capital Corporation, the Industrial and Commercial Bank of China and China Construction bank as well as office of China Merchants Bank, Agricultural Bank of China and the Bank of Communications.

Much of this was due to the City Commercial Banks (CCBs) and Regional Banks being consolidated to create global banks. As well as China’s banks expanding internationally and a huge range of legislation changes, it could be argued that rural banking reforms will have the biggest impact on China’s finance market in the coming years.

The consolidation of China’s larger banks left a gap in funding for Small and Medium-sized Enterprises (SMEs) who often have difficulty attracting financing from large banks due to a lack of firm land ownership or insufficient real estate rights to achieve preferred collateral.

In order to further promote domestic growth, the Chinese government has started to reform banking so that SME funding becomes easier. This has led to a growth in rural banking, the consolidation of some rural banks into newer and more flexible city commercial banks, as well as the development of microcredit companies and village and township banks to fund rural SME’s and individuals.

These newly reformed and trans-regionally expanded CCBs are now leading the way in SME financing and more innovative solutions in China, argues Jason Bedford, Financial Services Manager at KPMG. “ For example, Bank of Beijing was the first bank to use intangible [assets] as collateral.”

These rural banks, are largely blocked from lending to State-Owned Enterprises (SOEs) but can now provide for this vastly underserved SME market to help grow their loan book.

“Bank reforms are going to make it significantly easier for SMEs to acquire funding,” says Ben Cavender, Associate Principal at China Market Research. “Meaning that smaller businesses in China have more options for raising money in China, which is an absolute requirement for fostering growth and development.”

This is certainly a step in the right direction, particularly in terms of promoting growth and new development in rural areas and will hopefully stop SME’s in China having to pay exorbitant rates for loans from underground banks or trust companies.

However, there is still caution in the market due to the lack of expertise in pricing for risk. Both previous loans and new loans given by these smaller banks are at risk that the loans won’t perform. “The size of the future Non Performing Loan wave is unknown,” says Stephen Green, China Chief Economist at Standard Chartered. “It will depend upon GDP growth, fiscal revenues and how well the land market does.”

What might be seen as a challenge for these reforming institutions actually offers an area of opportunity for foreign banks and investment institutions. Foreign banks have significant experience in pricing for risk. Jason Bedford at KPMG says that “a number of banks are engaging us and other service providers to help them put in place SME credit risk assessment systems.”

There are still barriers to entering the rural banking sector in China for foreign firms, but Ben Cavender believes there is certainly a lot of room for growth. “Foreign banks like HSBC, Citibank, Standard Chartered or ANZ are still very much in the early stages in terms of their involvement in rural banking but their roles are likely to grow and as the system becomes increasingly flexible.”

Perhaps the best example of this development in foreign-owned rural banking in China generated from reforms over the last three years is HSBC. Elton Lee, head of rural banking at HSBC China, points out that “since market entry requirements for banks seeking to establish a present in rural areas have been relaxed, over 1,000 sites have been identified for new rural financial institutions by the China Banking Regulatory Commission as of 2009.”

HSBC opened the first foreign-owned rural bank in December 2007, and now has eight rural banks with 13 outlets. Offering services such as greater flexibility on SME loan collateral and unsecured individual lending, and Lee thinks there is strong government support for further expansion of such organisations.

Such government support is slowly filtering through to the development of other types of financial institution, including microcredit companies (MCCs) and microfinance institutions (MFIs). Although still in their infancy in terms of financial sustainability and size, MCCs and MFIs offer another alternative source of funding for both SMEs and rural individuals, which will help meet China’s objective of improving development in rural and industrialized areas outside of the major cities.

There are certainly hopes that MCCs and MFIs in China will develop in the same successful way as they have in Bangladesh, where Grameen Bank has pioneered this tool to contribute to poverty eradication, and at the same time has also managed to be run as a successful commercial entity.

However, as Michele Geraci, Senior Research Fellow and Head of China Programme at the Global Policy Institute points out, the Chinese market is very different to other parts of the world and the outlook for MCCs and MFIs should be cautious, despite the fact that there were 1,334 MCCs registered in China by the end of 2009.

Most of the for-profit institutions are domestic, and these companies lend to both individuals and SMEs in many cases. As of yet it has proven difficult for foreign companies to operate as anything but not-for-profit ventures. Geraci says that the Global Policy Institute’s study into Microfinance “suggests that return on capital cannot exceed 17 per cent even under the most optimistic operating assumptions.” Furthermore, each company’s scope of operation is limited to county level and achieving economies of scale is difficult. “Therefore, we are faced with uncertainties on both the demand and the supply side,” he argues.

Although the MCC and MFI market is still very restrictive to foreign companies, Geraci believes that it’s not a market that should be ignored. Regulations will inevitably change and foreign institutions and banks can then focus on SME financing, which is currently the preserve of the major banks. This could pave the way for foreign-owned MCCs to become fully-fledged village and township banks in the future.

Perhaps the slowest market of all to develop will be the genuine MFIs with loans strictly for individuals in rural areas of around RMB 2,000-5,000. As Julia Meek, Chief of Staff at microfinance platform Wokai, points out: “There is some optimism, support and encouragement from the Chinese government, but regulations still mean it is difficult to be sustainable and to fully enter the market. However, we are confident this will change in the future.”

What that future holds is yet to be fully determined but it is certainly a space worth watching.

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