Financing China’s Smallest Businesses

By Delia Harrington

China’s financial services sector is quickly evolving, in part due to high-profile developments such as the rise of Internet tech giants and controversy over peer-to-peer (P2P) companies like Ezu Bao (which went bust after collecting $8 billion in deposits). But despite the overall economic slowdown, at least one market segment continues to grow robustly. There are over 50 million micro, small and medium enterprises, or MSMEs, in China. They account for approximately 90% of all enterprises in China and 80% of total employment in China’s urban areas. Yet many are still underserved by China’s financial services sector, including the new Internet-based financial institutions.

Rise and Fall of Internet Finance Players

China’s tech giants are riding the surge of a booming economy, driving innovations in payments and products for a population that’s increasingly mobile-savvy and active on the Internet. But it hasn’t all been good news for China’s Internet finance companies, as P2P lenders have recently come under fire for fraud. As a result, the Chinese Banking Regulatory Commission released draft regulations in December 2015 and have been accepting commentary from the sector. Ideally, the new regulations will protect consumers without restricting innovation and economic growth.

Furthermore, the accessibility of P2Ps still leaves much to be desired. Although some individuals and MSMEs can use these services, most of China’s P2Ps operate almost exclusively in China’s largest and most developed cities, leaving large swaths of the country, including many MSMEs, without access to inclusive financial services.

Rising Credit Risk Across China

Currently, all banks and non-bank MFIs are facing difficulties, regardless of their size. Indicators of portfolio at risk—a measurement often used to assess the health of financial institutions—are rising across the industry, meaning that Chinese financial institutions are facing increasing numbers of outstanding loans past due. Traditional banks and others are now less willing to lend to segments they have deemed risky, including MSMEs, many of whom do not have traditional credit histories. China has had a credit bureau since 2009, but it only recently included borrowing history with microcredit companies (MCCs) or P2Ps. As a result, many small businesses have an incomplete or nonexistent credit history and can’t access loans to hire more employees, expand, build credit or save in a safe way. Instead, they must turn to friends, family members and moneylenders rather than work with regulated institutions.

There are ways around this lack of formal history. Based on the work of Grassland Finance Ltd.—Accion’s partner in China—we have seen that in-person assessments are essential. Collecting informal information by talking to friends, neighbors and family members about a potential client’s spending habits and other debts can be even more insightful in evaluating applicants than formal credit history, if one exists at all. However, in-person assessments take time and energy, resulting in a high client-acquisition cost, which banks and many other lenders are unwilling to take on.

SHUHUA CHEN MAKES STEAMED BUNS AND CHINESE WRAPS AT HER SHOP IN QIANJIN VILLAGE, PINGZHUANG COUNTY, INNER MONGOLIA, CHINA MAY 9, 2013.
Photograph by Rohanna Mertens, photos provided by Accion

Obstacles for Microcredit Companies

While MCCs are currently the best option for MSMEs in need of capital, there’s still a long way to go. Microcredit companies started appearing in China around 2009, and there are now about 8,500 MCCs, collectively reaching almost $150 billion in outstanding portfolio. However, many MCCs have limited client bases as they don’t have credit models or a way to manage risk. MCCs are regulated by local provincial regulators, as opposed to the central banking regulators, so the restrictions vary from one location to the next. Most MCC investors must obtain a special license from district, city and provincial governments. Each license requires protracted negotiations before an official approval can be granted, and, in some cases, the process takes years.

This hurdle is compounded by the fact that very few banks are willing to lend to MCCs, so the only source of significant funding is equity. Banks face no regulatory hurdles when it comes to lending to MCCs but, unfortunately, most are not interested. This slows growth and forces MCCs to come up with alternative ways to work within the regulations in order to serve and reach more clients.

Looking Forward

Accion believes that MSMEs will continue to play an important role in strengthening China’s economy. As regulations are put in place and new investors enter the sector, financial services providers would be wise to focus on growing segments that are currently un- or underserved. If formal financial services are made available to this growing segment, we could see an immense impact on the overall economy. There is still much to be done.

This post originally appeared on The Wall Street Journal’s Multipliers of Prosperity, in partnership with the MetLife Foundation.

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