Reports of failing small- to medium-sized enterprises (SME) have trickled out of China in recent months. An official from the association for those enterprises in Wenzhou, Zhejiang province, said that if the central government's economic tightening policy does not change, or if the government does not give special support for struggling businesses, then 40 percent of the SMEs in the area may at least partially halt operations. Also, some may suffer bankruptcy soon, the association said. This statement comes after reports of three high-profile bankruptcies of SMEs in Wenzhou in April and claims in the Chinese media that profits for 35 export-oriented small- and medium-sized businesses in Wenzhou have fallen by 30 percent. Other reports suggest a high number of businesses are on the verge of failure elsewhere in the manufacturing hubs of the Yangtze and Pearl river deltas. Growing financial troubles among small- and medium-sized businesses pose an immediate challenge to China's economic tightening policy, and reveal a fundamental challenge to its economic model.
The Challenges for Smaller Companies
Reports of bankruptcies suggest that in the current economic climate, Chinese SMEs face greater challenges to their survival than was hitherto acknowledged. In the first two months of 2011, the Chinese Ministry of Industry and Information Technology recorded a slight uptick in bankruptcies, reporting that 15.8 percent of the country's SMEs were facing bankruptcy, up by 0.3 percent since 2010, and that the financial losses involved had grown by 22.3 percent. The ministry ordered local governments to carry out financial surveys on the health of small- and medium-sized businesses under their jurisdiction. However, as is often the case, there are mixed indicators. The three SMEs that went bankrupt in Wenzhou are facing allegations of corruption and mismanagement in local courts, suggesting that their situation may not be indicative of broader economic problems affecting enterprises of their size. Of course, corruption and mismanagement are widespread, so the specific allegations against these companies do not rule out the possibility of negative conditions affecting numerous businesses. Local statistics say the number of businesses withdrawing from the market has actually fallen this year, but local statistics are geared toward showing positive economic news. This trend is potentially of great importance because the bankruptcies are being attributed to the central government's ongoing drive to tighten controls on the economy — especially on bank lending — in order to wind down the high levels of lending during the global economic crisis, reduce credit risks, and moderate the economy's growth rate to prevent overheating. The tightening policy has moved at a very gradual pace, with the moderate reduction in bank lending and hikes to banks' required reserves not translating to reduced credit expansion overall
. However, the restriction of financial channels on the margins has begun to bite, especially for those who do not have the right political connections to ensure access to credit. SMEs fall under the latter category. Small- and medium-sized businesses have more trouble getting credit than the government's favored state-owned enterprises (SOEs). While SOEs have benefited most from government policies since the global crisis, SMEs have borne the brunt of the post-crisis credit restrictions. While SME lending has surged, according to official statistics, the truth is that local governments can classify small- and medium-sized businesses however they choose in order to make their statistics meet central government mandates that credit be extended to this sector, while not actually doing a better job of making credit available throughout the SME spectrum. Larger SMEs are more likely to get credit than the numerous smaller ones, which banks see as posing greater risks of default without the redeeming good connections or the extensive collateral that SOEs often have. The problem of SMEs getting access to credit is an old one. Sometimes, powerful small- and medium-sized businesses trumped up complaints to get more favorable policies, but for others, it is a genuine problem. In the current context of government credit tightening, the problem appears to be getting exacerbated. The alternative, going to the underground lending sector, forces higher financing costs on SMEs. Moreover, greater difficulty accessing credit comes at a time of other economic challenges. Businesses are facing demands for higher wages. As inflation pushes up prices for food, rent and some consumer goods, workers cannot keep pace. Across the country's urban landscape, wages are estimated to have risen by more than 20 percent since 2010. This phenomenon adds great expense to businesses that already operate on thin profit margins. According to the Global Times, export companies' average profit margin fell as low as 1.4 percent in the first two months of 2011. Raw materials prices also pose a problem. Though the government attempts to limit domestic prices on commodities, international commodity prices have spiked, leading to price rises at home for goods needed as inputs for manufacturers. The gradual appreciation of the yuan against the U.S. dollar may also have added to concern among exporters, theoretically making Chinese products less attractive, though its pace has been gradual (barely more than 5 percent against the U.S. dollar in one year). Additionally, a stronger yuan can offset high prices of imported materials. A massive challenge comes in the form of weak external demand
. Most SMEs are built to export goods to customers abroad. The collapse in global trade in 2008-2009 did great damage to the SME sector, which did not receive anywhere near the amount of government support or stimulus that larger, more politically powerful SOEs did. Though trade recovered rapidly and exports boomed by around 30 percent in 2010, the anticipated slowdown in export growth in 2011 is taking its toll — exports are growing around 20 percent in May, down from 26.5 percent in the first quarter and plenty of downside risks are arising from China's domestic economy, Europe's debt troubles, and persistent problems with the American recovery. Many small SMEs are not accepting production orders in the fear they will incur greater losses; this behavior contrasts with the 2008 slowdown when they were desperately seeking new orders.
A Significant Part of the Economy
The threat of failing SMEs cannot be taken lightly. SMEs account for about 80 percent of China's manufacturing employment. Because the supply chain is extensively connected, one failure can affect a number of other enterprises negatively, potentially leading to a wave of layoffs and unemployment. STRATFOR sources say that if Wenzhou companies are suffering, then others elsewhere certainly are — Wenzhou has a history of being an economic model for other cities and a leading indicator for new trends. Other STRATFOR sources say the majority of private small- and medium-sized businesses are technically bankrupt and survive through whatever government support they can get, and often, tax evasion. The question, then, is how will the government respond? During the global financial crisis, the government stepped in to prevent the sector from collapsing. Beijing increased tax rebates for exporters and other subsidies, and presumably, the central government will do so in 2011 if bankruptcies become a broader problem. The China Banking Regulatory Commission announced in May that it has officially approved 75 percent of credit guarantees to companies that provide support for small- and medium-sized operations seeking loans. The commission hopes that by better regulating these companies, it can improve the financial situation for SMEs. However, more urgent and direct means of government support will be likely if bankruptcies grow rapidly. This urgency raises a serious policy dilemma. The government's current tightening policy may have to be abandoned if growth slows and joblessness looms. Unfortunately, doing so will encourage further spikes in inflation, which could result in the same outcome. The central government does not look kindly on private SMEs because they exist outside of its control. Beijing hopes to consolidate the sector ultimately, allowing restructuring to wipe away the inefficient or outdated enterprises and encouraging low-end manufacturing to move inland, while coastal operations are upgraded. But progress is moving slowly. Consolidation faces resistance, as has happened in the steel sector. And SMEs on the coast do not have the funds to upgrade their production, which means that the move to boost production in the interior will simply add to overcapacity in low-end industry, and increase competitive pressure on all SMEs. For China, an attempt to let SMEs go bankrupt and allow restructuring to run its course raises too great a risk of sudden, massive unemployment, and would add to social unrest among workers
, particularly migrant workers, in an already precarious social and economic environment. Authorities are unlikely to allow deep retrenchment in the sector at present, though they will continue to seek to restructure the sector in the long run. Fortunately for China, while foreign demand is weak, it has not collapsed and exports continue to grow, albeit at a slower pace. Yet, the fact that problems are emerging, despite exports holding up, points to flaws in the internal structure
. China's likely deferral of structural reform points to its larger economic problem. The export-driven economic model is reaching a peak as foreign demand weakens and export growth slows. This decline will strain the weak portions of the export sector. State-driven investment cannot support the economy forever, and it heavily favors the state sector, further squeezing the private sector. Household consumption is not picking up the slack, and any attempt to boost people's incomes or reduce their burdens in a serious way will put greater financial stress on the industrial and corporate sector or government finances. The worst is yet to come for businesses, as workers' demands for higher wages are set to continue, especially as the workforce peaks (expected to happen in 2013). This trend gives workers more bargaining power, placing more cost pressure on companies with thinning revenue streams. Thus, while it is not yet clear how extensive the latest round of bankruptcies will be — and while government support is fully expected — these signs of failing businesses point to grave challenges ahead.