Business Environment for SME Development in China

Professor Yang YaoChina Center for Economic Research

Peking University

Creating A Conducive Legal & Regulatory Framework for Small and Medium Enterprise Development in Russia

A Policy Dialogue Workshop, St. Petersburg, RussiaSeptember 14-16, 2003

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1. Some Facts of SMEs in China

SME shares of economy in China: 2001

0%

40%

80%

Number Output Assets Revenue Profit &tax

Other

SMEs

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1. Some Facts of SMEs in China

Generating employmentLow capital intensitySimple technology Low profitabilityRelatively small contribution to national tax income

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2. The Success Factors

Vast market and cheap labor: It is easy to run a successful business

China followed the Soviet Union by adopting a heavy industry-oriented development strategy in the planning period of 1952-1978; the supply of consumer goods was limited in the 1980sSMEs started in the countryside where labor was cheapMost SMEs use simple technology

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2. The Success Factors

Dual-track approach adopted by the government: Protecting large SOEs while encouraging private businesses to flourish

This approach won the support of both the vested interests and the newly emerging private sectorThe state sector became efficient by preserving and gradually releasing its productivityThe growth and growing strength of the private sector has pushed the state sector to reform

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2. The Success Factors

Minimum government intervention and exaction: Room for SMEs to flourish

SMEs’ contribution to tax income is limitedEntry barriers have been eliminated in recent yearsWhile administrative hassles exist, the government is still relatively effective by international comparisons

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2. The Success FactorsStrong incentives for bureaucrats: Government officials are promoted based on the performance of the local economy

This might be the most cited and studied difference between China and RussiaEvery local government in China adopts a pro-economic development and pro-business approachThe promotion system enhances central monitoring and provides a counterbalance to the negative effects of fiscal federalism

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2. The Success Factors

Large amount of FDI: Provide capital and entail spillovers to SMEs

Many FDI firms are themselves SMEsThey provide backward and forward linkages to the national economyFDI does not have strong technological spilloversFDI spills managerial knowledge to local firms

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2. The Success Factors

Entrepreneurship: SMEs are best developed in areas where a viable commercial sector has long existed

Small business centers are developed in localities without any factors of success except entrepreneurial spirit

• Yiwu county in Zhejiang province (remote, no resources, but diligent people)

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3.Legal Environment

China has a set of reasonable laws regulating and protecting business operationsPeople are increasingly relying on the courts to resolve commercial disputesBut the enforcement of court rulings is weak

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3.1 Firm Registration

Four types of private business:Single proprietorshipSingle-owner firms: no minimum requirement for registered capitalPartnership firms: some restrictionsCompanies: high requirements for capital

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3.1 Firm Registration

Firm registration used to be time-consuming and costly

It took a long time to get approvals and licensesThere were inconsistencies in the requirements (e.g., a firm is required to get its name approved before it could open a bank account, but without a bank account it could not register a name)The costs of capital registration, travel, and other spending were high (amounted to 10% of registered capital in extreme cases)

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3.1 Firm Registration

Recent government initiatives to streamline firm registration

One-stop registration: related government agencies are placed in one big lobbyOpening up the market and lowering the barrier of entryStreamlining and speeding up the approval process

• Redesigning the process to make it consistent• Ten-day notification rule

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3.2 Contract EnforcementWeak but improving

Rate of enforcement of court rulings

Year Rate (%)

1992 78.0

1993 80.3

1994 83.2

1995 84.6

1996 84.2

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3.2 Contract Enforcement

Reasons for weak enforcement:Lack of sufficient fundsInadequate personnelRegional protectionismFavorable treatments for large establishments

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3.3 The China ParadoxWhy has China maintained a very high economic growth rate while having a weak legal system?

Informal enforcement mechanismIllegal but productive activities:• Illegal activities induced by high rents

produced by market and institutional distortions

• Diversion of funds and assets from the SOEs to private firms

• “Triangle debts” as a means to get finance

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3.4 But It Still Pays to Strengthen Rule of Law: Zhejiang v.s. Sichuan

Differences in the rule of law:Zhejiang:• Sufficient funds and a fairly clean legal

system• High rate of trust of the court

Sichuan: • Insufficient funds and a corrupted legal

system• Low rate of trust of the court

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3.4 But It Still Pays to Strengthen Rule of Law: Zhejiang v.s. Sichuan

Differences in performance of the banking sector:

Zhejiang:• High trust between banks and firms and among

firms themselves• Flexible collateral requirements (e.g., buyer’s

credit and using tax rebates as collateral)

Sichuan:• Mutual distrust between banks and firms• Limited services• Net outflow of bank deposits

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4.Government CapacitiesChanging mind-set

The government only took care of SOEs in the past, but now has largely de-emphasized ownership and extended supports to all sorts of firmsThis has been done through several major efforts among which:

• The 1999 Constitutional amendment formally acknowledged the role of the private sector

• The establishment of an SME agency in the central government institutionalized a framework of supports to SMEs

• The 2002 SME Promotion Law set guidance and standards for government supports to SMEs

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4.1 Government Administration

Days to clear customs

Ethiopia14.7

18.610.7

China7.9

8.96.8434 firms

101 firms

11.7

Bangladesh12.710.7

559 firms

Pakistan17.2

20.413.9125 firms

Relatively efficient bureaucracy

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4.1 Government Administration

Relatively clean governmentsA recent survey of 600 firms in Sichuan province found that corruption ranked sixth in firms’ concerns

But unstable government policies and implementation

The same survey found that they ranked the third in firms’ concerns (following finance and unfair competition)

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4.2 The SME Promotion Law

Most of the articles of the law are suggestive and wait for local governments to provide detailed implementation plansThe catching point is the pledge to establish

A SME account in the central budget, andThe SME Development Fund: to provide supports to SMEs in the areas of starting-up, technological innovations, training, export, and environmental protection

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4.3 Financial Programs

Designated SME fundsInterest rate subsidy schemes for technical upgrading and innovationsOther programs

The Star Plan: for small businessesThe Torch Plan: applied hi-tech projects863 Plan: R&D commercialization

Provincial plans

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4.4 The SME Innovation FundThe fund was established in 1999 to provide merit-based free funds to technically advanced start-up SMEs. It is managed by the Ministry of Science and Technology. The budget for the fund ranges from 500 million to 1 billion RMBThe major criteria for selection are technology, profitability, and the management team. Evaluation of individual proposals takes place in Beijing by experts in technology, accounting, and management. The fund is regarded as the fairest in terms of the evaluation process. As a result, it has a very good reputationThe fund has played a significant role of leverage for a recipient firm to attract more equity investment and bank loans. In Sichuan, it is estimated that 1 yuan from the fund can bring to the firm 5 yuan from the market

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4.4 The SME Innovation FundFunding to start-up companies generally has a low success rate. Among 15 such firms financed in Sichuan in 2002, only 3 have shown a sign of good performance. The problem is the lack of managerial capacity of the teamThe evaluation process can be improved by adding more weights on economic performanceThere are cases of frauds in which firms provide false information just for the purpose to get free money

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4.5 The SME Guarantee Fund of Sichuan Province

The fund is managed by the Sichuan SME Service Center under the provincial economic and trade commission. Its registered capital is 20 million yuan. In 2002, it guaranteed 170 million yuan of loans. The term is usually 1 year, but can be extended to a maximum of 3 years. Up to now, less than 1% of the guaranteed loans have been defaulted. The fund is applying to the provincial government for 20 million RMB to expand its operationIssues

Why can the fund do better than the banks in identifying good customers?The fund seems to face a soft budget in its operationThe management team of the fund seems to be inadequately staffed

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4.6 Inter-regional SupportsThe one-to-one help program: Jiangsu and GuangxiIn the 1980s, more than 1,200 help projects were implemented between those two provinces, covering almost all economic areas. Jiangsu has a sound textile industry and many projects involved the transfer of technologies in this industry. For example, before 1980, Wuzhou city of Guangxi province only had 4 textile factories producing an output less than 4% of the city’s total industrial output. Its partner in Jiangsu, Changzhou, happens to have a large textile industry and an experienced workforce. Changzhou sent more than 300 persons/times of technicians and managers to help Wuzhou build its textile industry. By 1990, Wuzhou was able to produce a large variety of textile products, and the share of the textile industry in the city’s industrial output increased to 17.6%

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4.7 General Reflections on Government Supports

In an imperfect market, government supports partly substitute for the market to serve the role of a financial intermediary But cautions are highly recommended:

Involve private agencies in the evaluation processWhenever possible, keep the government’s role as a resource provider, not a business player Prevent the formation of vested interests in the government

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5.Taxation

SMEs pay less taxes than large firms

They are more likely to evade taxesLocal governments do not spend much efforts in collecting taxes from small firms

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5.1 Problems with Taxation

High tax ratesValue-added tax: 17%Corporate income tax: 33%Personal income tax: taxable income starts very low and the rate is strongly progressive

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5.1 Problems with Taxation

Ill-defined tax basesThe VAT is production-based rather than consumption-based, discouraging investment and technological innovationThe deduction for corporate income tax is very restrictive. For example, it does not allow deduction of R&D expenditures and sets a very low limit on deductible wage bills

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5.1 Problems with Taxation

Too much discretionary power vested in tax officers

Negotiation of taxes and unequal tax burdensCorruption

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5.2 Solutions

Lower the tax ratesThe effective rate of corporate income tax is already 28%

Make taxation more production-friendlyMake VAT consumption-basedAllow R&D expenditures deducted from corporate income tax

China is heading toward this directionAgricultural taxes will be eliminated soonCorporate income tax will be reduced

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6. Business Culture

There is a high and a low equilibrium of trust and economic growth How to foster trust?

The government should behave honestly and follow the rule of lawThe legal system should be strengthenedBusiness associations should be encouraged

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6.1 Turning government agencies into business associations

ProsPolitically feasibleMaking use of the old networkWorking with the government closely and in many cases carrying out certain regulatory functions such as maintaining standards and enforcing intellectual property rights

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ConsInertia of government officialsUnspecializedLimited services

6.1 Turning government agencies into business associations

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Yibin Association of Registered Accountants

Entry to the accounting business is highly regulatedBut fierce competition still leads to low profit margins and low quality of servicesThe association set floor prices but failed to maintain

6.2 A Failure Story

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… Not alwaysTwo free business associations in Yibin city

The Chamber of Commerce of Beauty Salons • Lack of leadership, funds, and tangible services

The Chamber of Commerce of Wenzhou Merchants

• A sense of belonging, strong leadership, and tangible services

The key: Leadership

6.3 The Freer the Better?

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7. Possible Lessons for Russia

Market-building before law-buildingStrengthening the rule of law is time consuming and costlyThe lack of rule of law may be just a result of excessive government controlEliminating excessive government control and market distortions is easier and more effective

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7. Possible Lessons for Russia

Government assistance is necessary but the methods should be refined

Use government assistance as a signal and selective mechanism rather than a complete substitute for the marketInvolve private agencies in the operational processPrevent vested power and interests in the government

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7. Possible Lessons for Russia

Both China and Russia are highly government-centered societies

This model of state governance can be very effective if things go well, but can lead to disastrous results if things go wrong

When Russia enhances government assistance to SME development, it is wise to keep in mind the negative side of a strong government

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7. Possible Lessons for Russia

Low tax rates are not only conducive to economic growth but also reduce government efforts in tax collection and the likelihood of corruptionGovernment involvement can play a role in fostering trust and business culture