SMEs struggle as liquidity takes a slide and interest rates surge

Train accidents, tree felling or skyrocketing home prices — China's online ‘protest square' now throbs with energy and angst. This time, the attention of thousands of internet protestors has been drawn to urgent calls from Europe on its $3.2 trillion (Dh11.75 trillion) foreign exchange purse. But standing in the way of the European special purpose investment vehicle or the ‘rescue fund' are thousands of struggling small and medium Chinese enterprises.

For almost a year now, Chinese SMEs, which transformed the country into a manufacturing behemoth and whose export earnings helped build a neat pile of forex reserves, have been battling severe liquidity crunch and impossibly high interest rates. Any move at this juncture to bail out Europe with these funds will be deeply unpopular and under no circumstance do decision makers want to be perceived as taking from the Chinese poor to give to the European rich. China has nearly $800 billion invested in euro-denominated assets and Europe is the largest export market, yet investing in any more European bonds is turning out to be a political hot potato.

SME crunch

Intense online debates on how best to spend the forex pouch centre around more sops for the SME sector, reeling under the worst debt crisis in more than two decades. Although foreign reserves can't easily be diverted to solve domestic problems, there is enough reason for anger at bailing out Europe.

Small firms have borne the brunt of a relentless tightening campaign as banks lent only to big, state-owned enterprises. The Chinese central bank had tightened its monetary policies significantly since last year, including raising benchmark interest rates and the reserve-requirement ratio, to fight surging inflation and deflate property bubbles. Left with less capital to lend, banks were reluctant to lend to SMEs and raised interest rates for them.

A severe liquidity crunch drove smaller companies to the shadow loan market where annual rates of interest went up to 25 per cent, sometimes more than 15 times the benchmark lending rates. The fallout of this capital crunch had maximum impact in eastern China's industrial belt. A number of private enterprises were pushed to the verge of bankruptcy when bosses were unable to repay the informal high-interest loans. In coastal Zhejiang, traditionally home to the most enterprising Chinese businessmen, private enterprises used to be the pillar of local economy, sustaining 90 per cent of jobs. Its richest city Wenzhou has been the worst affected by the debt crisis with more than 90 owners of private companies reported to have disappeared, committed suicide or declared bankruptcy — invalidating debts of about $1.57 billion owed to banks and individual creditors.

The East China debt crisis is an example of how macro economic policies have had a very direct impact on small- and mid-sized private companies. Businesses expanded rapidly during the credit binge created to stimulate the economy during the 2008-2009 global financial crisis. However, when it came to tightening lending to curb inflation, entrepreneurs found themselves unable to repay loans this year, generating a temporary socio-economic crisis. Vast-scale salvage efforts are now on. Banks have been directed to relax repayment terms and lend more to small firms and display higher tolerance level to debt. These steps led to a rebound of the Shanghai Composite last week, with the market expecting a credit relaxation in the coming months. However, it is too premature for a fundamental shift in monetary policy.

Smart credit avenues

The current difficulties being encountered by the SME sector in securing bank loans have had an unexpectedly positive fallout. It has created space for private equity and venture capital companies to strike more rational deals. While a year earlier, PE/VC outfits were chasing companies, hyper-inflating valuations, the tide has now turned.

In the face of severe financial pressures, many SMEs have now lowered their valuations and become more open to equity investments. The VC/PE outfits, in return, are more rational when assessing investments, and are able to buy stakes at a lower price. Nor are they willing to pay a price-earnings ratio higher than ten for equity investment, while a year earlier, ratios higher than 15 were common. The number and amount of VC/PE investment in China hit a record high in the third quarter and investment surged 128 per cent year-on-year to approximately $3.4 billion.