SMEs vs SOEs: Who is the Real Loser?

There is a well-known but unfair business competition in China: SMEs (Small-and-Medium-sized Enterprises) vs. SOEs (State-owned Enterprises).

Let us recap the basic background information first:

In our earlier article: Why PBoC Favors RRR, we already mentioned that Chinese banks always favor lending money to SOEs over SMEs under the current policy. Some people even say that the current interest rate policy is just to subsidize SOEs.

Under this unfair condition, SMEs face huge difficulty in financing, while SOEs can always borrow money pretty easy from Chinese banks. In some extreme cases, SOEs could still be able to borrow money from banks even some of them do not have strong business to support their loans and do expose some default risks. Now this problem is getting more and more serious in China: although SOEs have some level of government backing, Chinese banks which lend money to them are not safe. Why? The key issue is SOEs traditionally do not think it is a must to pay back those loans to bankers, even they have been granted at a discounted interest rates in what we described an unfair market.

In this situation, your investment strategy can be very simple: Avoid SMEs, Buy SOEs as only bankers or SMEs will suffer. SOEs should never be the loser at all.

Then the above investment formula seems necessary to be reviewed. In our article about CBRC 10 Rules Part I, we can see that CBRC (China Banking Regulatory Commission) has started to find ways to support SMEs after the SME Credit Crisis. In our article about CBRC 10 Rules Part II, we can say that the supplementary rules mainly encourage commercial banks to support SME-specific loans not exceeding RMB 5 million, and will also encourage commercial banks to have growth rate of their SME (Small-and-Medium-sized Enterprises) lending become larger than the growth rate of their SOE (State-owned Enterprises) lending. It is turnaround and SMEs are no longer the default loser of the game.

Now the shift towards supporting SMEs by CBRC (China Banking Regulatory Commission) seems to be more reasonable. In real economy, it is not feasible to support only SOEs (State-owned Enterprises) and abandon SMEs (Small-and-Medium-sized Enterprises). Both SMEs and SOEs should be supported in a fair way, thus creating a better balance for China economy as a whole.

However, is CBRC too aggressive this time? Although the new rules open green lights and should be a big step for SME financing, SMEs loan business unavoidably imposes more risks to banks and therefore more bad loans can be expected.

The main point is whether Chinese banks can handle these potential losses. In fact, Chinese banks have been using SPVs (special-purpose vehicles) to exclude subprime-grade loans from their balance sheet just like the western banks, and then re-package them for sales to investors as marketable assets. In our article about CBRC Additional Regulatory Rules, you may note that the CBRC additional rules do not ban this kind of SPV activities, though requiring Chinese banks to include these loans back into their balance sheet, setting provision coverage ratio (PCR) for bad loans, and therefore having a big impact on the costs of the bankers. In particular, Chinese banks need to satisfy a 150% provision coverage ratio (PCR) for bad loans, and to satisfy a 11.5% capital adequacy ratio (CAR) if they are systemically important banks or a 10.5% capital adequacy ratio (CAR) if they are non-systemically important banks.

With the potential increase in bad loans and the tighter enforcement of banking regulations, it appears that no matter the business should shift towards SOEs (State-owned Enterprises) or SMEs (Small-and-Medium-sized Enterprises), Chinese bankers will still be the real loser of the reform, especially if their profit margin from loan-to-deposit interest rate difference will be largely reduced once implementing market-based interest rates. Reference: Market-based Interest Rate Reform.

The bankers now should ensure sufficient capitals and need a better risk management, in order to maintain the stability of the whole banking system. The central bank should also realize the need to cut reserve requirement ratio (RRR) whenever necessary to keep the strong lending power of the bankers, otherwise the real economy will become the loser as well and it is definitely not something that the central government would like to see.