By Carsten Herrmann-Pillath and Feng Xingyuan
The coastal city Wenzhou is a barometer for the economic development of the coastal area. The recent financial crisis in this manufacturing city reflects the looming crisis of the traditional manufacturing sector of the coastal area of China. While it is a big challenge for many domestic SMEs to survive in their industrial upgrade or transformation and remain competitive, it is the same for foreign enterprises to seize this opportunity and take over the corresponding market segment. German companies have kept almost intact in this crisis. They can further expect to benefit from the exports of their machines and equipment from Germany to China’s coastal area suffering from this painful industrial update or transformation.
However, they would be able to capture their maximal interest by involving in the great division of labor and knowledge only after a less possible dual deregulation - the financial and economic deregulation – which is badly needed for regaining the vitality of the private sector in the coastal China in near future. The pilot financial reform in Wenzhou is only a beginning of the “Long March” of the financial deregulation, not to mention the overall financial and economic deregulation alongside the coastal line and even across China.
Wenzhou as a barometer for the economic development of the coastal area
Wenzhou is a barometer of the economic and financial development in coastal area of China. This area is again the manufacturing center of the world. The economy in Wenzhou is quite dependent on its manufacturing which generated 46.1% of GDP. Agriculture plays only an insignificant role, generating 3.2% of GDP. In Wenzhou, manufacturers are concentrated in production in traditional competitive sectors, i.e. traditional labour-intensive industrial branches such as plastics, textiles, shoe wares or simple electronic consumer goods. A large part of their products are sold abroad. The recent economic downturn in Wenzhou signals to a large degree the downturn of the manufacturing industries in coastal area of China. Problems faced up by manufacturers in Wenzhou have their similarities with those faced by manufacturers in coastal area outside Wenzhou.
On March 28, 2012, the Chinese State Council assigned the city of Wenzhou to status of a ‘Comprehensive Pilot Financial Reform Zone’. This is the only zone of this kind in China. Given the fact that Chinese reforms always proceeded by taking experimental steps first, and then extending measures on a national scale, if they are successful, this measure deserves close scrutiny.
One might be curious about why Wenzhou was chosen as such a reform zone. With a first glance, Wenzhou is a city whose economy performs almost average among in China in terms of its per capita GDP and thus doesn’t appear to deserve our special attentions. It is a large city of Zhejiang province, with a resident population of more than 9 million people, the largest prefecture-level city in this coastal province in terms of population, making around one sixth of the total of the province. Wenzhou generated a per capita GDP of 36734 RMB in 2011, dropping from antepenultimate position to the last among the 11 prefecture-level cities of the province, well below the level of the province which is 58427 RMB, but a little higher than that of the whole China (which exceeded first time the threshold of 30000 RMB) in 2011.
However, Wenzhou is often regarded by many people as a special place in China, because it established itself as a private sector economy as early as in the 1980s. More than 80 percent of local GDP is produced by private companies, of which 78 percent are family owned firms. Thus, Wenzhou is a microcosmos in which all problems of this sector crystallize in clear shape. For decades now it has been promoted as a ‘model’ for private sector development in China, known as ‘Wenzhou Model’, especially in comparison with the ‘Sunan Model”, featured by the reliance on the development of the collective economy in the 1980s in the South Jiangsu region. This dynamics of the private sector is rooted in special historical contexts, reaching back into the Imperial era (1127-1279). Zhejiang province was home to Yongjia School, an important Confucian school that expressed strong support for commercial activities and emphasized the public virtues of private economic endeavours. This pragmatism was also a hallmark of local government attitudes after China started her reforms in 1978. At that time, Wenzhou was a rural backwater which suffered severe constraints from its remote location, infrastructural deficits and misplaced emphasis on agriculture. Very soon, the entrepreneurial spirits of Wenzhou were revived and Wenzhou business started to expand nationally and internationally. This business acumen is rooted in strong traditional social structures, in particular the extended family, undergirded by the spread of modern attitudes, especially the increasing significance of Christianity, which earned Wenzhou the nickname of a ‘Chinese Jerusalem’.
Background for the decline of Wenzhou and the whole coastal area as a world manufacturing center
The recent pilot reform initiative reflects increasing concerns about the unfavorable development of the local economy in Wenzhou. Although economic growth has been remarkable in Wenzhou, with a rate of 9.5% in 2011, it is losing its momentum since the global financial crisis started in 2008. This deterioration of the economic situation is accentuated with the increasing pressure on China resulting from the weakening of global demand for Chinese exports, partly in the wake of the Euro crisis.
The manufacturing in traditional competitive sectors of Wenzhou and the whole coastal area as well is losing its momentum, and many private investors are lack of investment channels at the same time. This happened for several reasons beside the above mentioned unfavorable external demand factor.
First, the macro-control policies in recent years, whether they were to loosen credit, or to tighten credit, had negative impacts upon the access of SMEs to credit. In the second half of 2008, the central government launched an economic stimulus package in total of four trillion RMB. Most of the funds flowed to the state-owned enterprises, the state infrastructure projects, as well as local government investment and financing vehicle companies. In view of a high inflation rate during last year, the central government exerted a tight credit control by setting an extremely high deposit reserve ratio and enforcing other credit control measures. In this situation, most loans still flowed to the state sector entities or projects, while SMEs suffered most. Many SMEs had to rely on informal finance and borrowed funds at interest rates which were much higher than the lending rates of commercials banks to solve their liquidity problems and maintain their business.
Second, since the profit margin of private industrial enterprises has declined rapidly, with that of some produces has vanished during last years, many producers faced with problems with their liquidity, have to either keep their business running, undergo an industrial upgrade, or to switch to other products or businesses. Private industrial enterprises are mostly concentrated in the traditional competitive sector, the prices of their produces often don’t go up, but go down, while their costs keep surging up during last years. Costs of wages, social security, environmental protection and raw materials, all of them have kept rising. To undergo an industrial upgrade, most enterprises are lack of necessary technologies and knowhow.
Third, the government set a quantity ceiling and exerted a tight credit control for consumers’ purchase of apartments in property market of major cities and forced investors outside that market.
Fourth, stock market is not worth investing. It was sluggish because of unfavorable macroeconomic environment and unoptimistic microeconomic foundations of many listed companies. Their long-term perspective is also dismal.
Finally, private enterprises are not allowed to invest in key industries which are controlled by administrative monopolies and public utilities are mostly controlled by local state owned companies.
In this regard, some enterprises are lack of funds while some others are unable to utilize their funds. Also the informal financial sector became a sector, not only for investment by a part of population, but also for speculation by another part of population in Wenzhou. Many entrepreneurs had to raise funds among local population with some promising a monthly interest rate as high as 10% or even higher.
The pilot financial reform is conducive to mitigate the financial problems of SMEs in Wenzhou
Traditional social structures underlie one of the most interesting phenomena in Wenzhou, namely the role of informal finance in business. Informal finance includes all the financial organizations and activities which are beyond the regulation by the financial regulatory body, including direct or indirect borrowing among individuals, households and enterprises, rotating savings and credit associations, unregistered lenders, individual or institutionalized mediators, intermediaries, ‘underground banks’ etc. Shadow banking is included here. However, informal finance includes more. Many borrowings are not interest-based and don’t belong to banking at all. Equity fund raising for a new project or by an existing company outside the stock market also counts to informal finance. Informal finance in broad sense includes receivables of enterprises which are estimated 13900 billion Yuan in total.
The above assignment of Wenzhou to a status as the sole pilot financial reform zone aims to mitigate the financing problems of local SMEs. It was to be traced back to the informal financial crisis which took place in the second half of 2011. This local area-wide collapse of some large scale informal financial activities was coincided with the outburst of the liquidity crisis of many private enterprises, including some local “dragen-head” companies, so leading companies in their respective sectors. They heightened the sense of an overall crisis in Wenzhou. Premier Wen Jiabao even showed his own concern on that issue and paid an inspection trip on October 4, 2011 to Wenzhou to investigate the economic and financial situation and problems there. The just reason why the Premier did such an inspection himself is that the State Council anticipated that the acute liquidity problems SMEs are facing up with in Wenzhou reflected the acute economic and financial situation of SMEs in the whole coastal area, indicating a downturn of economic dynamics of the whole country.
Informal finance also stands in the center of interest of the recent reform initiative. Nationally, according to a 2010 survey by the China Enterprise Survey System of 4256 companies across China, more than 55.3 percent of the sample companies state that they rely on informal finance as a main or supplementary source of funding. For many SME, informal finance is the most important source of external finance. The extent of informal finance is difficult to establish: According to survey research, the total amount of fund used to disburse informal credits in Wenzhou was about 44 billion RMB, the informal loan balance reached 110 billion RMB, with an annual interest rate of 180 percent in 2011. This would amount to around 18.2 percent of the credit volume in formal finance. However, these numbers hide the fact that many informal finance activities relate with equity investment, often actually implying a credit transaction, such as long-term credit in the extended family and the social network. A large part of the registered capital of private enterprises are not own capital of the shareholders, but funds borrowed from other members of the extended family and the social network.
Yet, this peculiar mix of Chinese traditions and business spirit, combined with the local economic conditions and government policy, has led Wenzhou onto a developmental trajectory which is increasingly seen as a dead end. As mentioned above, their businesses, including export business focuses on traditional competitive sectors. The private sector is dominated by small and medium scale companies which make up for more than 99 percent of all companies. These businesses face formidable challenges in industrial upgrading in order to survive in the current global economic environment. One of the most pressing constraints on this is funding, which is reflected in the fact that the rate of investment in Wenzhou lies far below the provincial and the national averages (33 versus 47 and 67, respectively in 2010). This figure clearly reveals the financial repression in the Chinese financial system: After the financial crisis of 2008, the Chinese government launched a large scale stimulus program, but that was channeled mainly via the formal financial sector into public projects and central and local state-owned companies, thus driving the resurgence of this part of the Chinese economy, or renationalization, to the detriment of the private sector. Zhejiang province is dominated by private companies, and thus did not fully catch up with the national investment craze. The situation in Wenzhou is even more pronounced.
In Wenzhou, informal finance has actually been the mainstream sector for the SME. Informal finance is extremely rich in institutional and organizational terms. It has deep traditional roots, for example in the shape of Rotating Savings and Credit Associations which flourished in China already in Imperial times (One finds records in a history book on Tang Dynasty). There are innumerable ‘underground banks’ in various disguised forms in Wenzhou. 28 years ago, one leading local entrepreneur also established the first on-the-surface private bank ‘Fangxing Qianzhuang”, so under the traditional name of qianzhuang. There are many forms of hidden or unhidden, charged or uncharged, direct or intermediate finance, including different forms of informal credit relationships between companies. The formalization degrees of various forms of informal finance are also different. So, one has to distinguish between ‘grey’ informal finance and those aspects that are clearly illegal. The latter includes deposit taking or fund raising from the broad public, relending, lending among companies and cross border informal transfer of foreign exchanges. There are many grey areas in between: For example, deposit taking from individual investors is possible, and interest can be hidden in many forms, such as paying out less than the principal in a seemingly interest-free credit contract.
Wenzhou has seen a series of reform initiatives over the decades, which, however, obviously did not cure the basic problems in financing local business. When Wenzhou was declared a financial sector experimental zone in 1987, this opportunity was spent without major impact. In the late 1990s, after a brief period of liberalization of rural finance, the central government cracked down in 1997 and 1998 on all activities that were perceived as illegal, in particular, deposit taking in informal finance. In Wenzhou, local government allowed for much local flexibility, but the risks became all too obvious when already in the first half of 2011 some large scale fund raising activities of some enterprises collapsed, and when this situation got worse in the second half of the year, causing local protests of affected investors and savers and panics in the informal financial market. Such events coincided with banks’ hesitation with disbursing loans to private enterprises, with the informal sector risks getting larger and government’s overall policy of credit control by keeping the deposit reserve ratio as high as 21.5% at a time an lowered down to 20.5%.Further, the central government’s reluctance to take more far-reaching steps towards reforms in direction of financial pluralization is bolstered by the interest group politics involving the special give-and-take relationship between the state-owned banks and state-owned enterprises which have dominated in lending businesses and seem to have been ideal supporters of the central macro-control policies.
Pilot financial reforms in Wenzhou: A brief sketch
In spite of these constraints, local government in Wenzhou had attempted to implement single reform measures cautiously over the past years. For example, in June 2010 an Equity Operation Center Ltd. of Wenzhou was established. Yet, the center was almost inactive and no essential equity transactions took place until the new round of pilot financial reform. Three local government companies hold all the shares. Only recently activities have accelerated, on a low basis. Only recently, with the State Council’s announcement of assigning Wenzhou to a status of the ‘Comprehensive Pilot Financial Reform Zone’, the Center has been kept busy in dealing with equity transfers.
Private equity initiatives also have been supported in the shape of Private Capital Management Companies, two of which started to operate in spring 2012, with a further one scheduled to be launched soon. All of them are based in districts, counties or county-level cities of Wenzhou. These companies are owned by local private sector companies and serve to channel private equity into newly established firms and business projects.
With the new designation as a pilot area for financial sector reforms, Wenzhou enters a new stage of development. The officially approved reform measures are:
1. Standardize and develop informal finance, draft a management method for informal financing, establish a management system for keeping record of informal financing, and build up a monitoring system for informal financing.
2. Acceleration of the development of new-type financial institutions. The participation of private capital is encouraged in the shape of setting up or taking shares of the rural banks, credit companies, rural mutual fund associations etc. Private capital participation is encouraged and supported in the reform of local financial institutions. Eligible micro-credit companies could be transformed into rural banks.
3. Development of specified asset management institutions. Private funds will also be guided toward the establishment of venture capital and private equity companies and related investment management institutions.
4. The government will allow the city´s residents to make direct offshore investments by creating regular and convenient direct investment channels.
5. Deepening local reform of financial institutions. The government will encourage qualified state-owned banks and share-holding banks to set up special units to deal with credit grants to small enterprises. It will also encourage the financial leasing enterprises and other financial institutions to operate. It will push forward the restructuring of the rural commercial banks, rural cooperative banks, and rural credit cooperatives.
6. The government will encourage the innovations of financial products and services targeting at small and micro enterprises and explore to establish a multi-level system of financial service provision.
7. Developing local capital market. The government will encourage lawful transactions of non-listed companies´ shares, technologies and cultural properties.
8. Actively developing various types of debt products. To encourage more financing of enterprises, especially small micro-enterprise through the bond market.
9. Broadening the field of insurance services, and encouraging the innovation and development of services in insurance products for specialized markets and industry clusters, and encouraging and supporting commercial insurers to participate in the social security system.
10. To strengthen the building of social credit system (especially a credit information system). Promote the development of integrity of government affairs, business integrity, social integrity, and judicial public integrity, promoting small and micro enterprises and rural social credit system. Strengthen the supervision of credit markets.
11. Improve the local financial market administration, prevent the emergence of a regulatory vacuum, and systemic risks and regional area-wide risks. The government will also establish a financial statistics system and strengthen the monitoring and early warning.
12. Establishing mechanisms for preventing risks inherent in the comprehensive financial reform. The government will clearly define the boundary of the local financial administration responsibilities, strengthen and enforce the duty of local government in dealing with financial risks and maintaining the local financial stability.
These measures need to be seen against the background of what has not been approved. All the measures had been proposed by the Wenzhou local government, but some local government considerations were not included in the reform concept approved by the central government. These locally considered measures include:
- The move from a mandatory plan governing the establishment of local credit guarantee companies, microcredit companies, rural mutual fund associations and other informal or semi-formal financial institutions to a system of registrations based on a transparent minimal sets of requirements, which would have broadened the scope for private entrepreneurial initiative;
- The expansion of the legal qualification of main initiators initiating microcredit companies and village banks to natural persons;
- The liberalization of interest rate policies;
- he experiment with opening up and running OTC market in Wenzhou;
- The establishment of a Science and Technology Bank in Wenzhou.
This gap between officially announced policies and local expectations is ominous: In fact, the twelve reform measures do not introduce substantial deviations from the national legal framework for local finance. So, more radical changes were avoided, such as the liberalization of interest rates.
A central concerns of the reform initiatives are to make informal finance more transparent, make them more formal by lowering the threshold of private capital’s entrance to formal and semi-formal financial sector, and enable better access of SMEs to funds. Based on earlier plans, Wenzhou government established the Wenzhou Informal Credit Registration Service Center on April 26, 2012. The center invites agents active in informal finance to register their activities, also aiming at matching supply and demand for informal finance services. The main benefit for the parties is greater transparency of market conditions, and enhanced legal safety for the registered contracts. Most recently, the volume of registered capital already exceeded 1.3 billion RMB.
This initiative matches with changes in the financial regulatory system. Wenzhou government set up the Wenzhou Local Finance Regulatory Service Center, which for the first time integrates the pertinent activities of different government bureaus, such as the tax bureau, the commercial bureau or the local police department. The main task of the Center is to monitor the development of informal finance and to contain illegal activities such as fraud and illegal deposit taking.
Wenzhou government is now organizing a tender for main initiators of the 30 new microcredit companies to be established this year. Till end of 2013, 100 microcredit companies will be established to cover all central towns and all districts, with a total registered capital of 80 billion Yuan. A set of minimal requirements are established. Microcredit companies will get registered as soon as the initiators meet all the requirements. The government in Wenzhou set a high target plan in introducing more financial institutions to boost the pluralization of financial institutions. Beside the introduction of above mentioned microcredit companies, within 2012, municipal branches of all the banking financial institutions will set up special financial institutions servicing small businesses, and all rural cooperative banks and rural credit cooperatives will be transformed into rural commercial banks. In 2013, there will be village banks and other new-type financial institutions in each county, district and county-level city of Wenzhou. .
The reform concept seemingly contains few new add-ons which symbolize new breakthrough in laws and regulations. However, it can still have a big impact upon the financial and economic development within the city and across China. One can regard the reform concept as a framework plan in which the reform can be further concretized by the local government further. The ongoing concretization of the reform concept is worth noticing. It shows that under the given legal framework, local governments can also be very creative to better develop local financial market and better service the SMEs. And the reforms in Wenzhou can not only help ease access to credit and equity local enterprises’ need. They can also become good examples for local governments of other regions to learn how to develop local financial market in concrete.
The way ahead: a dual deregulation is in urgent need
The pilot financial reforms in Wenzhou and their extension to other regions are now a must. However, even if such reforms are pushed forward across China, a large part of Chinese enterprises will still face up with the problems of industrial upgrade. Here the loss of comparative advantages because of the rise of the costs of production and difficulties with technological advancements constitutes a core obstacle. Market openness to private enterprises is still a big problem. Many sectors are controlled or dominated by central or local administrative monopolies and are still not open to private enterprises’ investment. Private enterprises need to find new business sectors outside traditional manufacturing sectors for their investment. Therefore, a dual deregulation is necessary to boost local economic development in Wenzhou and across China: the financial and economic deregulation. A one-sided financial regulation is unable to rescue Wenzhou and the coastal area as a world manufacturing center.