Abstract: China could consider several measures to further ease the cash flow pressures on its small- and medium-sized enterprises (SMEs): First, pare down their financing costs, not by artificially reducing the lending rate, but by monetary easing or interest subsidies; second, help accelerate their collection of receivables; and third, provide them with direct subsidies.
I. WHY SHOULD WE PAY ATTENTION TO CASH FLOWS?
Small- and medium-sized enterprises (SMEs), or private businesses, are very important to the Chinese economy. The Chinese government has introduced many policies to help businesses weather the COVID-19 pandemic’s shocks, a focus of which has been supporting SMEs.
China’s 2022 Government Work Report has proposed many policies aimed at propping up SMEs, including tax and fee cuts, tax refunds, promoting overdue payment clearance, and providing them with better financial services. Apparently, supporting SMEs remains a key in stabilizing the country’s macroeconomy.
How has the cash flow issues of SMEs come in the spotlight? It started when we heard complaints from SMEs that they suffered a liquidity crunch, as to which China’s macroeconomic statistics have also offered some clues. For example, while total social financing (TSF) and short-term financing surged in January this year, but the country still recorded negative growth in its M1 (not seasonally adjusted), which did not improve until in February.
In general, growth of M1 has been sluggish in China, betraying businesses’ poor liquidities and scarce cash flows in the short run.
Generally speaking, what worry us the most when we talk about financial risks are the balance sheets of businesses, because it is exactly balance sheet deterioration that leads to defaults or even bankruptcies. Many financial crises are, as a matter of fact, balance sheet crises.
But at the same time, cash flow risks could also trigger financial crises. Even with robust balance sheets, businesses that run out of cash in the short run could also suffer default or even bankruptcy pressures.
Financial institutions used to suffer cash crunches in history. For example, a bank can be deemed as normally running if it absorbs deposits of 100 yuan, lends out 90 yuan, and puts the rest 10 yuan into its pool of cash reserves. Assuming that in this case it should be able to maintain a proper balance sheet, then if depositors want 20 yuan of theirs back and the bank does not have enough cash to meet this need, it would cause a run. That’s how the 1907 panic hit. There was a small business owner who went to the bank to withdraw his money, only to be told that he had to come again the next day because the bank did not have enough cash. The run happened when so many others who heard about this rushed to the bank, asking to have their money back.
A bank with what had been supposed to be a fairly sound balance sheet just crashed like that. Later, policymakers came up with a set of policy mechanisms, including giving central banks the role as the lender of the last resort and introducing the deposit insurance system, with the main target of reducing risks of liquidity crisis.
Last year, a few real estate developers in China defaulted on their debts. Objectively speaking, not all developers have the problem of insolvency. A lot of them only had their cash flows cut off.
That’s why we need to look at cash flows in addition to the balance sheet when assessing the sustainability of a business.
Liquidity crisis of SMEs in China is worth special attention because of one major financial event with global implications: the Federal Reserve’s interest rate hike. In history, rate hikes by the most important central bank in the world will produce a certain level of monetary tightening across the global market. Fast hikes by the Fed will lead to capital outflows, currency depreciation, higher price of money, higher interest rate or even asset price declines in many developing economies. Of course, different countries have different problems, but basically all countries will find themselves under strain because of this, and those with bad economic fundamentals could even plunge into financial crises.
Tightening liquidity may worth heightened attention in the global context, but I don’t see it much of an issue in China at the moment, given its relatively sound economic fundamentals, large markets, steady growth, current account surplus and huge foreign exchange reserves, and it imposes certain controls on its capital account. It’s possible that the People’s Bank of China (PBC) can manage to maintain monetary policy independence. However, further hikes by the Fed could tighten liquidity in China as well, and in that case SMEs may become more vulnerable to cash flow crises.
II. THREE NEW CHALLENGES FACING SMES
First, their leverage ratio or the asset-liability ratio has significantly risen. I did a research years ago on the deleveraging moves by Chinese companies after the global financial crises, and found that most of the deleveraging back then happened with private businesses. State-owned Enterprises (SOEs) were also doing it, but not by as much. Deleveraging was one of the most important policies in China in 2016, which, however, was carried too far that it worsened the financing environment facing private businesses rather than improving it. One important lesson to learn from this is that in an unstable financial environment, private businesses would find themselves badly positioned against leverage ratio risks and liquidity risks compared to SOEs.
As a matter of fact, before the global financial crisis, SOEs and private businesses had leverage at similar levels. As of the end of 2017, SOEs recorded an average debt-asset ratio of 60.4%; private businesses, 51.6%. There was already a huge gap between the two of around 9 percentage points. After that, the Chinese government introduced policies to improve the financing environment for SMEs—one of paramount importance to that administration, as a matter of fact, rolling out several rounds of moves almost every year. By the end of 2021, SOEs had an average leverage ratio of 57.1%, and private businesses, 57.6%. In other words, after four years of policy efforts, private businesses are now more leveraged than SOEs. During the Covid outbreak in 2020, total credits of SMEs surged by 30% which without doubt was owed to the strong policy supports. That year, SME financing achieved positive growth despite the lackluster economy, and climbed up by a further 25% in 2021.
The data has revealed two things:
One, over the past years, China’s policies aimed at financing SMEs have delivered tangible outcomes, pushing up their leverage ratio. But this is a coin with two sides: on one hand, it means that SMEs can borrow money when they need to; on the other hand, it indicates tighter cash flows going forward. Amid economic downturns, the heavily leveraged ones will face greater liquidity pressure.
Two is a new issue, on sustainability. At the moment, SME financing grows annually by 25-30% each year. How long can government support last in order to help SMEs on a continuous basis? This is a question worth considering. Despite the progress in channeling funds to SMEs, they will face debt repayment issue as their leverages increase. Money borrowed will have to be paid back, after all.
Second, private businesses still finance at high costs. While they are not so much leveraged than SOEs, the pressure of debt repayment is much higher on them. According to official statistics, SMEs borrowed at an average rate of 5.6% last year, SOEs, at 3.8% (LPR). The disparity is even bigger if we look at the real interest rate (nominal loan rate less inflation).
Most SMEs are in the middle- and downstream of the manufacturing industry, and their product price is the consumer price. Last year, Consumer Price Index (CPI) in China climbed up by 0.9%, and so the real loan rate of SMEs would be 4.7% (nominal loan rate of 5.6% less 0.9%). In comparison, most SOEs are in the upstream, and so their interest rate should be discounted with the Producer Price Index (PPI). The loan prime rate (LPR) was 3.8% last year, and PPI, 8.1%, and that would produce a real loan rate of SOEs at -4.3%.
Gauged with the nominal loan rate, the financing cost for private businesses is 1.6 percentage points higher than SOEs; while in terms of the real loan rate, the gap widens to 9 percentage points.
Third, receivables collections have delayed remarkably. Receivables are the amount that a company is entitled to receive from its customers for goods or services sold on credit. Surveys show that during the pandemic, the average time taken for SMEs to collect their receivables extended from 30 days to 90 days. My guess was that it was because against a sluggish economy, SMEs’ bargaining power has greatly reduced. Before the Spring Festival last year, many of them were struggling to get back their money to pay their employees, leaving them financially vulnerable. If they push too hard, they could displease their major clients and put their future orders and even survivals at risk.
In 2020, the total amount of accounts receivable was 14.7 trillion yuan comparable to the 15.5-trillion-yuan total volume of SME loans in that year. In other words, large businesses withheld almost all of the loans that the government pushed banks to offer to SMEs for three months and for free. What is even more interesting is that a survey found that the SMEs’ receivables were prone to default in the past two years, whereas the receivable collection periods of large enterprises were shortened. If SMEs can’t collect their receivables on time, they’ll have to borrow money to stay in operation, which increases the company’s leverage, the cost of capital, and cash flow risk.
III. ISSUES TO NOTE IN POLICY IMPLEMENTATION
China's Government Work Report for 2022 highlights a number of measures that could help SMEs with cash flow issues, including tax and fee reductions, increased financing, and arrears payments. There are also some other policies that could be implemented to help SMEs with their cash flow.
The first step is to lower the cost of financing for SMEs. The government has been asking financial institutions to reduce SMEs’ financing costs over the last few years, mainly through administrative orders. Such a move is acceptable during a pandemic but it isn’t sustainable. Market-based risk pricing is the most significant part of financial decision-making. The bigger the risk of an enterprise, the higher the cost of its financing should be, otherwise it will harm the soundness of financial institutions. Therefore, government should seek monetary policy easing or fiscal subsidies rather than constantly urging banks to maintain loan rates low.
Second, shorten the accounts receivable collection days for SMEs. Accounts receivable is a matter between businesses, but if the defaulters are mostly large enterprises, notably SOEs, then some government policies would be helpful in solving the situation. For example, the government could propose a reasonable accounts receivable collection period (back to around 30 days before the pandemic); see if large enterprises regularly default on payments to SMEs when doing credit analysis on them; and another example would be to encourage large enterprises to make the accounts payable period an important part of their ESG (environmental, social and corporate governance) and publish it on a regular basis.
Third, SMEs should be subsidized. The government has assisted them in surviving the pandemic through measures such as tax and fee reduction, as well as urging financial institutions to lend to SMEs, but the difficulty is that those who borrow or who are eligible for tax and fee reductions are SMEs that are still doing well. Those in distress are unwilling to take up loans and are unable to obtain tax breaks because they pay less tax. Therefore, if our fiscal policy is to safeguard the main body of the economy, is it possible to directly offer subsidies to SMEs, as what other countries do? Once the enterprises stabilize this year, they will be better off next year.
To summarize, SMEs cash flow risk is an important issue. Given the high enterprise leverage ratios, liquidity pressure is likely to be intensified if the Fed's tightening monetary policy has an influence on China’s liquidity. It will be critical to stabilize economic entities and the macro economy if we can plan ahead and take certain measures to lessen the cash flow risk of SMEs.
This is the speech made by the author at the National School of Development, Peking University, on March 15, 2022. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations. It is translated by CF40 and has not been reviewed by the author himself.
