Betting on the Wrong Horse

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Mao Jiatai's disposable cups ought to runneth over. In 2002, says the entrepreneur from western China's Sichuan province, his private company raked in $2.5 million in sales by manufacturing paper containers for food and beverages. He has four production lines making paper cups in hangar-like buildings, and 20 young women from the countryside toil in the yard beside them, pasting labels featuring words such as "White Family Potato Noodles" onto single-serving bowls. Business has never been better. Yet Mao, like so many other owners of private companies in China, can't seem to catch a break in his efforts to take his firm to a higher level.

Last year Mao wanted to boost production to ride a trend of restaurants' serving tea in paper cups with colorful plastic holders. Although he had plenty of collateral in the form of sales contracts, machinery and inventory, lenders wouldn't grant him even a small line of credit to maintain a steady supply of paper. To raise funds, Mao sold his house and moved into a space above his office. That financing delay, he fears, has cost him customers who will go instead to state-owned companies with better access to capital. "The government sees state enterprises as its sons, so it helps them," Mao says dejectedly. "I get nothing, so someone else will drink up my market."

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The privations of entrepreneurs like Mao have alarming consequences for the entire country. As China shifts from a state-controlled economy to a free-market system, the nation's health hinges in large part on the success of gritty local companies producing pedestrian goods and services. Small- and medium-size enterprises (SMEs) generate most of China's employment growth, and new jobs are vitally important to social stability. According to government statistics, companies with an annual revenue of less than $30 million provide more than eight out of every 10 jobs in urban China and account for three-quarters of the country's total industrial output. "Small businesses are simply the most important component of China's economy," says Eric Siew of the International Finance Corp. (IFC), the commercial lending arm of the World Bank. The IFC also runs training programs for Chinese bankers.

But despite economic reforms and the elevation of capitalists into the ranks of the Communist Party, small firms like Mao's remain cut off from many of the resources that grease the wheels of commerce. Like their counterparts everywhere, China's grassroots entrepreneurs gripe about taxes and bureaucratic obstacles. Their biggest complaint, however, is their inability to get bank loans. In a recent survey of 600 private companies in Sichuan by the IFC, access to financing was cited as the No. 1 problem, far ahead of unfair competition and corruption.

The reason: China's antiquated and deeply indebted banking system still lends mainly to lumbering state-owned enterprises, not private companies. Although authorities have been allowing thousands of these uncompetitive state vestiges to fail—since 1995, 56 million factory workers have lost their jobs—thousands more remain on life support, enjoying a steady supply of government-directed "policy loans" that will in all likelihood never be paid back. China's four biggest banks are technically insolvent because they are owed an estimated $500 billion in nonperforming state-enterprise loans. Yet, according to the Asian Development Bank (ADB), state firms continue to soak up approximately 70% of all loans.

Turned away by banks, Sichuan's budding entrepreneurial class must rely on unconventional lenders, including pawnbrokers and loan sharks, to meet its capital requirements. Liu Qingrong, for example, borrowed money from friends and family to set up a Chinese medicine factory in 1992. Within two years, her traditional remedies were outselling those produced by her biggest state-owned competitor by a margin of 5 to 1. But her rival, which was backed by local officials, still received every advantage, including governmental assistance to raise capital via a stock-market listing. "It was bitter medicine," Qingrong recalls.

Despite competition, her 300-employee company has managed to expand, using its $10 million in assets to secure small loans from banks. But obtaining financing still challenges her creativity. In 2000 she bought two ailing state-run factories, borrowing heavily from a real estate developer she knew to fund the purchases. Such alliances sometimes involve dangerous trade-offs: last year Qingrong was obligated to guarantee a $200,000 loan made to one of her benefactors, accepting that she would be on the hook if it defaulted. "I was terrified," she says. "If we'd had to repay, we would have had to stop production."