Betting on the Wrong Horse

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Then again, a quid pro quo with a business associate is probably a less costly option than borrowing money from pawnbrokers that have become China's de facto commercial lenders. The booming city of Chengdu, Sichuan's capital, is home to some 200 pawnbrokers. Don't think of them as sleazy purveyors of rusting bikes and busted TVs. The tiled floors and tawny sofas of Liu Jianjun's Building China Pawnshop suggest a bank lobby, and rightly so. His loans, which can run up to $1 million each, mostly go to private businesses.

Parked in front of the pawnshop one day last month was a new Volkswagen. The owner of a construction company had hocked it 10 minutes before in exchange for a quick $10,000 to meet expenses. He would be well advised to repay it fast because Jianjun charges interest rates of up to 5.7% a month. It's all legal and above board. Although regulators and law enforcement officials in the past have cracked down on underground lenders (loan sharks tend to use gangsters to collect unpaid debts), the government currently allows pawnshops to operate because without them, small-business owners would have almost nowhere else to turn. "Banks make it difficult and confusing to get a loan," Jianjun says with a smile. "Our business is booming."

China's bankers, however, shouldn't take all the blame. Lending institutions are trying to adopt sophisticated credit-analysis techniques to apply to private borrowers, but even if they were world-class financiers, they would have a hard time offering credit to some of China's seat-of-the-pants entrepreneurs. For one thing, the government caps the annual interest rate banks can charge at 6.6%, an amount that barely compensates them for their risk. It also bars them from accepting things like sales contracts or inventory as collateral—even though small companies usually lack hard assets like land or machinery.

Moreover, it is often a pain to lend to small firms. Their owners show up in bank lobbies with account books that frequently combine grade-school math with Enron-style deceptions, making it nearly impossible to place a value on their operations. Liu Binbin has seen it all as a lending supervisor at the Chengdu City Commercial Bank (C.C.C.B.), one of a hundred or so such banks set up over the past several years across the mainland specifically to lend to small companies. One applicant, the owner of a factory that makes pickled vegetables, visited Binbin's office recently with his ledger: a single piece of handwritten paper folded in his breast pocket. Other would-be borrowers often pile receipts on Binbin's desk in lieu of a balance sheet. Even those who keep books "usually have two or three," Binbin says. "They figure out what we want and write it down."

China's industry regulators recognize that capital must flow more freely to the private sector if the economy is to retain its momentum. In addition to promoting lenders such as the C.C.C.B., Beijing this year is expected to raise the interest rates banks can charge. In January the country enacted a new law specifically to promote SMEs, in part by creating a massive fund to expand a nationwide network of loan-guarantee offices that, in effect, allows the government to co-sign loans to creditworthy companies. Similar loan-guarantee schemes have worked well in other countries. Wang Hailin, director of the policy department at the State Economic and Trade Commission, calls the program "one of the most practical measures taken in recent years to support SMEs in China."

But state-owned enterprises are muscling in on the initiative. In Chengdu last year, a government-owned machine-tool company was saved from bankruptcy after local bureaucrats ordered one of the city's four credit-guarantee offices to back loans to the factory. Officials feared that if the company closed, laid-off workers would raise a fuss. The case is not an isolated incident. Yan Guosong, general manager of a Chengdu loan-guarantee agency, estimates that more than half of government-backed business loans are now going to state enterprises. "The central government created guarantees to help small businesses, but it wound up lending to state-run companies anyway," he complains.

What makes it so difficult to cut off outmoded state ventures in favor of private firms is the government's dread of a grassroots social uprising. The number of jobs created in China barely keeps up with the armies of workers laid off by failing enterprises—and angry, laid-off workers are the biggest threat to the country's stability. Sichuan has seen its fair share of trouble: last June, traffic in Chengdu came to a halt on two occasions when workers held a protest about unpaid salaries; in September, 800 oil refinery workers in Chongqing demonstrated over paltry severance payments.

Indeed, the transition to free enterprise still has a long way to go—and in the meantime, Beijing is failing to support its most important capitalists: the small, private companies that can generate jobs for the masses. Time is running short. "If the trends don't change, China could face a real labor crisis in the next five years," warns Min Tang, chief economist for the ADB in Beijing. Meanwhile, says Tang Limin, a director of the Sichuan Investment Promotion Bureau: "State enterprises still have the government protecting them. Private companies live and die alone."