By Valerie Sartor

Since the reform and opening up that began in 1978 in China, more than thirty million private businesses have surfaced, causing the boom in China’s economy.

Yet many of these private businesses ventures have no access to official sources of credit.

China’s state banks cater to state-owned enterprises - most private financing officially remains illegal. Chinese entrepreneurs are forced to fund their capitalist dreams by defying national banking laws. They use many ways to acquire financing for venture capital and loans. Rotating credit associations and private banks disguised as other types of organizations are two ways money passes into private businesses.

Kellee Tsai is an assistant professor of political science at Johns Hopkins University in the United States. Her book, Back-Alley Banking, uses research into China’s unknown banking systems to explain how small private businesses acquired their funding. Her thesis suggests that local social groups and political connections have helped creative small-scale entrepreneurs to get needed monies and to secure various private property rights. In China, industrious businessmen and politicians both have capitalized upon the vague and amorphous government regulations to get rich. Some bureaucrats, for instance, ignore their jobs as government guardians and choose to invest their time, connections and money into private ventures. And businessmen travel informal financing paths, ranging from Ponzi schemes to pawnshops.

All the while, Ms. Tsai leaves tedious academic writing to her colleagues. Her book is wonderful reading, and it should be helpful to foreigners doing business in China – if only to better understand the Chinese business psyche, which, for practical reasons, often views law as a given nuisance to be subverted rather than obeyed. Further, knowing where potential partners get their capital from could impact whether you choose to do business with them or not.

Ms. Tsai must have come up with her book’s title by discovering that many types of private finance in China were hidden and as convoluted as a Chinese hutong. This is because financing outside of a state bank, such as the People’s Bank of China, is officially illegal. The finance agency might be registered with another official governmental agency. Despite this seemingly valid registration status, the operations remain incognito “just in case” of any sort of official crackdown. So Ms. Tsai stopped looking in legal channels and started looking down back alleys to find out how China makes new business.

Ms. Tsai defines informal finance as all types of financial exchanges that are not officially sanctioned by China’s banking system. This ranges from money lending (interest-free or otherwise) between friends and relatives and shopkeepers, to informal business lending with interest rates. Other financing arrangements included rotating credit associations and private money houses.

All across China, many types of creative financing have appeared. Each varies from province to province and even from county to county. Every local government exerts influence on the lending apparatus and Ms. Tsai defines them into four main categories.

The first category developed in China’s poor, mountainous regions. These operations were poor under communism; now some are even poorer because no economic growth has been possible, despite the reforms. The local bureaucrats are dysfunctional at best. These areas have little informal financing; people with incentive have left the region.

The second type of informal finance concerns areas that didn’t receive much financial support from the central government in Beijing under Mao. Ms. Tsai cites the coastal south; capital and funding was denied there because Mao thought that foreigners considered the area a likely point of entry in case of war, and because geographically this region is near Taiwan and Hong Kong. Instead, financially, they became self-reliant. Zhejiang is famous for the small-scale private sector that boomed even before Deng Xiao Ping announced reforms. Early on, this southern coastal region bent the rules regarding informal finance. A variety of informal financing mechanisms currently exist; some are highly successful and competitive.

Ms. Tsai cites Wenzhou as the most famous place in the south. During the mid-1980s, up to 95 percent of all financial flows didn’t go through state banks. Locals withdrew their money from state banks to earn interest from the informal banks, causing the state banks to have to float their interest rates. Up to 2003 some black market operations charged interest by the hour and were open 24/7, according to Ms. Tsai. Even more interesting, little communities of Wenzhou people have sprung up around the world because they are so well connected to each other.

The Chinese call the third kind of illegal banking system the ‘Sunan model’. The word refers to those parts of China where strong brigade and collectivist institutions were built during the Maoist years when the local state government greatly influenced the local economy. During the reform and opening up these places gave birth to healthy township and village enterprises and fueled rural industrialization. Sunan model regions are known for close relationships between local businesses and the local governments. Until the 1990s, collective enterprises turned to the state banking system but the private sector depended on informal financing systems. In the 90s, collectives themselves began undergoing privatization, but still had great connections to the state bank and received special treatment. Meanwhile, the truly original private firms had to depend on their own informal financing, as usual.

The fourth and final developmental type consists of regions that received great funding during Mao’s era. These privileged places had massive factories, many employing from 50,000 to 80,000 workers. Under communism they thrived. Later, with the reforms, they floundered due to competing developmental priorities. The government continues to feel obligated to subsidize and assist state-owned enterprises because they employ so many people, and without steady jobs social unrest is highly likely. Yet those employed by the local governments also are being pressured to create more wealth so they support and tolerate new kinds of local economic activity in their areas. Businessmen in these areas must be very careful and very discreet as well as very creative because relationships and politics are so closely intertwined.

Ms. Tsai points out that local politics and the local economy has created many different patterns for creative financing. She cites a reading club that acted as a front for an informal stock market as a case in point. Someone with an advantaged position used it to discreetly garner wealth for a small group of friends/investors. The magazine reading club owner happened to be a former manager of the People’s Bank of China who got bored with his desk job and wanted to make more money. With his local government contacts he easily registered his club and with his experience and network he quickly created a way to trade futures. Members actually called their profits ‘reading bonuses’. In China this in one of many examples where a person with excellent guanxi and some know-how innovates and starts up a private business.

By the late 1990s the private sector in China had grown to contribute an estimated one-third of GDP and most had no access to formal credit. Whether private sector development can be successful in the long run without access to formal credit over time still is unknown. Ms. Tsai and other experts feel that China needs more regularized access to formal sources of credit. For one, illegal funding carries inherent risks. Second, when informal credit sources are not properly regulated, they run the risk of becoming corrupt.

Ms. Tsai also points out that, beginning in 2001, after China has signed up to join the WTO, the financial system did become slightly more liberal. But the changes are small and long in coming.

China continues to stand as a unique economic model and any foreign businessman coming here should take note of that.

    Channel: Local Wisdom     |