1. Business Environment for SME Development in China Professor Yang Yao China Center for Economic Research Peking University Creating A Conducive Legal & Regulatory Framework for Small and Medium Enterprise Development in Russia A Policy Dialogue Workshop, St. Petersburg, Russia September 14-16, 2003

2. 2 1. Some Facts of SMEs in China

3. 3 Generating employment Low capital intensity Simple technology Low profitability Relatively small contribution to national tax income

4. 4 2. The Success Factors Vast market and cheap labor: It is easy to run a successful business China followed the Soviet Union by adopting a heavy industry-oriented development strategy in the planning period of 1952-1978; the supply of consumer goods was limited in the 1980s SMEs started in the countryside where labor was cheap Most SMEs use simple technology

5. 5 2. The Success Factors Dual-track approach adopted by the government: Protecting large SOEs while encouraging private businesses to flourish This approach won the support of both the vested interests and the newly emerging private sector The state sector became efficient by preserving and gradually releasing its productivity The growth and growing strength of the private sector has pushed the state sector to reform

6. 6 2. The Success Factors Minimum government intervention and exaction: Room for SMEs to flourish SMEs’ contribution to tax income is limited Entry barriers have been eliminated in recent years While administrative hassles exist, the government is still relatively effective by international comparisons

7. 7 2. The Success Factors Strong incentives for bureaucrats: Government officials are promoted based on the performance of the local economy This might be the most cited and studied difference between China and Russia Every local government in China adopts a pro- economic development and pro-business approach The promotion system enhances central monitoring and provides a counterbalance to the negative effects of fiscal federalism

8. 8 2. The Success Factors Large amount of FDI: Provide capital and entail spillovers to SMEs Many FDI firms are themselves SMEs They provide backward and forward linkages to the national economy FDI does not have strong technological spillovers FDI spills managerial knowledge to local firms

9. 9 2. The Success Factors Entrepreneurship: SMEs are best developed in areas where a viable commercial sector has long existed Small business centers are developed in localities without any factors of success except entrepreneurial spirit Yiwu county in Zhejiang province (remote, no resources, but diligent people)

10. 10 3.Legal Environment China has a set of reasonable laws regulating and protecting business operations People are increasingly relying on the courts to resolve commercial disputes But the enforcement of court rulings is weak

11. 11 3.1 Firm Registration Four types of private business: Single proprietorship Single-owner firms: no minimum requirement for registered capital Partnership firms: some restrictions Companies: high requirements for capital

12. 12 3.1 Firm Registration Firm registration used to be time-consuming and costly It took a long time to get approvals and licenses There were inconsistencies in the requirements (e.g., a firm is required to get its name approved before it could open a bank account, but without a bank account it could not register a name) The costs of capital registration, travel, and other spending were high (amounted to 10% of registered capital in extreme cases)

13. 13 3.1 Firm Registration Recent government initiatives to streamline firm registration One-stop registration: related government agencies are placed in one big lobby Opening up the market and lowering the barrier of entry Streamlining and speeding up the approval process Redesigning the process to make it consistent Ten-day notification rule

14. 14 3.2 Contract Enforcement Weak but improving Rate of enforcement of court rulings YearRate (%) 199278.0 199380.3 199483.2 199584.6 199684.2

15. 15 3.2 Contract Enforcement Reasons for weak enforcement: Lack of sufficient funds Inadequate personnel Regional protectionism Favorable treatments for large establishments

16. 16 3.3 The China Paradox Why has China maintained a very high economic growth rate while having a weak legal system? Informal enforcement mechanism Illegal but productive activities: Illegal activities induced by high rents produced by market and institutional distortions Diversion of funds and assets from the SOEs to private firms “Triangle debts” as a means to get finance

17. 17 3.4 But It Still Pays to Strengthen Rule of Law: Zhejiang v.s. Sichuan Differences in the rule of law: Zhejiang: Sufficient funds and a fairly clean legal system High rate of trust of the court Sichuan: Insufficient funds and a corrupted legal system Low rate of trust of the court

18. 18 3.4 But It Still Pays to Strengthen Rule of Law: Zhejiang v.s. Sichuan Differences in performance of the banking sector: Zhejiang: High trust between banks and firms and among firms themselves Flexible collateral requirements (e.g., buyer’s credit and using tax rebates as collateral) Sichuan: Mutual distrust between banks and firms Limited services Net outflow of bank deposits

19. 19 4.Government Capacities Changing mind-set The government only took care of SOEs in the past, but now has largely de-emphasized ownership and extended supports to all sorts of firms This has been done through several major efforts among which: The 1999 Constitutional amendment formally acknowledged the role of the private sector The establishment of an SME agency in the central government institutionalized a framework of supports to SMEs The 2002 SME Promotion Law set guidance and standards for government supports to SMEs

20. 20 4.1 Government Administration Days to clear customs Ethiopia 14.7 18.610.7 China 7.9 8.96.8 434 firms 101 firms 11.7 Bangladesh 12.710.7 559 firms Pakistan 17.2 20.413.9 125 firms Relatively efficient bureaucracy

21. 21 4.1 Government Administration Relatively clean governments A recent survey of 600 firms in Sichuan province found that corruption ranked sixth in firms’ concerns But unstable government policies and implementation The same survey found that they ranked the third in firms’ concerns (following finance and unfair competition)

22. 22 4.2 The SME Promotion Law Most of the articles of the law are suggestive and wait for local governments to provide detailed implementation plans The catching point is the pledge to establish A SME account in the central budget, and The SME Development Fund: to provide supports to SMEs in the areas of starting-up, technological innovations, training, export, and environmental protection

23. 23 4.3 Financial Programs Designated SME funds Interest rate subsidy schemes for technical upgrading and innovations Other programs The Star Plan: for small businesses The Torch Plan: applied hi-tech projects 863 Plan: R&D commercialization Provincial plans

24. 24 4.4 The SME Innovation Fund The fund was established in 1999 to provide merit-based free funds to technically advanced start-up SMEs. It is managed by the Ministry of Science and Technology. The budget for the fund ranges from 500 million to 1 billion RMB The major criteria for selection are technology, profitability, and the management team. Evaluation of individual proposals takes place in Beijing by experts in technology, accounting, and management. The fund is regarded as the fairest in terms of the evaluation process. As a result, it has a very good reputation The fund has played a significant role of leverage for a recipient firm to attract more equity investment and bank loans. In Sichuan, it is estimated that 1 yuan from the fund can bring to the firm 5 yuan from the market

25. 25 4.4 The SME Innovation Fund Funding to start-up companies generally has a low success rate. Among 15 such firms financed in Sichuan in 2002, only 3 have shown a sign of good performance. The problem is the lack of managerial capacity of the team The evaluation process can be improved by adding more weights on economic performance There are cases of frauds in which firms provide false information just for the purpose to get free money

26. 26 4.5 The SME Guarantee Fund of Sichuan Province The fund is managed by the Sichuan SME Service Center under the provincial economic and trade commission. Its registered capital is 20 million yuan. In 2002, it guaranteed 170 million yuan of loans. The term is usually 1 year, but can be extended to a maximum of 3 years. Up to now, less than 1% of the guaranteed loans have been defaulted. The fund is applying to the provincial government for 20 million RMB to expand its operation Issues Why can the fund do better than the banks in identifying good customers? The fund seems to face a soft budget in its operation The management team of the fund seems to be inadequately staffed

27. 27 4.6 Inter-regional Supports The one-to-one help program: Jiangsu and Guangxi In the 1980s, more than 1,200 help projects were implemented between those two provinces, covering almost all economic areas. Jiangsu has a sound textile industry and many projects involved the transfer of technologies in this industry. For example, before 1980, Wuzhou city of Guangxi province only had 4 textile factories producing an output less than 4% of the city’s total industrial output. Its partner in Jiangsu, Changzhou, happens to have a large textile industry and an experienced workforce. Changzhou sent more than 300 persons/times of technicians and managers to help Wuzhou build its textile industry. By 1990, Wuzhou was able to produce a large variety of textile products, and the share of the textile industry in the city’s industrial output increased to 17.6%

28. 28 4.7 General Reflections on Government Supports In an imperfect market, government supports partly substitute for the market to serve the role of a financial intermediary But cautions are highly recommended: Involve private agencies in the evaluation process Whenever possible, keep the government’s role as a resource provider, not a business player Prevent the formation of vested interests in the government

29. 29 5.Taxation SMEs pay less taxes than large firms They are more likely to evade taxes Local governments do not spend much efforts in collecting taxes from small firms

30. 30 5.1 Problems with Taxation High tax rates Value-added tax: 17% Corporate income tax: 33% Personal income tax: taxable income starts very low and the rate is strongly progressive

31. 31 5.1 Problems with Taxation Ill-defined tax bases The VAT is production-based rather than consumption-based, discouraging investment and technological innovation The deduction for corporate income tax is very restrictive. For example, it does not allow deduction of R&D expenditures and sets a very low limit on deductible wage bills

32. 32 5.1 Problems with Taxation Too much discretionary power vested in tax officers Negotiation of taxes and unequal tax burdens Corruption

33. 33 5.2 Solutions Lower the tax rates The effective rate of corporate income tax is already 28% Make taxation more production-friendly Make VAT consumption-based Allow R&D expenditures deducted from corporate income tax China is heading toward this direction Agricultural taxes will be eliminated soon Corporate income tax will be reduced

34. 34 6. Business Culture There is a high and a low equilibrium of trust and economic growth How to foster trust? The government should behave honestly and follow the rule of law The legal system should be strengthened Business associations should be encouraged

35. 35 6.1 Turning government agencies into business associations Pros Politically feasible Making use of the old network Working with the government closely and in many cases carrying out certain regulatory functions such as maintaining standards and enforcing intellectual property rights

36. 36 Cons Inertia of government officials Unspecialized Limited services 6.1 Turning government agencies into business associations

37. 37 Yibin Association of Registered Accountants Entry to the accounting business is highly regulated But fierce competition still leads to low profit margins and low quality of services The association set floor prices but failed to maintain 6.2 A Failure Story

38. 38 … Not always Two free business associations in Yibin city The Chamber of Commerce of Beauty Salons Lack of leadership, funds, and tangible services The Chamber of Commerce of Wenzhou Merchants A sense of belonging, strong leadership, and tangible services The key: Leadership 6.3 The Freer the Better?

39. 39 7. Possible Lessons for Russia Market-building before law-building Strengthening the rule of law is time consuming and costly The lack of rule of law may be just a result of excessive government control Eliminating excessive government control and market distortions is easier and more effective

40. 40 7. Possible Lessons for Russia Government assistance is necessary but the methods should be refined Use government assistance as a signal and selective mechanism rather than a complete substitute for the market Involve private agencies in the operational process Prevent vested power and interests in the government

41. 41 7. Possible Lessons for Russia Both China and Russia are highly government-centered societies This model of state governance can be very effective if things go well, but can lead to disastrous results if things go wrong When Russia enhances government assistance to SME development, it is wise to keep in mind the negative side of a strong government

42. 42 7. Possible Lessons for Russia Low tax rates are not only conducive to economic growth but also reduce government efforts in tax collection and the likelihood of corruption Government involvement can play a role in fostering trust and business culture