The Catch in China’s Factory Stabilization: Small Firms Struggle

  • Manufacturing PMI shows divide between large, small companies
  • That’s a problem, as smaller companies are more profitable

A hint of unintended consequence lingers beneath the largely stable result seen in China’s official factory gauge for June. Monetary and fiscal stimulus is propping up the most inefficient part of the $10 trillion-plus economy while nimbler private firms fall behind.

The manufacturing purchasing managers index showed big companies reported improving conditions while small- and medium-sized firms showed deterioration. The steeper slide in a separate factory measure from Caixin Media and Markit Economics -- whose sample is composed of mostly small, export-driven businesses -- also highlighted the trend.

As the growth outlook deteriorated late last year, policy makers spurred a credit expansion in early 2016 and stepped up stealth fiscal stimulus to help achieve President Xi Jinping’s goal for at least a 6.5 percent expansion. Much stimulus has been pumped via government policy lenders, which fund specific causes such as infrastructure or agriculture, and state-owned commercial banks. Both tend to favor lending to large, state-backed borrowers over smaller, private businesses.

"Banks never support smaller enterprises as much as they do big ones, although the majority of China’s economy is actually small and medium-sized companies," said Li Wei, the China and Asia economist for Commonwealth Bank of Australia in Sydney. "If you see a sector doing well in China, there must be ample money behind it. And money isn’t a problem at all for state-owned enterprises."

A range of private indicators underscore the tough times facing smaller firms.

One thing to be said for the policy approach: it has worked to stabilize the economy this year, with the official factory PMI at 50 in June and the services index perking up to 53.7. Problem is, it doesn’t really gel with longer-term goals to boost the private sector and shake up state-owned firms, some of which even the government admit are "zombies."

President Xi and Premier Li Keqiang have repeatedly encouraged banks to lend to the vibrant SMEs in various speeches this year, and the People’s Bank of China has lowered required reserve ratios for lenders who offer a certain portion of loans to small firms. Friday’s PMI reports are the latest indications such measures aren’t working.

Diverging fortunes for small and large companies "may lead to growing imbalances since smaller businesses seem to be more driven by efficiency," said Frederik Kunze, chief China economist at Norddeutsche Landesbank in Hanover, Germany. "Reliance on rather old growth drivers like property investments and SOE activity might crowd out investments by entrepreneurs and small businesses, despite the lower productivity."

That means the latest stimulus efforts may in the end only support the most inefficient part of China’s economy -- the state-owned plants mired in excess capacity and debt. At the end of May, state-owned companies had accumulated 82.8 trillion yuan in debt, which is more than 70 percent of the banking system’s total credit to non-financial companies.

"Even after decades of economic reform, the economy is still state-run as state-owned banks aren’t entirely operating on a commercial basis," said Raymond Yeung, senior economist at Australia & New Zealand Banking Group Ltd., adding that China needs aggressive SOE reform. "State-pushed growth can’t be sustainable."

— With assistance by Xiaoqing Pi

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