Financing China's Rural Enterprises (Chinese Worlds)

Financing China’s Rural Enterprises

Rural enterprises have played an important role in the extraordinary success of China’s economy over the last two decades. They have greatly increased offfarm employment in rural areas and have brought substantially increased incomes and standards of living to many rural people. Jun Li analyses the role of state policy, financial institutions and local government in the growth of these successful small and medium-sized enterprises from a business finance perspective. Financing China’s Rural Enterprises is an important contribution to ongoing debates in the study of contemporary China’s financial development. It will be of interest to academics studying reform in China and small business finance as well as economists, policy-makers, and those engaged in business with China. Jun Li is Research Fellow in the Enterprise Research and Development Centre, University of Central England in Birmingham. His research interests include entrepreneurship in China, technology and innovation management.

Chinese Worlds

Chinese Worlds publishes high-quality scholarship, research monographs, and source collections on Chinese history and society from 1900 to the present. ‘Worlds’ signals the ethnic, cultural and political multiformity and regional diversity of China, the cycles of unity and division through which China’s modern history has passed, and recent research trends toward regional studies and local issues. It also signals that Chineseness is not contained within territorial borders – some migrant communities overseas are also ‘Chinese worlds’. Other ethnic Chinese communities throughout the world have evolved new identities that transcend Chineseness in its established senses. They too are covered by this series. The editors see them as part of a political, economic, social and cultural continuum that spans the Chinese mainland, Taiwan, Hong Kong, Macau, South East Asia, and the world. The focus of Chinese Worlds is on modern politics, society and history. It includes both history in its broader sweep and specialist monographs on Chinese politics, anthropology, political economy, sociology, education, and the social-science aspects of culture and religions. The series editors are Gregor Benton, Flemming Christiansen, Delia David, Terence Gomez and Frank Pieke. The Literary Fields of Twentieth Century China Edited by Michel Hockx Chinese Business in Malaysia Accumulation, Ascendance, Accommodation Edmund Terence Gomez Internal and International Migration Chinese Perspectives Edited by Frank N. Pieke and Hein Mallee Village Inc. Chinese Rural Society in the 1990s Edited by Flemming Christiansen and Zhang Junzuo

Chen Duxiu’s Last Articles and Letters, 1937–1942 Edited and translated by Gregor Benton Encyclopedia of the Chinese Overseas Edited by Lynn Pan New Fourth Army Communist Resistance along the Yangtze and the Huai, 1938–1941 Gregor Benton A Road is Made Communism in Shanghai 1920–1927 Steve Smith The Bolsheviks and the Chinese Revolution 1919–1927 Alexander Pantsov Chinas Unlimited Gregory Lee Friend of China – The Myth of Rewi Alley Anne-Marie Brady Birth Control in China 1949–2000 Population Policy and Demographic Development Tomas Scharping Chinatown, Europe Flemming Christiansen Financing China’s Rural Enterprises Jun Li

Financing China’s Rural Enterprises

Jun Li

First published 2002 by RoutledgeCurzon, an imprint of Taylor & Francis 11 New Fetter Lane, London EC4P 4EE Simultaneously published in the USA and Canada by RoutledgeCurzon 29 West 35th Street, New York, NY 10001 This edition published in the Taylor & Francis e-Library, 2003. RoutledgeCurzon is an imprint of the Taylor & Francis Group © 2002 Jun Li All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data A catalog record for this book has been requested ISBN 0-203-21735-7 Master e-book ISBN

ISBN 0-203-27316-8 (Adobe eReader Format) ISBN 0-415-29682-X (Print Edition)

To my parents

Contents

List of figures List of tables Preface

xi xii xiv 1

1

Introduction The objectives of this study 3 Methodological problems 5 The case studies 7 Outline of the book 10

2

The paradox of financing rural enterprises The financing of rural industries in China: a paradox 12 Determinants of financing of small firms 20 A reform dynamics perspective 27 Conclusions 29

12

3

Industrial growth and the pattern of financing Basic characteristics 32 Rural industrial growth: 1978–94 36 Growth and fluctuations 41 Over-dependence upon debt financing 45 Conclusions 52

31

4

Financial management of rural industries Growth rates, profitability and debt capacity 53 Shortage of equity capital 55 Tax shields and soft credit 64 Financial weakness and risk absorption 68 Conclusions 71

53

x

Contents

5

The financial management of rural financial institutions The restructuring of rural finance 74 A lending strategy of trade-off between yield and risk 78 New incentive structure and liabilities portfolio 82 Local government–bank relations 88 Undesirable consequences and financial risk 91 The rural financial sector under dynamic reform 93 Conclusions 95

73

6

Local state capacity and community risk-sharing The expansionary drive 99 The financial capacity of local governments 100 Competitive tax evasion 106 The community risk-sharing mechanism 110 Conclusions 116

98

7

Conclusions

119

Notes Bibliography Index

127 134 144

Figures

4.1 Sources of funds for rural industrial enterprises 5.1 The structure of rural finance in Chaoan County, Guangdong Province 6.1 The local institutional structure in Chaoan County

57 77 115

Tables

1.1 2.1 2.2 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 5.1 5.2 5.3 5.4

Comparative major economic indicators The financial life-cycle of the firm Main source of financing in relation to risks Firm size in terms of employment in rural industrial enterprises, 1978–94 Composition of rural industries by ownership (%) Regional patterns of rural industry, 1990–4 Growth of rural enterprises in comparison with other sectors in China, 1978–94 (growth rates of gross industrial output, %) Cyclical patterns of national industry and rural industry Industrial growth and fluctuation, 1978–94 Growth and risk of rural industry, 1985–94 Comparative financial gearing (%) Balance sheet of rural industries in selected years Working capital structure of rural industrial enterprises Working capital loans of rural enterprises Sources of fixed capital investment in rural collective enterprises, 1986–94 (%) Profitability of rural industrial enterprises Capital contributions by local governments Distribution of after-tax profits in rural collective enterprises Uses of net profits in rural collective enterprises (%) Capital intensity in rural collective industries Capital intensity of selected industries Trade credit of rural collective enterprises (billion yuan) The average nominal and real interest rates (%) Response to a questionnaire on financing preference Financial cost of enterprise bonds Loans to rural enterprises, 1979–92 Sources of loans of rural enterprises Interest rates and rates of repayment in rural financial institutions Loans portfolio of the rural financial sector (%)

9 21 23 33 35 36 37 42 43 44 45 45 46 47 49 55 58 59 59 61 62 63 65 67 69 79 80 81 82

List of tables 5.5 5.6 5.7 6.1 6.2

Deposit structure of the ABC and RCCs Composition of deposits (%) Performance of selected banking sectors (1993) Depreciation in rural industrial enterprises Collective enterprises and output by administrative jurisdiction

xiii 86 87 93 109 111

Preface

This book grew out of my doctoral thesis, for which I was awarded a PhD by University of Lancaster, in 2000. This project has been a long journey, from identifying the research topics, through the painful search for truth and finally to completion in this book. During this journey, I owe a great debt to my supervisors, Dr Jenny Clegg and Dr Flemming Christiansen, who have given me great support. Their close reading and encouraging suggestions have provided a most fruitful source of inspiration and have helped me carry out the various stages of the research. In particular, at each supervision meeting, Jenny always made sure I had enough hard questions to think through. I also remember at a time when progress appeared slow and frustrating, Flemming provided timely endorsement on the framework of the research and the ideas I was developing, which brought back my confidence. When I passed the viva, it was Flemming, together with Jenny, who assured me they believed the thesis was publishable as a book. Without their support and encouragement, this book would not have been possible. The study involved two periods of fieldwork in China in 1995 and 1996. I have received enormous help during this fieldwork. Local officials kindly assisted me in organising the work, and many managers of rural industrial enterprises patiently answered my questions in the interviews. My sincere gratitude goes to all of them. In particular, I am grateful to Chen Hanwei, Head of the General Office of the Chaoan County Government; Wang Canwei, the Epidemic Prevention Station of Chaozhou City; Lin Deyuan, Director of the Rural Enterprise Bureau, Chaoan County; Zheng Yuanwen, Head of the Industrial and Transportation Office of Anpu Township, Chaoan County; Zhong Enxiang, Senior officer of the County Branch of the Agricultural Bank of China, Tong County; and Wang Zhenxiang, Head of the Management Department of the Rural Enterprise Bureau, Tong County. The research was supported by Edge Hill College of Higher Education and the Great Britain–China Educational Trust in the UK. I wish to acknowledge their generous support. My gratitude also goes to two anonymous reviewers for offering suggestions for improvement and to the editor at RoutledgeCurzon, Rachel Saunders, for her kind assistance.

Preface

xv

Finally, the members of my family deserve my sincere gratitude for their patience and encouragement. No words can describe my appreciation for the love and constant support I enjoyed from my parents. I dedicate this book to them. My wife Ling and my son Alan are, however, the only ones who have had to endure personally the consequences of my long journey through the research. I acknowledge my real debt to them.

1

Introduction

The growth of the Chinese economy in the post-1978 period is truly phenomenal. From 1980 to 1995 the growth of Chinese gross domestic product (GDP) averaged ten per cent per annum, outpacing the performance of all former socialist economies in transition, as well as the so-called Asian Tigers. At cumulative rates Chinese GDP grew more than twelve-fold over the two decades. Exports rose a hundred-fold. By the end of 1990s China was already in the top ten in the world in trading terms. Remarkably, this growth has been led by rural enterprises, composed of collective enterprises, co-operatives, individually owned businesses, private corporations, and foreign joint ventures. By far the most impressive growth, however, has been that of rural collective enterprises. In the period 1978–94, when previous constraints on rural industrial development were gradually lifted, rural industries grew at an unprecedented rate of over 20 per cent per annum, out-performing all other sectors of the national economy. The consequences of rural industrial growth are far-reaching. In rural areas, by 1994 rural industries produced some 67 per cent of rural social output1 and employed 100 million farmers from the agricultural sector, who were released as a result of the success of rural reforms related to the household responsibility system. In other words, each year from 1978 to 1994 rural industries created some 6 million jobs for surplus labour force in rural areas.2 Rural enterprises have become the new source of income for rural households. It was estimated that about one third of average income per capita in rural areas came from such businesses. In the same period 1978–94, rural industries contributed industrial profits of an estimated 64 billion yuan in support for agricultural and rural development (yi gong bu nong), equivalent to about 64 per cent of the state agricultural investment.3 To the national economy as a whole, the contribution of rural industries is equally remarkable. In 1994 rural industrial enterprises were responsible for 45 per cent of the country’s total industrial output, compared to only 12 per cent in 1978. Rural enterprises contributed 39 per cent of the country’s total exports and were also the main source of attraction for foreign investors. Accordingly, rural industries have emerged from their previous marginal position as an ancillary activity in the agricultural sector to become the

2

Financing China’s rural enterprises

driving force of China’s spectacular economic growth in the transitional period. The miracle of rural industries in China distinguishes the Chinese reform economy from all other former socialist economies under reform. First, China’s reform is initiated by a ‘bottom-up’ approach and succeeds in rural areas in the first place. Set up by local governments and farmer entrepreneurs, and operating in rural areas, rural enterprises first broke the dominance of urban industries, particularly state-owned enterprises, in the 1980s. Some have gone on to win a niche market in international competition. Second, the rural industrial sector is made up overwhelmingly, though not exclusively, of small and medium-sized enterprises. Time has witnessed the change of favour in this sector from ‘small is beautiful’ to ‘larger is better’, as a result of encouragement by the state as well as the pressure of competition. However, industrial growth continues to be driven very substantially by small businesses. The miraculous growth of rural industries has attracted considerable attention all over the world, with a comprehensive investigation by the World Bank (Byrd and Lin 1990) in the late 1980s providing a fascinating start. However, understanding the success of rural industries is proving to be a complex task. What are the new ideas and concepts underpinning the Chinese reform and development experience? To what extent do the Chinese models of rural small business development challenge the orthodox ideologies and paradigms that prevail in the international community? What can other countries learn from Chinese concepts and practices, underpinning institutional and regulatory capacities, and management processes? This book reflects such immense interest and seeks to examine the Chinese experience from a small business financing perspective. International experience shows that finance is a major constraint on the growth of small enterprises (Storey, 1994). There has been continuing and vigorous discussion, mainly in Western countries, about the financing of small enterprises. However, research on this particular area in studies of Chinese rural enterprises has been relatively overlooked. This does not mean the issue is of secondary importance. Constraints on financing of rural enterprises have been a focal point of business development policies and a constant concern of enterprise managers and local governments alike ever since rural industries resurged in the late 1970s. The shortage of capital in rural industrial enterprises, particularly in periods of credit squeeze, sometimes reached such a severe degree that overall rural industrial growth suffered. Of course, the shortage of capital in the rural industrial sector is by no means unusual, given that these enterprises have grown at an exceptionally fast rate. There are far more complicated issues involved, however. At the macro level, during the reform period rural enterprises have frequently been denied access to credit from financial institutions. At the same time, state-owned enterprises continue to receive the bulk of loans from state banks despite the poor performance of most of them as well as the dramatic reductions in their share of national industrial output and employment. This

Introduction

3

tension in the allocation of resources raises the questions of how the growth of rural enterprises is financed and what mechanisms facilitate the flow of financial resources to the rural industrial sector. At the micro level, fast-growing rural enterprises, despite facing high financial risk as a result of their vulnerability in terms of growth rates and profitability, borrow heavily and aggressively and thus display an unusual pattern of over-dependence on debt. Surprisingly, these enterprises have shown an amazing resilience: they survive unbelievable financial pressure and bounce back to achieve exceptional growth time and again. Hence, if the fast growth of rural industries is attributable to the hard budget constraints to which they presumably are subject, why do these enterprises prefer an aggressive to a conservative strategy of financial management and why are financial institutions prepared to support them? Again, if the financial management that prevails in the rural industrial sector can be explained by the existence of a local community risk-sharing mechanism, how is the local economy with a small industrial base able to absorb the disproportionate financial risk? Despite the importance of these questions for the better understanding of the success of China’s rural enterprises, there is limited empirical evidence on how rural small industrial enterprises are financed and how these highly indebted small enterprises are able to absorb financial risk and maintain their remarkable growth. This book addresses these issues on the basis of new statistics available from government publications and field research in China between 1995 and 1996. It provides a comprehensive analysis of the financing of China’s rural enterprises in the period 1978–94, and discusses the key issues concerning rural enterprise development in China. It explores many aspects of rural enterprise financing, examining the financial pattern of rural enterprise, enterprise financial management, rural financial institutions, and local governance. In general, this book seeks new insights into the growth of Chinese rural enterprises and so to fill a gap in the study of contemporary China.

The objectives of this study The primary task here is to develop a conceptual approach to reform dynamics in order first, to understand how the dynamics of economic reform in China has created a unique resource allocation mechanism for financing rural industrial enterprises, and how it shapes the mechanism of financial risk absorption; and secondly, to analyse the success of rural industries in China from the perspective of small business financing. This task involves a number of specific investigations. The first is to examine the behaviour of rural small businesses in managing finance and the interrelationships between debt capacity and debt financing, as well as the impact of soft budget constraint on financial risk absorption in rural industries. This requires investigating to what extent the financial pattern

4

Financing China’s rural enterprises

of rural small industrial enterprises can be explained by such factors as performance of output growth, profitability, tax shields, and bankruptcy costs. It also means investigating to what extent the severe shortage of equity capital reinforces the need to depend on debt financing and how soft budget constraints and a flexible rural labour market affect the financial management of enterprises and their ability to absorb financial risk. A second area of investigation is the financing of small businesses in rural areas from the perspective of financial reform dynamics. This involves examining how financial decentralisation creates new incentives for rural financial institutions, how it changes their liabilities portfolio and how these changes affect credit management with regard to the lending strategy of trade off between yield and risk, particularly in the loan management of rural financial institutions. How the local government–bank relations influence the switching of the banks’ lending priorities, and what undesirable effects this has on the macro-economy, are also examined. Finally, the impact of soft credit on the debt capacity of rural industrial enterprises and on their ability to avert financial risk is analysed. The role of local governments also needs to be investigated, focussing on the interrelationship between the financing pattern of rural enterprises and the financial capacity of local governments. The essential components of the local community risk-sharing mechanism are examined, and to what extent a small local economy is able to absorb financial risk is assessed. In the analysis of the financing of rural industrial enterprises, the focus is on rural collective industrial enterprises. The reasons for this are two-fold. First, collective industrial enterprises are predominant in the rural industrial sector, and they are founded and supported by local governments. These facts make the analysis relevant to the issues of community mechanisms of financing, risk-sharing, and risk absorption. Second, economic data on collective industries is more easily collected, thus allowing a more thorough investigation of this sector. Therefore, except where stated otherwise, rural industrial enterprises in this book refer to collective enterprises only. The book also focuses on small and medium-sized enterprises. As will be seen in Chapter 3, this conforms to the reality of the rural industrial sector. Because small and medium-sized enterprises make up the overwhelming majority, it is reasonable to use national aggregate statistics on rural industries as the basic analytical materials, without worrying about some exceptions, such as the very small number of large-scale enterprises. Where case studies are used, the definition of small and medium-sized enterprises suggested by the European Committee (ENSR, 1993) is preferred. This is because there are real difficulties in defining smaller enterprises. As Storey (1994) says, the real problem in doing so is that smaller firms are not homogenous. A small firm in one sector may not be called small in another sector in terms of capitalisation, sales, or employment. Therefore, when statistics such as number of employees, sales, profitability, and assets are used as the objective measure of size at the sector level, it is quite possible that in

Introduction

5

some sectors all the firms might be regarded as small, while in other sectors there are possibly no small firms at all. In recent years, the term ‘small and medium-sized enterprises’ (SMEs) has become increasing popular simply because their definition, using employment as the single measure of size, has the advantages of simplicity and data availability. According to the European Commission, the SME sector is disaggregated into three components: (a) Micro enterprises (less than 10 employees); (b) Small enterprises (10 to 99 employees); and (c) Medium enterprises (100 to 499 employees). Thus, enterprises that employ less than 500 workers will be broadly considered as SMEs regardless of their subdivision. Arguably, this definition remains arbitrary, but it is more flexible to use and provides consistency in international comparison. The definition of SMEs in China is not straightforward at all. Usually, production capacity is used as the measure of size in manufacturing industry, while employment or sales measures are used in other sectors. The production capacity approach is compatible with the traditional planning system, and is useful as a tool of government planning management. In particular, under the economic decentralisation and administrative devolution regime, this approach helps identify the government’s responsibility for capital investment grants and to supervise investment projects at certain levels. Generally, the size of firms with respect to production capacity has been determined sector by sector, and has been adjusted from time to time. All these add to the problem of consistency and make inter-sectoral comparison difficult, if not impossible.

Methodological problems Research into the financing of rural industrial enterprises presents some specific methodological challenges. First, the limitation of data is a major constraint on a thorough analysis of rural industries. This issue has been well recognised by scholars in the area of Chinese studies, and in part explains why less work has been done on rural industrial finance than in other studies of rural enterprises. Recent years have witnessed an improved availability of information on business finance in rural industrial enterprises and rural financial institutions, thereby greatly increasing the possibility of doing research in this area. In this book, data comes mainly from four sources: • •

China Statistics Yearbook, Almanac of China’s Rural Enterprises, Almanac of China’s Rural Finance 1991, and Almanac of China’s Finance; Rural Enterprises in Contemporary China and Finance in Contemporary China in the Contemporary China Series;

6

Financing China’s rural enterprises

• •

Information collected from fieldwork; Other empirical data from various sources.

In these relatively diversified sources of information, a number of vital statistics were available only for rural enterprises in general rather than rural industrial enterprises specifically. This was particularly so in data relating to financial information on enterprises and financial institutions. This problem results in a constant concern about consistency in the use of data because, by the official Chinese definition, rural enterprises include not only industry but also agriculture, forestry, transportation, and commerce, and catering. To resolve this problem, this book has implicitly assumed, as Weitzman and Xu (1995) have rightly argued, that because rural industrial enterprises produce about three quarters of the output of all rural enterprises and are the most efficient rural enterprises, it may be reasonable to identify the rural industrial sector with the rural enterprise sector, and thus to apply information relating to rural enterprises to the analysis of rural industrial enterprises. That this book seeks to piece together the pattern of the financing of enterprises at national level also gives rise to the problem of generalisation. First, different small enterprises might grow at different speeds over the same period, hence facing financial constraints to various degrees. So, ideally, the analysis should distinguish between rural industrial enterprises according to growth rates and explore the difference in financial management between fast-growing enterprises and other enterprises. Second, rural industrial enterprises are heterogeneous, including small high-tech enterprises, export-oriented enterprises and manufacturing enterprises aiming at local markets. These enterprises in different sectors confront different tasks of financial management and different financial constraints. The problem of small high-tech enterprises, for example, may be more severe in seeking venture capital, while the problem of export-led enterprises can lie in the acquisition of export credit. Similarly, enterprises producing for domestic markets will have their unique financial problems. If rural industrial enterprises could be broken down into subcategories and the character of capital structure of each subcategory could be well defined, the understanding of the financing of rural industrial enterprises would be greatly improved. Finally, China’s vast size has important implications as well. The wide diversity in natural resource endowments, population density, physical and human capital, history of rural industrial development, and tradition and culture result in great regional variations in rural industrial growth and patterns of financing. Unfortunately, all these considerations could not be satisfied given the availability of statistics when this research was carried out. In the end, some compromise had to be made. In general, this book is written on the premise that studies focussing on the broad picture at national level provide the proper

Introduction

7

starting point to stimulate debate, given that the subject has so far attracted less attention and less research. Having said that, I have used as much information as possible from my two periods of fieldwork carried out in Chaoan County of Guangdong Province and Tong County of Beijing, in order to supplement the general picture with a reasonable amount of specific detail.

The case studies The setting of the two case studies is atypical of rural industrialisation in China as a whole. Both places, Chaoan County and Tong County, would be hard to recognise as the so-called typical development models such as Wenzhou or South Jiangsu, or to represent the full set of institutional arrangements in the context of business finance. The development of rural enterprises with local character has been a distinct feature in China’s rural industrialisation over the post-1978 period. This often leads to the problem of the representativeness of case studies just mentioned. Christiansen (1990) has rightly said that no place is a ‘typical’ representative of national policies and that each would show development paths divergent from those followed in neighbouring regions. To address this problem and to supplement the small sample of case studies, this book draws on evidence from as many existing studies as possible. Chaoan and Tong counties were selected first because both are relatively industrialised and have achieved extraordinary industrial growth over the post-1978 period. They have therefore faced problems typical in financing fast growing enterprises. My personal knowledge of both regions and guanxi or personal contacts were other factors in the choice of places for the fieldwork. Chaoan County is where I grew up and returned to regularly after I left for Beijing to study for my first degree in the late 1970s. Beijing is my second home where I lived and worked after I left university and Tong County is a suburban county administered by Beijing.4 My personal knowledge of these two places has given me some insight into the socio-economic conditions of these regions and their recent development. The first period of fieldwork was carried out in Chaoan County in August and September 1995. The county was briefly re-visited to monitor the continuing development of rural enterprises during the second period of fieldwork in July and August 1996, though the main purpose of the second period of fieldwork visit over that time was to investigate the rural financial sector in Tong County. In both periods of fieldwork, data at the county level was collected from relevant government departments. As expected, data collection at the enterprise level proved to be more difficult because these enterprises were generally reluctant to release comprehensive financial information, either from considerations of self-protection or simply due to poor book-keeping. In Tong County, just before I went there, the county branch of the Agricultural Bank had completed an investigation into 155

8

Financing China’s rural enterprises

enterprises, each with borrowing of 200,000 yuan and over. Reports from the investigation were provided generously. In addition, extensive interviews were made with enterprise managers and officials in local government. The choice of sample enterprises was generally made in consultation with local government officers. In both fieldwork visits, sample enterprises were limited to industrial firms, mainly in manufacturing. This was done to keep comparability with previous surveys on the subject. In total, seventeen in-depth case studies were made in two periods of fieldwork. These enterprises varied in the form of ownership, but many of them were collectively-owned. Except for a few, most enterprises were founded in the 1980s. On average, these enterprises employed 330 workers and produced an industrial output of 24 million yuan. Generally speaking, both Chaoan and Tong counties are at the intermediate level of development, as can be seen from Table 1.1. Both counties are more developed in terms of three per capita economic indicators than the national average, but they are not as developed as the most prosperous regions, such as Zhongshan City, Guangdong Province. Taking rural enterprise output per capita as an example, in 1996 Chaoan and Tong counties achieved 8,498 and 10,656 yuan respectively, much more than the national level. In the same year, however, the rural enterprise output per capita in Zhongshan City was 23,831 yuan, more than double the figures of Chaoan and Tong counties. For this reason, it may be reasonable to say that Chaoan and Tong counties represent a large number of counties with an average rural industrial development. Thus inferences from the fieldwork in both counties will be helpful in understanding the general situation in the rural industrial sector in China. Because this book covers the financial management of rural industrial enterprises, the banking management of the rural financial sector, and the economic management of local governments, it is not appropriate to follow the usual convention of presenting fieldwork results in a distinct chapter. Instead, examples from fieldwork have been used to illustrate and support arguments to which fieldwork results are most relevant. Chaoan County Chaoan County is situated in the eastern part of Guangdong Province, approximately 400 km east of Guangzhou, the provincial capital. With a rural population of 1,114,484 in 1996, the county’s arable land per farmer was 0.33 mu,5 only 0.46 per cent of the province’s average. This tension between rural population growth and diminishing arable land has been the major challenge facing the county’s agricultural sector over the past few decades, and seems to have stimulated the early development of rural non-agricultural activities in the people’s commune period. After 1978 the repressed rural industrial sector surged, growing at a rate of between 30 and 40 per cent per annum throughout the 1980s. In 1996, rural enterprises in Chaoan produced

Introduction

9

Table 1.1 Comparative major economic indicatorsc All China (i) In aggregate terms Population (10,000) 119,850 Agricultural outputa 15,750 Industrial Outputa 76,909 Rural enterprise outputa 42,589

Guangdong

Zhongshan

Chaoan

Beijing

6,897.0

126.8

111.4

1,077.7

827.1

22.5

14.9

89.6

8,815.5

418.6

89.3

5,335.1

302.3

94.7

13,163 583.0

Tong County

62.5 9.8 58.1 66.6

b

(ii) In per capita terms Agricultural output 1,314 Industrial output 6,417 Rural enterprise output 3,553

1,199

1,771

1,338

831

1,567

12,782

35,998

8,015

12,214

9,299

7,735

23,831

8,498

5,410

10,656

Notes: (a) 100 million yuan. (b) Yuan per head. (c) Figures for 1996 for the regions but 1994 for all China. Sources: China Statistics Yearbook 1995, p.59, p.332, p.365, and p.377. Statistical Yearbook of Guangdong 1997, pp.67–9, p.274, pp.559–77. Beijing Statistical Yearbook 97, p. 36, pp. 161–2, pp. 473–5.

an output of 9.5 billion yuan, which accounted for 83 per cent of the county’s gross rural social output. Fengxi and Anpu are two dominant townships in the rural industrial development of Chaoan County. These townships, making up 9.0 and 10.5 per cent of the county’s population respectively, produced 34.6 and 16.3 per cent of the county’s rural enterprise output in 1996. Fengxi township is dominated by the manufacturing of pottery and Anpu township specialises in the processing of fruit products. Tong County Tong County is a suburban county under the direct administration of Beijing, and is located about 20 km east of the city centre. The county, with a population of 625,117 in 1996, is the largest county in Beijing. Around 74 per cent of its population in 1996 was classified as ‘farmers’. Over the last decade, output of rural enterprises in Tong County increased by 40 per cent per annum. In 1996, rural industrial enterprises in the county produced an output of 6.7 billion yuan, ranking it number three in Beijing’s eight counties. The output value of rural enterprises constituted about 69.5 per cent of the

10

Financing China’s rural enterprises

county’s rural social output in 1996. Since 1991, Tong County has become one of the top 100 counties in China in terms of gross output of rural enterprises. Although private rural enterprises have developed rapidly in recent years, the significance of rural collective enterprises remains dominant: in 1996 they employed 80.3 per cent of the total rural enterprise workforce, produced 82 per cent of the total rural enterprise output and contributed 73.7 per cent of the tax revenues.

Outline of the book This book is organised as follows. After the first chapter outlining the objectives, methodology and structure of the study, Chapter 2 reviews the existing debates on the financing of rural industrial enterprises, discusses the usefulness of the analytical tools employed in small business studies in the West for the investigation of rural enterprises in China, and identifies the hypotheses of the study. Chapter 3 provides an overview of the basic characteristics of rural industrial enterprises and highlights the growth pattern of rural enterprises between 1978 and 1994. The main focus of the chapter is to identify the pattern of financing of rural enterprises and to investigate some of the challenges it poses to allocation of resource and financial management in the context of growth instability and fluctuation. To obtain a better understanding of the factors that influence the pattern of financing of rural industries, the next three chapters examine the different facets of the mechanisms related to financial management within small businesses, allocation of financial resource and risk absorption in the local community. Chapter 4 focuses on the financial management approach in rural enterprises. Factors that affect the debt capacity of enterprises are examined in order to identify the critical factors responsible for the debt-dependence found in rural industries. This chapter further investigates how these highly geared enterprises absorb financial risk internally. Chapter 5 analyses the financing of rural industries from the perspective of rural financial institutions. It briefly reviews the reforms of the financial system as a whole and of the rural financial system in particular. Specifically, this chapter discusses the impact a rural financial system in dynamic reform has had on credit management in financial institutions, and on the changing relationships with rural enterprises and local governments. It first examines the key aspects of banking management, such as incentive structure and liabilities portfolios in order to understand the reasons behind the change in lending priorities observed in the post-1978 period. The interdependence between rural financial institutions and local governments, and its implications for allocation of resource towards rural enterprises, are also discussed. The chapter also analyses the reasons explaining why rural financial institutions are able to sustain despite extending sizeable credit funds to risky enterprises. Chapter 6 discusses the role of local governments. The financial relationship between enterprises and local governments, and local mechanism of

Introduction

11

community risk-absorption are examined within the framework of local state capacity. In particular, this chapter analyses issues related to local financial capacity and responsibilities, the building of ‘bottom–up’ capacity with substantial scope for adoption of flexible policies, and the components of the mechanism of community risk-sharing and its institutional foundation. The last chapter, Chapter 7, presents a summary of the conclusions of the book as a whole.

2

The paradox of financing rural enterprises

Although China’s rural industries have sustained an extraordinary performance for almost two decades, their success remains to be understood. This is particularly so with regard to the financing of rural industries. In studies that explicitly or implicitly touch on the issue of financial management in the rural industrial sector, two main approaches can be identified. One can be referred to as the ‘hard budget constraint’ approach, which emphasises the fundamental change in budget constraint on the rural industrial sector and the implications of this change for the phenomenal performance of rural industries; the other is the ‘local state corporatism’ approach, which underlines the developmental role of local governments in promoting rural industrial growth. While both approaches present interesting explanations for the success of rural industries, they fail to give full account of a paradox concerning the financing of rural industries. The paradox is, on the one hand, that if rural industrial enterprises were responsible for risk absorption, why did they use an aggressive strategy of debt financing? On the other hand if it was the local community that absorbed financial risk, how was it possible for a local economy with a small industrial base to engage in profit re-distribution? To understand this paradox, this chapter develops the conceptual approach of the ‘reform dynamics’. This chapter is organised as follows. The first section reviews the arguments in the current debate on China’s rural industries that are relevant to the issue of financing of rural industries, and discusses the failure of these debates to explain the problematic pattern of financing of rural industries. The second section draws on key concepts from general theories of small business finance to provide the analytical tools used in the research for this book. The final section presents a conceptual approach that offers a new perspective for the analysis of the financing of rural industries.

The financing of rural industries in China: a paradox China’s economic growth between 1978 and 1995 has been remarkable, contrasting sharply with the fall or even the collapse of some other former socialist economies in that period of time. Under ambitious transformation

The paradox of financing rural enterprises

13

and structural adjustment programmes designed to emulate the Western economic system, Russia and the Eastern European economies commonly adopted the ‘big-bang’ approach. Believing that privatisation and a rapid shift to markets would be the only certain path for the transition from central planning, they saw their economies moving painfully into chaos, with a steep decline of output, deterioration of living standards and rampant inflation. China’s gradual economic reform has proved to be distinctive. It has produced the fastest sustained growth this country has ever seen since 1949, and in this process public ownership of industrial enterprises, whether state-owned or collectively-owned, has remained dominant. In particular, it is the small and medium-sized collective enterprises in rural areas that have been a major driving force of China’s economic miracle (Byrd and Lin 1990, Weitzman and Xu 1994). As will be seen in Chapter 4, rural enterprises display a number of characteristics. First, they are not state-owned, and most of them are also not privately owned. Rather, they display a wide variety of ownership patterns, the predominant one being collective ownership by townships or villages. Second, these collective enterprises have a close relationship with local government. Third, the average size of rural collective enterprises is significantly smaller than that of the state-owned enterprises. Finally, the property rights of these enterprises have been vaguely defined. According to orthodox economic theory, rural enterprises without a true owner who has clear rights and incentives to manage the firm for profit maximisation, ought to be inefficient. In reality, they have performed as well as private enterprises (Svejnar 1990, Weitzman and Xu 1994). Hence, Weitzman and Xu (1994) raised the debate about this paradox. Why have vaguely defined rural enterprises performed so well? Or in the broader sense, why did the reform of ownership appear irrelevant to the success of the Chinese economy under reform in the 1980s? In the debate on this paradox, some have suggested that because the rural enterprises have a different ownership form from that of the state-owned enterprises and in addition are seen to face stiff market competition, they should effectively be considered as private (Zhou 1996) or ‘semi-private’ (Peng 1992). But this line of argument has been widely rejected. There are two more accepted explanations, which can be referred to as first, the ‘hard budget constraint’ approach, and second, the ‘local state corporatism’ approach. The remainder of this section will discuss the implications of both approaches for the financing of rural industries. The ‘hard budget constraint’ approach The ‘hard budget constraint’ approach emphasises the relationship between the performance of rural enterprises and the budget constraint of these enterprises. There are three types of explanatory perspectives offered by this approach.

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Financing China’s rural enterprises

The ‘marketisation’ perspective The ‘marketisation’ perspective emphasises the relationship between the performance of small enterprises and the competitive pressure of markets, or the effect of so-called ‘marketisation’. Rural industries grow out of markets: they purchase their inputs from and sell their products to markets at competitive prices, they are subject to harder budget constraints, and they have to depend on their viability in the market. Therefore, they have been driven by markets to improve their performance for the sake of their survival. Rawski’s work (1996) best reflects this line of reasoning. He argues that desirable enterprise behaviour is most likely to be subject to two conditions: (a) competition creates pressure to economise and innovate, and (b) governments allow unsuccessful firms and their workers to suffer the consequences of failure. Thus, if the government is unwilling or unable to help the victims of competition, enterprises must learn to compete regardless of ownership. The marketisation perspective pinpoints one aspect of rural industrial success and helps to explain why pro-market economic reforms became predominant in China in the 1990s. In the 1980s, however, the emergence of markets in China could hardly be given the full credit because the product markets were highly segmented, a free labour market existed only to a very limited degree, and the capital market was only embryonic (Singh 1993). The ‘local government-led growth’ perspective In contrast to the marketisation perspective, Walder (1995) conceptualises the ‘local government-led growth’ perspective from a property rights point of view. First, he argues that local government-led growth is effective because clearly-defined property rights are realised at the local government level, although not at the enterprise level. China’s fiscal reforms have assigned local governments property rights over increased income; these reforms have served to clarify the rights of local governments over assets they administer, in effect reallocating property rights downward within government hierarchies. In other words, this fiscal contracting system has provided an economic foundation for rapid, local government-led economic growth, by giving officials both the incentive and the investment funds to become effective promoters of local industry. Thus, growth will result as long as there are secure property rights held by an organised unit and sufficient incentives for that unit to pursue growth. Second, Walder argues that enterprises are subject to hard budget constraints because China’s fiscal reforms have strengthened financial incentives for local governments, and local governments have fewer nonfinancial interests in the operations of their enterprises. In other words, local governments would be more concerned about creating better-paying jobs than about having strong commitment to full employment at the cost of the efficiency of their enterprises. This is because that there is a labour force in

The paradox of financing rural enterprises

15

rural areas that is underemployed and poorly compensated in agricultural pursuits. Moreover, local governments do not, Walder argues, have great interest in industrial enterprises as providers of social welfare and housing. Third, he contends that local governments are unable to soften the budget constraints on rural industrial enterprises because in smaller jurisdictions, governments face harder budget constraints and are unable to engage in financial balancing operations, or redistribution of industrial profits, between enterprises. Local governments are thus better able to monitor enterprises and to enforce their interests in strong financial performance. As a result, public enterprises have attained many of the desirable features. Walder rules out the possibility of extensive balancing operations in the local community. The reasons, as he puts it, are (a) local governments have a small and less diversified industrial base, and balancing operations cannot be sustained at these levels; (b) prices and profits are too unpredictable to make balancing operations feasible. As a result, local governments are less able to tolerate poor performance from any single firm precisely because there are so few enterprises that they cannot therefore redistribute income among them. Similarly, Singh (1993) asserts that local governments have relatively little scope for allowing a ‘soft budget constraint’ on enterprises under their control; there is no way for local governments to soften their own budget constraints and thus no room to soften the budget constraint on enterprises. The ‘federalism’ perspective According to Qian and Gérard (1998), the term ‘federalism’ refers to the devolution of fiscal authority from central to local government. They argue that federalism works against soft budget constraint because if the enterprise anticipates that it will be bailed out by the government, it will not have the incentive to improve its performance. A bail-out depends on the opportunity cost of the government’s funds, in particular, the marginal benefits of investing in infrastructure. In the case of federalism, local governments must compete among themselves to attract outside capital to their non-state enterprises. Because infrastructure investment raises the marginal product of capital, it is therefore a useful instrument in the competition for capital. Hence, the opportunity cost of bailing out failing enterprises is higher under federalism, and accordingly federalism entails a harder budget constraint on enterprises. The federalism perspective is quite correct to demonstrate the linkage between the budget constraint of enterprises and the opportunity cost of local governments’ investment in an open economy. But as far as the township and village economy in rural China is concerned, the assumption of an open economy with a significant component of investment inflow is hardly satisfied, particularly in the case of the Chinese economy in the 1980s. In fact, rural industrial growth over the period of the 1980s was largely generated by endogenous factors, as the World Bank study (Byrd and Lin 1990) revealed.

16

Financing China’s rural enterprises

In summary, it can be inferred from the ‘hard budget constraint’ approach that if rural industrial enterprises were subject to hard budget constraint, they should be aware of their full financial responsibility and the disastrous results of business failure, and as a result should employ a relatively conservative mode of financial management. In other words, it would be logical to assume that they would avoid over-dependence on debt financing and that they would use debt financing only to the degree that their overall financial health was not compromised. Of course, a small number of enterprises may be tempted to finance their fast growth with loans, but this approach contends that over-dependence on debt financing would be unlikely to become a common practice in rural enterprises. However, as will be seen in the Chapter 4, rural industrial enterprises were generally highly-geared in the period under investigation. Indebted small enterprises face higher financial risk and are prone to failure when their business growth is volatile and cash flow stream is unreliable and unpredictable. Therefore, the ‘hard budget constraint’ approach cannot satisfactorily answer the following questions. First, why do the supposedly conservative enterprises with hard budget constraint take an aggressive attitude towards financial borrowing? Second, how can highly-geared enterprises have absorbed financial risk and sustained their growth despite, as shall be seen, dramatic fluctuations in the market? Moreover, Walder appears to overemphasise the role of local governments as single-minded market-oriented actors by ignoring much evidence observed by the World Bank study that local governments have multiple objectives. If local governments do not have interests in the non-financial performance of rural enterprises, why do they over-collect after-profits from the enterprises they administered? The ‘local state corporatism’ approach The ‘local state corporatism’ approach, while not denying the influence of the market in the development of rural enterprises, emphasises the distinct role of local governments in promoting rural industrialisation (Song and Du 1990, Byrd and Gelb 1990, Oi 1992, 1995, Walder 1995). Local state corporatism1 is an analytical concept suggested by Oi (1992, 1995) to generalise the role of local government in rural industrial development. In Oi’s definition, local state corporatism is a new kind of institution that co-ordinates economic enterprises in its territory as if it were a diversified business corporation, with officials acting as the equivalent of a board of directors. Rural industries are seen to be under a form of public ownership no different from the large urban state sector, except that government has clearer incentives and a greater ability to monitor firms and enforce their interests as owners. This form of ownership is the root of the special relationship found between local governments and rural enterprises. In the debate on local governments’ participation in rural industrialisation,

The paradox of financing rural enterprises

17

two explanations are particularly relevant to the discussion of financing patterns of rural industries. The mechanism of community risk-sharing The World Bank study emphasised the significance of a community mechanism for risk-bearing and absorption of losses that is based on the strong community objective of local governments (Byrd 1990, Song and Du 1990). As described by Byrd (1990), this mechanism shows that local government is able to (a) redistribute the profits of collective firms; (b) shift the debt obligations of a specific firm to other firms; (c) overwhelmingly influence the allocation of community capital, including loans from local bank and credit co-operatives; and (d) bear most of the risks of debt financing that would otherwise be taken by banks or enterprises. To make this work, the essential part of the mechanism is to redistribute after-tax profits of rural enterprises within the local community. As also argued by Naughton (1994a, 1994b), local economies are more diversified than any individual enterprise, so local governments are able to spread the risk incurred by start-ups, essentially by having the entire local community absorb the cost of failure. By underwriting a portion of the risk of entry, local governments enable start-up firms to enter production on a large scale, starting with some mechanisation and exploiting economies of scale. However, this mechanism may not function well everywhere. As Byrd and Gelb (1990) observed, the unsuccessful launch of rural industrial enterprises may also lead to financial predation, as observed in certain backward areas. Oi (1992) also questions the efficacy of such a mechanism in underdeveloped regions. She argues that the key variable seems to be the sources of income in a village, specifically the degree of local industrialisation after the adoption of the household responsibility system. The World Bank study described the financial aspects of the local government–enterprise relations but did not answer a number of questions. Does the existence of the community risk-bearing mechanism lead to the softening of budget constraint on rural industrial enterprises? Does that mechanism contribute to the employment of aggressive financial management? If the observed financing pattern of rural industrial enterprises is partly explained by the very existence of the community risk-bearing mechanism, then how can rural industrial enterprises have achieved phenomenal success under such soft budget constraint and hence a weak financial position? If the local economy at the township and village level can barely absorb risks because of the small size of their industrial base, as Walder (1995) suggested, or if this mechanism is an exception in a few areas rather than the common practice, then do rural industrial enterprises take full responsibility for financial risk? Finally, for what reasons do rural industrial enterprises take an aggressive rather than conservative stance in their financial management?

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Financing China’s rural enterprises

Overcoming rural financial market imperfections Local governments help to overcome rural financial market imperfections (Naughton 1994b). An immature capital market in rural areas in the 1980s could slow down entry by individual entrepreneurs in China, and local government sponsorship of collectives helped to overcome this particular capital market imperfection. One important aspect of local government involvement has been their information advantage in the enterprises they administer: they evaluate credit ratings among enterprises to guide the allocation of bank loans (Oi 1992), and they are better able to assess the risks of start-up businesses under their control (Naughton 1994b). The other aspect of their involvement is that local governments play some part in the rural financial market. They serve as the guarantor for township enterprises, mobilise through the use of personal and professional connections funds for any major investment undertaking, and support the operation of semi-private credit institutions (Oi 1992). With local governments facilitating the flow of capital to rural enterprises, firms are able to take advantage of relatively abundant household savings. In return, the profitable opportunities and reasonable risk levels in the rural small firm sector keep real returns high and contribute to high saving rates (Naughton 1994b). Nee (1992) emphasises the justification of local government involvement from a transaction costs perspective. He argues that an economy under reform has the characteristic feature of weak markets and incomplete institutional reforms, then, institutional arrangements, or ‘neolocalism’ as Nee (1992) calls them, have the advantage of reducing transaction costs, and local governments economise on transaction costs when the institutional arrangements underpinning markets are weak. First, in the absence of contractual law hardened by routine compliance and enforcement, rural industrial enterprises need political allies to go to bat for them in negotiating and enforcing contracts, especially with dominant state agencies and enterprises. For example, state enterprises can be very slow in paying smaller collective firms for subcontracted parts, and such debts pose severe problems for local industries in meeting current salaries and expenses. In addition, rural industrial enterprises as subcontractors may suffer from possible losses due to the abrupt abrogation of contracts without compensation. Second, obtaining business contracts with local government backing may reduce transaction costs for state enterprises and foreign firms as well, by providing official assurance that the terms set by the contract will be fulfilled in a timely manner. Given the reason for local government participation, Nee asserts that the government–enterprise relations are dynamic and will adapt to the changing environment. In summary, the corporate analogy that is widely used to define the local government–enterprise relations offers a powerful explanation for the distinctiveness of China’s reform economy. This local state corporatism approach suggests that financing of enterprise does not depend on the availability of

The paradox of financing rural enterprises

19

resources in individual companies but on community resources as a whole. As financial risk is spread and shared by all enterprises in the local community, the debt capacity of an individual company is likely to increase. But, just as Walder argues, how is it possible for the local government to engage in extensive balancing operations in the local economy with a small industrial base? Not to mention in those local economies in poor regions, where financial predation appears more likely? Local state corporatism emphasises the role of local governments in organising local financial market for the best use of local financial resources. However, this explanation appears to overlook the evolution of rural financial institutions under reform and their divergent interests. In the financing of rural industries, if local governments had had an information advantage over rural banking institutions, and could help choose the right investment projects, then rural banking institutions should have gained from this involvement of local governments and should have had a healthy balance sheet as a result. But why were they reported to suffer from poor financial performance in the 1980s? Evidence shows that they tended to end up as the risk-bearers (Byrd 1990). So what factors have contributed to this special government–banking institution relation? If the rural banking sector tended to be the risk-bearer, how was it incorporated into the local community risksharing mechanism? And how did this sector absorb financial risk? Finally, it is also widely observed that local governments have considerable power in principal–agent relations, and they tend to press rural banking institutions to finance their priority projects regardless of the interests of local banks. This fact has led Wong (1987) to argue that the existence of local governments with substantial allocative power has been detrimental to economic efficiency. She suggests that economic inefficiency may occur because: (a) the fragmentation of control under local governments impedes resource flows, and local opposition may partly slow the development of capital markets; (b) resource allocation is not subject to ‘market regulation’, when local governments are making the bulk of investment decisions; and (c) local governments reduce competition by shielding enterprises from market pressure and by intervening in interregional trade. While Oi seems to be optimistic about the active role of local government, Wong is right to note the undesirable macroeconomic effects that this role may have had on economic activities outside rural areas. Neither of them, however, gives any account of how these two contradictory effects could co-exist in the 1980s. In conclusion, the paradox in the performance of rural enterprises from the financial perspective is: if the market is the place in which the viability of rural industrial enterprises is determined, and both local governments and enterprises are subject to hard budget constraints, then why do rural industries employ an aggressive mode of financial management? Instead, if high rates of borrowing by enterprises can be explained by the existence of the community risk-bearing mechanism, that is, the spreading of financial risk within the community, then how is a local economy with a small industrial

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Financing China’s rural enterprises

base able to absorb financial risk incurred by highly-geared enterprises? Obviously, neither the ‘hard budget constraint’ approach nor the ‘local state corporatism’ approach has offered convincing answers to central questions about the mechanism of resource allocation in financing rural enterprises.

Determinants of financing small firms The financing of small businesses is unique when compared with financial management in large companies. This uniqueness to a great extent stems from the size of the business in terms of employment and assets. Small enterprises are often undercapitalised in the first place; they are more dynamic than other sectors of the economy, and growth usually produces financial stress, particularly in fast-growing ones. But they tend to have less choice than larger companies in their access to external capital: equity capital or long-term borrowing is scarcely available (Macmillan Committee, 1931) and loans tend to be obtained at penalty rates and terms (NEDC, 1986; Storey, 1994). Therefore, development finance in small businesses has been widely recognised as a tough management issue. In a generalised life-cycle analytical framework, Weston and Brigham (1993) sum up the financial problems of dynamic small businesses (Table 2.1). In the financial life-cycle of the small firm, growth before stage Growth 3 is critical because the firm may fail right from the start to advance to the next stage if potential financial stress factors are not properly dealt with. At the initial stage, small firms are set up with internal finance that typically takes the form of personal savings, loans from family and friends, and house mortgage if the firms are proprietor-owned. Growing small firms soon face the severe problem of liquidity constraint. First, small firms, particularly those in fast growth, are unlikely to generate sufficient retained profits to finance a significant increase in turnover and in the capital base required for expansion. Furthermore, small firms generally require finance in a series of discrete jumps of considerable size relative to existing turnover, rather than in regular small amounts, as demand for a firm’s products or services increases. In response to these changes in demand, small firms generally necessitate additional investment involving the purchase of new or additional capital equipment or a move into larger and possibly more modern premises. Given the indivisibility of capital, this investment will tend to be large relative to the existing capital base. Finally, the smaller the firm the more likely it is to be undercapitalised, using older second-hand capital equipment in old premises, and the greater the proportionate increase in its existing capital base that any new investment will represent. As a result of these factors, the accessibility of external capital becomes a necessary condition for small and medium-sized enterprises to survive financial stress and to expand. However, the choice among sources of financing is not an easy one at all. There are four broad factors that are of significance in the enterprise’s decision with regard to financing: financial

The paradox of financing rural enterprises

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Table 2.1 The financial life-cycle of the firm Stage

Source of finance

Potential stress factors

Inception

personal savings, loans from family and friends, house mortgage As above plus: retained profits, trade credit, bank loans and overdrafts, hire purchase, leasing As above plus: longer-term finance from financial institutions As above plus: new issue market All sources available Withdrawal of finance, firm take over, share repurchase, liquidation

Undercapitalisation

Growth 1

Growth 2 Growth 3 Maturity Decline

‘Overtrading’ Liquidity crises Financial gap Loss of control Maintaining R.O.I.* Falling R.O.I.

*R.O.I.  return on investment Note: This table is modified from Hutchinson and Ray (1986), p. 55.

gearing; bankruptcy costs; financial market imperfection; and soft budget constraints. Financial gearing Financial gearing refers to the use of debt in financing the firm. If all funds were supplied by owners in the form of equity capital, the firm would have no fixed periodic contractual cash payments for financing. From the pure financial point of view, the use of debt has three advantages. First, by raising funds through debt, the owners gain the benefits of maintaining control of the firm with a limited investment. Second, if the firm earns more on the borrowed funds than it pays in interest, the return to the owners is magnified. Firms with high gearing ratios have a chance of gaining higher profits but also run the risk of larger loss. Third, the use of debt also has the advantage of tax shield, as argued by Modigliani and Miller (1958, 1963). It has been a common practice worldwide that interest payments are tax deductible. This tax shield for debt financing enhances the after-tax value of the firm, thereby leading the firm to a maximal use of debt financing. Moreover, the pecking-order theory (Myers, 1984; Myers and Majluf, 1984) argues that there are three factors that affect the enterprise’s decision on seeking additional finance: (a) least resistance; (b) lower issue costs; and (c) least adverse signals. Since the use of internal funds relieves the financial manager of contacting outside investors and carries no issue costs, it naturally becomes the first choice. Debt comes next in the pecking order because debt financing has less resistance and lower costs than equity financing. In addition, the use of debt will not send an adverse signal to investors as is usually transmitted by the announcement of a share issue, thus driving down the share price. Therefore, the pecking-order theory concludes that when

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Financing China’s rural enterprises

choice between debt and equity has to be made, debt will always find favour over equity as long as the financial risk in relation to debt financing remains manageable. The use of debt incurs financial risk. In financial management terms, business risk is the variability of expected pre-tax returns on the firm’s total assets, while financial risk is the additional risk induced by the use of financial gearing and is reflected in the variability of the net income stream. The financial risk that is associated with the use of debt stems from the fact that the interest on debt is a fixed financial charge that must be paid regardless of the level of the firm’s earnings. The greater the use of debt, the greater the financial gearing and the greater the extent to which financial fixed costs are added to operating fixed costs. This feature of debt means that financial gearing magnifies variations in the return on equity. At a given level of financial gearing, when the profitability of the enterprise performs much better than expected, the interest payments will account for a much smaller proportion of the firm’s earnings before taxes and a larger portion of net income will accrue to the owner of the enterprise. By contrast, when profits of the enterprise plummet unexpectedly, then the obligation to pay the fixed financial charges will worsen the enterprise’s cash flow problem and eventually affects the return on equity. Furthermore, the increased risk of rising gearing causes interest rates to rise. So, if the dispersion in return is measured by the coefficient of variation, then with increased gearing, the coefficient of variation in every return indicator is magnified. Hence, gearing is a two-edged sword; if the returns on assets are less than the cost of debt, gearing reduces the returns on equity. The more gearing an enterprise employs, the greater is this reduction. As a result, gearing may be used to increase return on equity, but is used at the risk of increasing losses under adversity. Thus, gains and losses are magnified by gearing; and the higher the gearing employed by a firm, the greater will be the volatility of its returns. Given the very nature of debt, one vital factor in determining the use of debt is the performance of sales growth. Weston and Brigham (1993) suggest that the extent to which the small firm can exploit the advantages of debt financing is related to the firm’s rate of sales growth and its profitability. A high rate of sales growth in the firm means a relative decrease of the fixed charge in relation to the size of sales. Thus, a higher debt ratio generally leads to a higher expected rate of return. High profitability in turn allows the firm to generate more internal capital and improves the firm’s position in the bargaining process of lending. However, if the sales growth experiences high uncertainty and fluctuations, the logical inference is to use debt financing with more caution, and a conservative method of financial management is preferable. Using the life-cycle framework, Ward (1996) argues that as the firm moves through the successive stages of its life cycle, business risk is normally reduced in accord with the product life-cycle. Obviously if some of the total risks are

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Table 2.2 Main source of financing in relation to risks Stages

Business risk

Financial risk

Financing pattern

1. 2. 3. 4.

High High Medium Low

Low Low Medium High

Equity (venture capital) Equity (internal financing) Debt and equity (retained profits) Debt

Launch Growth Maturity Decline

Source: Ward (1996), ‘Developing financial strategies – a comprehensive model’.

not removed, the business will not progress to the next stage. Correspondingly, the financing patterns should change from dependency on equity finance to debt finance. The Ward model does not specifically refer to small business, but its implications for the small business sector are obvious. As shown in Table 2.2, at the launch stage business risk is particularly high because the product may not work properly or, even if it does work, the market research indications may prove to be wrong, with the eventual demand being too small to justify financially the total required investment. So the most prudent strategy of financial management is to use less risky equity capital and to keep financial risk low and manageable. When investment from the source of personal savings or venture capital is insufficient, the business may end up undercapitalised at its launch, as indicated in Table 2.1. At the growth stage, the main business risk remains high and it now relates to the ultimate market share achieved by the enterprise and the length of this period of sustained growth. The main target of financial management remains that of keeping financial risk low by using as much equity capital as possible. If internal financing proves insufficient, the enterprise may be forced to employ such financial instruments as trade credit, bank loans and overdrafts, and leasing. The feature of short-term maturity in these instruments could cause liquidity crisis. And when a certain amount of longer-term finance cannot be obtained from financial institutions before the enterprise has grown large enough to go public, the problem of a financial gap emerges. Only after the maturity stage can debt financing become an important tool for the enterprise. The central point in Ward’s analysis is that if a high business risk company uses large debt financing, its combined risk profile will be excessively high and its probability of total collapse will increase dramatically. This is a financing pattern that the enterprise should avoid. Bankruptcy costs Bankruptcy costs are a major factor that acts to counter the firm’s excessive use of debt, as asserted by Robichek and Myers (1965) and Baxter (1967). Financial stress occurs when promises to creditors are broken or honoured with difficulty. At moderate debt levels the probability of financial distress

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Financing China’s rural enterprises

would be low, and the tax advantage outweighs the cost of financial distress. But at a certain level of debt, financial distress increases rapidly with additional borrowing, and the tax advantage of debt is likely to shrink and eventually disappear. Sometimes financial distress leads to bankruptcy. Bankruptcy costs take several forms. The most obvious and direct costs are legal, accounting and other administrative costs that are associated with financial readjustment and legal proceedings. Nevertheless, some costs of bankruptcy arise before the actual legal procedures of bankruptcy take place. These indirect costs tend to have a more fundamental impact on the firm’s financial management. As the firm’s ability to honour its fixed contractual obligations deteriorates, or its financial strength weakens as a result of an abnormal debt ratio, it is in a poor position to negotiate external finance at a desirable structure of maturity and reasonable price. Moreover, financial institutions are likely to become increasingly reluctant to provide additional financing. Additionally, if creditors foresee that they will pay the costs if default occurs, they will demand a higher promised interest rate as compensation in advance before such default occurs. Tamari (1980) argues that although the failure of a large firm involves investors and creditors in a greater monetary loss, the higher bankruptcy rate of small firms forces external investors to be more hesitant towards this type of firm and so limits the small firms’ opportunities for obtaining external finance. Both direct and indirect bankruptcy costs imply that debt financing is not costless and risk-free, and any mistake in this respect may cost the firm’s smooth growth and, even worse, place it at high risk of business failure. Financial market imperfection Apart from bankruptcy costs, financial market imperfection is another significant factor that affects the small firm’s decision to borrow. Financial market failure2 is mainly associated with information asymmetry in the market, which shapes the principal–agent relationship. Jensen and Meckling (1976) point out the conflicting interests among parties to the firm that can be seen to enter into principal–agent relationships. An agency relationship is an explicit or implicit contract that involves the delegation of some decision-making authority to the agent. In the case of business finance, the entrepreneur acts as an agent for the investors and lenders, or the principal, and the principal aims to ensure that its agent acts in accordance with the contractual obligations, that is, repaying the loan plus the interest. Obviously, there is a possibility that the agent will not always conduct business in a way that is consistent with the best interests of the principal. Hence, the latter may insist on various types of protective covenant and monitoring devices in order to protect those interests. As a result, the principal–agent relation is costly, and the subsequent gearing-related agency costs encompass all contracting costs in the form of transaction costs, moral hazard costs and information costs (Smith, 1989).

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Agency costs occur as a result of information asymmetry in the financial market. The owner of a firm is recognised to have more and better information about the performance of his firm than outside investors. Williamson (1975) argues that firms are always better informed than ‘outsiders’ because they have access to ‘inside’ information. Moreover, entrepreneurs seeking finance normally have more information about their projects and greater control over them than their fund providers (Singh, 1994). This is particularly true in the case of smaller firms. For larger firms, and particularly for publicly quoted companies, information is collected by independent analysts and widely disseminated to a large group of potential and actual investors in the business. Such information is not so readily available for smaller firms, where external investment is likely to be minimal. For this reason the small-business owner is likely to be significantly better informed about the business than an outsider such as a bank. The owner of a new firm may not have better knowledge of the prospects of his business than the loan officer of a bank, as Jovanovic (1981) argues, because loan officers are likely to have derived their own experience from dealing with similar customers at a similar stage of business development. However, as the business grows, it seems likely that the asymmetry of information will increasingly favour the small firm rather than the bank, because the business owner acquires his information through experience of running the business on a daily basis. The bank’s monitoring procedure is unlikely to improve at the same rate because it deals with the firm only periodically as one of many customers. Besides ex ante information asymmetries that relate to distinguishing the possibility of default by entrepreneurs, there also exist ex post asymmetries leading to incentive problems requiring monitoring. Once the bank provides a loan, its control over the actions of the firm is limited. The agency problems mean the bank has to obtain information to monitor the actions of the agent in order to ensure they are acting in a way compatible with the contract. It also means monitoring and assessment costs can be considerable if an accurate decision is to be made on the viability of the project. The initial assessment costs are either invariant with the size of loan application, or are a decreasing proportion of the loan size. Costly monitoring and assessment may deter the involvement of financial institutions in the financing of smaller firms. Financial market imperfection has a number of implications. First of all, since financial institutions operate in an environment where full information on the borrowers and on the projects is not available, their decisions on lending may lead to adverse project selection. To seek protection, investors may demand higher rates of interest or higher expected returns as compensation for agency costs. However, the response of financial institutions may also produce unexpected results. Stiglitz and Weiss (1981) argue that an increase in interest rates may lead to moral hazards, that is, the firm is encouraged to alter its behaviour in favour of riskier, but higher-return projects at the expense of investors’ interests. If the project is successful the

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Financing China’s rural enterprises

firm obtains all the gains from this success, subject only to having to pay pre-fixed rates of interest. If the project fails and the firm closes, then the investor, rather than the firm, is the loser. Therefore, the lender’s best strategy is to ration credit rather than to increase interest rates. The implication is that some borrowers are excluded from access to credit, even though they may be prepared to pay the existing or even higher price for that credit. In addition, collateral and owner-equity are used as tools for overcoming the moral hazard problem. Under these circumstances, collateral, in the form of personal assets, limits a firm’s ability to raise additional debt capital and squeezes the personal equity base (Hutchinson, 1995). Soft budget constraint The concept of soft budget constraint was devised by Kornai (1980). It has been widely used in discussions of government–enterprise relations in socialist economies. The soft budget constraint refers to the phenomenon that firms in socialist economies are persistently bailed out by state agencies when revenues do not cover costs. There are two types of explanations of the soft budget constraint. First, in Kornai’s analysis, the cause of the soft budget constraint lies in the additional interests the state has in the non-financial performance of state-owned enterprises besides their profitability (Kornai, 1992). Those non-financial interests include the supply of scarce inputs for other enterprises, maintenance of full employment, funding of pensions, medical insurance, and provision of housing and social services. Non-financial preferences conflict with the government’s interest in the strong financial performance of firms, and financial interests are further weakened by the government’s flexibility in redistributing funds from profitable enterprises to subsidise those that are unprofitable. These non-financial interests constrain the ability of governments to enforce financial discipline over enterprises. Therefore, Kornai reasoned that no matter how strong the financial interests may be, the non-financial interests are so large that they weaken the desired incentives. Moreover, the government will rescue a failing firm because the government is unwilling to accept the social consequences (such as unemployment) of its closure. Second, the soft budget constraint arises as a result of the government’s accountability problem (Lin and Tan 1999). In a socialist economy, the prices of all kinds of inputs and of outputs are distorted and these inputs and outputs are allocated by administrative measures. Due to problems of information and co-ordination, the state can make wrong decisions regarding investment and production, and fail to deliver necessary materials and inputs in time. Consequently, the state is accountable for the failure and needs to allocate additional credits and other assistance to the enterprises in order to complete the investment, which gives rise to the soft budget constraint.

The paradox of financing rural enterprises

27

Kornai (1986) identifies four different ways and means that can soften the budget constraint of the firm: soft subsidies; soft taxation; soft credit; and soft administrative prices. Subsidies, taxation and credit are soft because their regulation and rules are negotiable, subject to bargaining, lobbying, etc. More particularly, taxation is soft when, for example, the tax rates are not uniform but almost tailor-made according to the financial situation of different sectors, different regions or different forms of ownership; the fulfilment of tax obligations is not strictly enforced; and there are leaks, ad hoc exemptions, postponement, etc. The credit system can be soft if the fulfilment of a credit contract is not enforced, unreliable debt servicing is tolerated, and postponement and rescheduling are in order. The softening of budget constraint relaxes the strict relationship between expenditure and earning. If the decision-maker expects such external financial assistance as highly probable, and this probability is firmly built into his behaviour, the prospect of bail-out reduces the incentives for the enterprises to avoid financial trouble. As far as the financing of enterprises is concerned, the softening of budget constraint makes the notion of financial risk largely irrelevant and encourages enterprises to use debt to the maximum. In summary, the discussion so far comes to the clear conclusion that debt financing has its advantages and disadvantages. An enterprise’s capacity to explore the merits of debt financing depends on its growth performance and profitability, its ability to absorb financial risk and the budget constraint it faces. If they are subject to hard budget constraint, the enterprises, particularly small ones, can be expected to employ a prudent or conservative strategy in financial management.

A reform dynamics perspective Why do China’s rural enterprises subject to supposed hardened budget constraints employ an aggressive mode of financial management? How is a local economy with a small industrial base able to absorb disproportionate financial risk? Both questions have not been convincingly answered by the studies of China’s rural industries, but they are key issues in understanding the pattern of financing of rural industries in China in the 1980s. To analyse the paradox of the success of rural enterprises mentioned earlier, the ‘reform dynamics’ perspective has been developed as the conceptual approach to be used in this study. This approach pays special attention to the environment in which rural enterprises in China operated in the 1980s and which can best be described as the environment of dynamic economic reform. Existing studies of rural industries have sometimes swung between being over-confident about the system that prevailed in the 1980s and being over-critical of that same system. Without doubt, the rural economic system in the 1980s helped rural industries achieve their unprecedented economic success, but this fact does

28

Financing China’s rural enterprises

not necessarily mean that it was a mature system. On the contrary, the system has to be closely examined in the context of reform dynamics, and the essential point of this is that the system is still undergoing change. Thus, in this sense, to claim that market socialism is a desirable end state seems to be premature. Similarly, too much criticism of the negative aspects of the system shares the same problem as the other arguments just mentioned, that is, it ignores the relative rationality of the behaviours of both local governments and enterprises in an environment of reform dynamics. The dynamics of economic reform in China after 1978 may be defined as a succession of responses to imbalance and disequilibrium on the part of both the enterprises and governments. First of all, this imbalance and disequilibrium occurred as a result the gradual introduction or further spread of market mechanisms intended to improve the functioning of the economy, as Knell and Rider (1992) claim. As a result, the emerging economic system was characterised by the interaction of the still-dominant central economic planning regime with market forces in a manner that subordinated market institutions. Nee (1992) describes the characteristics of the reform economy in the 1980s as weak market structure, poorly specified property rights and institutional uncertainty. Furthermore, in this ‘reform dynamic’ government administrations at each level maintained control over large parts of the economic system and devised selective policies to further the development of some areas of it above others. The economic institutions reflected economic de-centralisation and liberalisation, but they were strongly influenced by political and administrative devolution of power that induced self-interest behaviour by new independent agents in the economy, and the emergence of ever tighter regulation of economic activity in other areas. The dynamics of this economic reform thus generated many conflicting behavioural outcomes among the participants in economic activity. Therefore, recognition of the reform dynamics is essential to understanding the contradictory behaviours of small enterprises and the management of local economies. The central argument of this study is that in a dynamic-reform economic system, the interdependence between rural industrial enterprises, rural financial institutions and local governments was strengthened so that each party maximised its own interests. This became possible because the budget constraint of both rural industrial enterprises and rural financial institutions remained soft and the non-financial interests of local governments were strong and had to be pursued by the re-distribution of industrial profits within the local community. As a result, the pattern of financing of rural industries was largely determined by exogenous factors rather than by their own debt capacity. The financial risk this entailed was spread and shared within the local community, but the local community alone was not strong enough economically to absorb the whole financial risk. Instead part of the financial risk was channelled into the macro-economy. The specific hypotheses examined in this study are:

The paradox of financing rural enterprises

29

(a) There was a weak correlation between the pattern of financing of rural industrial enterprises and their debt capacity; and the mode of financial management of rural industries was exogenously determined. (b) The rural financial system in gradual reform provided soft credit on the one hand, and on the other encouraged rural financial institutions and local government together to engage in local competitive credit creation. Both factors contributed to the over-dependence on debt observed in rural industrial enterprises. (c) There was a dual dependence between local governments and enterprises in that while enterprises paid a lump sum of profits for general distribution in the community, in return they were awarded soft taxes and risk-bearing arrangements. In this way their budget constraint was softened. This was made possible because the fiscal system was still under gradual reform. (d) The dynamic reform of the rural financial sector created a situation in which local governments had an overwhelming influence on rural banking institutions and drew that sector into the community risksharing mechanism.

Conclusions This chapter has reviewed three areas of the literature, namely the ‘hard budget constraint’ approach, the ‘local state corporatism’ approach, and small-business finance. These approaches were used to derive the key hypotheses tested in this study. The hard budget constraint approach emphasises the change in budget constraints on the rural industrial sector and the implications of this change for the phenomenal growth of rural industries. It argues that because rural industries, as compared with state-owned enterprises, were subject to hard budget constraints they were responsible for profitability and losses. From a business financing point of view, this argument implies that rural industries would have employed a relatively conservative strategy of financial management, that is to say, using debt financing at a manageable degree. This inference, however, did not match the actual pattern of financing of rural industries over the period 1978–93. Alternatively, the local state corporatism approach draws special attention to the relationship between rural industries and local governments. It emphasises the developmental role of local governments, in particular in organising the local community risk-sharing mechanism. But this approach tends to exaggerate the local capacity to absorb financial risk incurred by the overdependence on debt in local enterprises. Finally, the reform dynamics perspective was proposed as a conceptual approach to analysing the pattern of financing of rural industries after 1978. This approach emphasises the need to take into account the implications of reform dynamics for the behaviour of each party involved in

30

Financing China’s rural enterprises

the rural industrial development and to examine the financial management of each party in the local economy in a reform dynamics perspective. To do this, the analytical tools of small business finance have been used in this study.

3

Industrial growth and the pattern of financing

The surge of rural industries has been the most remarkable achievement of the Chinese economy in the transitional period. From the recovery in the mid 1970s, rural industries expanded at an unprecedented scale in the early 1980s and have since then established themselves as the driving force of national economic growth. The extraordinary success of China’s rural industries has attracted great interest within China and abroad. A number of early studies investigated the growth of this sector. Among others, Griffin et al. (1984) examined the period 1978–83 and the World Bank (Byrd and Lin 1990) the period 1978–86. Ody (1992) supplemented the World Bank’s earlier work by extending the analysis to the period 1986–90, while Islam (1991) set his studies of rural enterprises in 1978–89 against the period prior to 1978. These studies are penetrating and excellent for our better understanding of dynamic performance and problems in the rural industrial sector. However, issues such as industrial growth, fluctuations and cyclical patterns, capital formation, and the interrelationships between these factors in the rural industrial sector received relatively less attention in these studies. This chapter focuses on growth and its fluctuations, and links it with the pattern of financing in rural industrial enterprises. It shows that as a sector of small businesses, rural industrial enterprises are vulnerable and unstable. This vulnerability accords with observations of the small business sector in other countries. But the specific feature of the rural industrial sector in China, as this chapter reveals, is that rural industrial enterprises, though facing unstable and uncertain growth prospects, employed an uncharacteristically aggressive strategy of financing, namely over-dependence on debt. Such a strategy is obviously counter to orthodox economic predictions. This anomalous feature of the rural industrial sector requires and receives investigation in this chapter. The chapter is organised as follows. The first two sections outline the basic characteristics of the rural industrial sector in China over the post-1978 period and the phenomenal growth of rural industrial enterprises stage by stag. This provides a useful historical background for research on this sector. The next section investigates the cyclical patterns of rural industrial growth

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Financing China’s rural enterprises

and the contributing causes. The final section links together fluctuations of output growth and capital formation to examine how rural industrial enterprises were financed in the period of 1978–94.

Basic characteristics The Chinese economy used to be dominated by state-owned enterprises, and this economic structure was not changed until the resurgence of rural industrial enterprises in the 1980s. Compared with state-owned enterprises, rural industries are a new, distinctive and powerful economic force. Generally speaking, they are small businesses, existing outside the regime of the planned economy regime. Predominantly, they are collectively-owned enterprises; collective rural industries accounted for a disproportionate amount of total output and contributed the majority of tax revenues and profits. These collective enterprises are promoted by and under the control of local governments, particularly at and below the township level. Finally, the development of rural industrial enterprises are under the constraints of local financial resources. These characteristics have defined a unique path of development for these rural industries and thus constitute the starting point for this study. Rural industrial enterprises are small enterprises In general, China’s rural industrial enterprises are small enterprises. As shown in Table 3.1, in the late 1970s when rural industrial enterprises began their momentous development, the average size in terms of employment in the rural industrial sector was around 22 to 26 workers. This then declined to between 8 and 10 workers, largely due to the upsurge of micro private enterprises after 1984. Hence, when judged by ownership, township and village industrial enterprises employed more workers and operated on a relatively larger scale than non-collective enterprises, including joint enterprises and private enterprises. This preponderance of collective enterprises with regard to the size of firms was strengthened after the mid 1980s as the number of workers employed in collective enterprises increased steadily. This is not to deny the fact that there were some very large companies with influence far beyond the local area. Becoming large has become a new focal point of policy in local governments since the late 1980s. Being small, rural industrial enterprises used to be proud of their flexibility and adaptability, like ‘a small boat, easier to turn round’. Without doubt, this was their unique strength and remains so. Nevertheless, small means vulnerable to change in economic climate and competitive environment. As market competition intensifies, the vulnerability of small businesses is exposed. This gave rise to a gradual change in attitude in favour of larger and stronger enterprises in local government policies in the late 1980s. In Chaoan County, for example, from the county’s rural enterprise bureau to the township industrial commission, the priority in the local government’s

Industrial growth and the pattern of financing

33

Table 3.1 Firm size in terms of employment in rural industrial enterprises, 1978–94 Years

Rural industry

Township

Village

Joint

Private

1978 1980 1985 1988 1990 1992 1994

22 26 8 8 8 8 10

n.a. n.a. 56 62 64 69 70

n.a. n.a. 24 25 26 28 30

n.a. n.a. 7 9 9 10 10

n.a. n.a. 2 3 3 3 4

Sources: Figures for rural industry from China Statistics Yearbook 1995, pp. 363–4. For joint and private enterprises, figures for 1985 from China Statistics Yearbook 1992, p. 437, and figures for 1994 from China Statistics Yearbook 1995, p. 407. Other figures from Almanac of Rural Enterprises in China, various issues.

development programme was to nurture prospective enterprises into big companies. Specifically for this purpose, the county set up a special fund in 1994 to support 100 enterprises on the conditions that the eligible firm either produced an output of at least 10 million yuan or made an annual tax payment of 500,000 yuan. The influence of big companies is obvious: in 1994, these 100 enterprises made up only 0.31 per cent of enterprises in number, but produced 27 per cent of output. At national level, it was reported that by the end of 1993 there were about 400 enterprises with an annual turnover over 100 millions yuan and 19,196 enterprises whose turnover was over 10 million yuan.1 From the early 1990s, a small number of rural industrial enterprises have even been listed on the stock market and have become public companies. In Sunde City, Guangdong Province, for example, the Meidi Group specialising in the manufacture of electric fans and air conditioners, and Wanjiale specialising in the production of domestic electronics, were listed on the Shenzhen stock market in 1993, each attracting equity capital of 190 million and 80 million yuan respectively.2 Despite this new development, the overwhelming majority of rural industrial enterprises remain small in terms of employment. Collective enterprises predominate It has been widely held that rural enterprises are neither state-owned nor private enterprises, but are collectives. This expression needs to be clarified. Rural industries originated from the former commune and brigade-run enterprises in the early 1970s. Before the development of private enterprises in rural areas was permitted in 1984, collective enterprises were almost the only registered form of organisation. Even so, they in fact included a certain number of private enterprises with ‘red caps’, for example, private enterprises registering themselves as collectives in order to by-pass restrictions and to take advantage of the new status. According to one estimate by the Ministry

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Financing China’s rural enterprises

of Agriculture, ‘red-capped’ private enterprises numbered 500,000 in 1983,3 accounting for more than one-third of the total number of rural enterprises. The real figure is everybody’s guess, however. After the restrictions on the development of non-collective enterprises were lifted in 1984, non-collective industrial enterprises, particularly private enterprises, mushroomed year after year, and within a short time they outnumbered collective industrial enterprises (Table 3.2). In 1994, four-fifths of rural industrial enterprises were private companies, while township and village enterprise combined accounted for little more than one-tenth. However, the story is different if output is taken into account. In 1994 again, the share of private companies in terms of output was down to no more than one-quarter, while the share of collective companies was up to two-thirds. Therefore, it would be wrong and misleading to equate rural industrial enterprises to township and village-owned enterprises and perceive them as collective without an explicit definition. The predominance of collective enterprises in the rural industrial sector should be understood in the sense that they have played a more significant role in the rural economy. Specifically, they consistently produced over three-quarters of the total rural industrial output and contributed a lump sum of revenue in terms of taxes and profits to governments at all levels. Rural industries are locally-promoted but under local financial constraints Underpinning rural industrial development after 1978 was the pro-active attitude and innovative initiatives of local governments in association with vigorous rural entrepreneurs. While industrial growth in most places was equally impressive, the regional differences were considerable. This partly reflects the path-dependence in development, but, more importantly, it reflects dependence on local resources. The significant development of China’s rural industry in the post-1978 period began in Jiangsu province and a few other relatively developed areas in the coastal region. In the 1980s regions with a long history of rural industrial development and a higher level of regional income soon took advantage of the change in the economic environment, while other regions with relatively humble economic conditions struggled to follow. This correlation of rural industrial growth with the level of local development has led to persistent regional disparities. Previous studies found that the growth of rural industry in the 1980s was fastest in China’s more developed provinces, especially those along the coast, and both the growth rates and national shares of rural industrial enterprises diminished from the central region to the western region (Wang 1990, Ody 1992). This regional disparity continued to exist in the 1990s. In Table 3.3, three parameters are selected to reflect the regional pattern of rural industries in the 1990–4 period. Column A shows rural industrial

Industrial growth and the pattern of financing

35

Table 3.2 Composition of rural industries by ownership (%) Years

All enterprises

(i) Numbers of enterprises 1985 100.00 1988 100.00 1990 100.00 1992 100.00 1994 100.00 (ii) Output of enterprises 1985 100.00 1988 100.00 1990 100.00 1992 100.00 1994 100.00

Township

Village

Joint

Private

4.71 3.23 3.17 2.94 2.49

13.73 10.05 9.43 9.11 9.01

16.09 9.34 7.84 6.50 7.10

65.47 77.45 79.56 81.44 81.40

41.63 40.63 39.35 40.57 33.70

36.27 34.88 34.18 34.67 35.84

8.31 8.43 7.42 6.03 6.75

13.79 16.06 19.05 18.73 23.71

Sources: Figures for 1985 and 1987 from China Statistical Yearbook 1992, p. 403; figure for 1994 from China Statistical Yearbook 1995, p. 375; and others from Almanac of China’s Rural Enterprises, various issues.

output per capita in 1990, representing the overall level of rural industrial development in the base year. Column B is the regional growth rate of rural industry between 1990 and 1994. By linking both columns, it can be seen to what extent regional growth of rural industries is determined by the regional level of development. Column C is the regional share of rural industrial output in 1994, which indicates the spatial concentration of rural industry in terms of output. As a whole, rural industries achieved fast growth in most regions in the 1990–4 period. But as predicted, the growth rates of rural industrial output across the country differed dramatically; the general pattern was that growth rates diminished from the coastal region to the remote hinterland. In terms of aggregate output, Jiangsu, Zhejiang, Shandong, and Guangdong were in the super league, these four provinces alone making up 56 per cent of the rural industrial output of the whole country in 1994 (see column C in Table 3.3). For the other provinces in the inland areas, it seems that faster growth was achieved in provinces that had relatively better economic conditions (for instance Sichuan, Shaanxi and Gansu in the west) and locational advantage (for instance Hunan, Anhui and Jiangxi in the central region). It was these provinces that benefited most from favourable state policies towards rural enterprises in inland China. Given their small industrial base, it is reasonable to expect the rural industries in inland areas to achieve higher growth rates if they reproduced the national growth performance. But by looking at columns A and B in Table 3.3 in the 1990–4 period, the general tendency towards catching-up appeared insignificant in most of the inland provinces. Therefore, the development of rural industries was clearly under local financial constraints. This will be analysed more fully later in this book.

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Financing China’s rural enterprises

Table 3.3 Regional patterns of rural industry, 1990–4 Region (i) Coastal region Average Liaoning Beijing Tianjin Hebei Shandong Jiangsu Shanghai Zhejiang Fujian Guangdong Hainan (iii) Central region Average Heilongjiang Jilin Inner Mongolia Henan Hubei Hunan Shanxi Anhui Jiangxi

A

B

C

1,040 739 1,527 2,275 615 896 1,687 1,812 1,602 492 689 60

53.74 52.77 44.59 38.21 48.44 60.77 52.26 44.20 61.14 47.31 52.62 67.67

4.82 2.23 2.26 5.64 15.62 18.80 3.23 13.84 2.15 7.27 0.10

278 220 272 98 345 356 226 474 276 239

51.48 40.58 39.88 54.10 40.93 51.77 54.19 48.71 60.75 74.00

0.94 0.79 0.37 3.61 3.15 2.40 2.06 3.21 2.56

Region

A

(ii) Western region Average 129 Sichuan 221 Guizhou 67 Yunnan 104 Tibet n.a. Shaanxi 260 Qinghai 58 Gansu 131 Ningxia 124 Xinjiang 65 Guangxi 88

B

C

46.68 52.38 30.50 38.09 n.a. 40.41 28.81 41.78 26.26 41.27 65.72

3.95 0.19 0.43 n.a. 1.03 0.02 0.37 0.05 0.12 0.87

Notes: A  output per capita in 1990; B  average growth over 1990–4; C  share of industrial output in 1994. Sources: Contemporary Rural Enterprises in China (1991), p. 148; China Statistical Yearbook 1992, p. 82; China Statistical Yearbook 1995, p. 93.

Local social and cultural traditions have also played a part in diversifying the pattern of rural industrial development. In the 1980s, two models stood out. The ‘Southern Jiangsu model’ exemplifies the long tradition of a collective economy in the region and thus the dominance of public ownership in rural industrial enterprises, with the support by the entrepreneurial local government; the ‘Wenzhou model’ illustrates the spontaneous development of private enterprises in an entrepreneurship-friendly environment.4 Of course, across the country various mixtures of these models appeared to apply.

Rural industrial growth: 1978–94 The growth of rural industry during the 1978–94 period took place in several phases. The first was 1978–83, the period in which restrictions on the development of industrial enterprises in rural areas began to lift, but policies

Industrial growth and the pattern of financing

37

Table 3.4 Growth of rural enterprises in comparison with other sectors in China, 1978–94 (growth rates of gross industrial output, %) Rural industry Years

GNP

National industry

Total

Collective industry

Noncollective industry

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

11.7 7.6 7.8 4.4 8.8 10.4 15.3 13.3 8.5 11.1 11.3 4.1 3.9 9.5 14.0 13.3 11.6

13.6 8.8 9.3 4.3 7.8 11.2 16.3 21.4 11.7 17.7 20.8 8.5 7.8 14.8 27.5 28.0 26.1

n.a. 8.8 20.0 9.9 12.1 16.9 64.4 41.7 28.2 33.3 34.0 10.5 14.5 19.0 47.2 60.9 27.1

n.a. 8.8 20.0 9.9 12.1 16.9 64.4 9.2 31.9 20.7 32.7 9.1 11.2 19.1 61.2 55.1 30.0

n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 16.0 81.3 37.3 14.1 22.3 19.0 17.0 77.9 20.0

Sources: China Statistical Yearbook 1992, p.31 and China Statistical Yearbook 1995, p. 32 for GNP index; China Statistical Yearbook 1995, p. 377 for index of gross output value of industry. For rural enterprises and rural industry, calculation is based on Almanac of Rural Enterprises in China 1989, p. 74 for the period 1978–88 and on the same series of publications onwards for the period 1989–94. Growth rates are converted with national industrial output deflator that is derived from China Statistical Yearbook 1992, p. 406 and China Statistical Yearbook 1995, p. 377.

remained fickle and uncertain. This was also the period in which a nationwide economic adjustment was launched and the direction of economic reform was heatedly debated. The truly explosive growth of rural industry began in 1984 and continued until the latter part of 1988, with annual rates exceeding 20 per cent. Efforts to stabilise the overheated economy between 1988–90, combined with the 1989 political crisis, changed the overall business environment rural industrial enterprises had so much enjoyed and caused a slow-down in growth. Recovery from the retrenchment policies was seen in the first quarter of 1990, and from 1991 changes of macro-economic policies soon brought rural industries back onto the fast growth track. The adjustment period: 1978–83 Between 1978 and 1983 the rural economy in China exhibited contrasts in development. In the agricultural sector, fundamental reforms in the household responsibility system were implemented in 1978, followed by substantial

38

Financing China’s rural enterprises

reforms in other agricultural policies such as taxation and purchase of agricultural products. Agricultural production responded extremely well and recorded its best successive harvest in history, thanks also to the good weather at the time. By contrast, in the non-agricultural sector rural industrial growth slipped from 25 per cent over the 1970–8 period to 8.8 per cent in 1979 and 14.1 per cent on average in 1980–3. To a great extent, the inconsistent policy environment was responsible for this slow-down. In 1979 for example, the State Council re-emphasised the significance of commune and brigade-run enterprises and reconfirmed the central government’s policies towards them in the ‘Stipulation Regarding Development of Commune and Brigade-run Enterprises’. A number of favourable measures on taxation and finance were immediately announced. Ironically, however, in that same year rural enterprises were blamed for their part in compounding the imbalance of the national economy when a nationwide economic readjustment was launched. Two major regulations were soon issued by the State Council as guidelines for adjustment in the rural industrial sector. These were the ‘Several Regulations Regarding Closure, Suspension, Merger, and Change of Products’ and ‘Regulations Concerning Changes of Taxation of Commune and Brigade-owned Enterprises’. Stringent control over rural industrial investment was put in place, causing an excessive fall in the growth of new fixed capital investment in this sector, down to 8.9 per cent in 1980 and further to 2.7 per cent in 1981.5 The essential reason for the change in policy derived from the uneasy accommodation of this market-led sector in the planned economic system. Compared with state-owned enterprises, rural industrial enterprises operated outside the state economic plan and were denied privileged access to government-controlled industrial inputs. Instead, they obtained these inputs from the emerging but controversial product markets. Moreover, when the controls on industry entry were relaxed, rural enterprises moved into the production of those consumer goods that traditionally were in the domain of urban industries. It was this development that triggered heated debate over their relation with urban industries and their position in the national economy. Inevitably, during the readjustment period in the late 1970s and early 1980s, rural industries were confined to concentrating on processing agriculturerelated materials, in order to avoid direct competition with state-owned enterprises. Certain industrial enterprises were closed, suspended, merged or converted to other lines of production. The number of firms fell from 794,000 in 1978 to 725,000 in 1981.6 Despite this harsh policy environment, rural industrial output still grew at reasonable rates from 1979 to 1983, by their own standards of course. The positive outcomes from this first major setback were that the adjustment had disciplined failing enterprises and taught those that remained a lesson in business management. The notably entrepreneurial response was to introduce the successful element of the household responsibility system into the management of rural enterprises. Eventually, a healthy

Industrial growth and the pattern of financing

39

foundation was set for a further round of development that was shortly to occur. The fast growth period: 1984–8 The year 1984 was the turning point in the course of rural industrial development, with the annual growth rate of rural industries soaring to as high as 64.4 per cent.7 By then, rural reforms in the household responsibility system began to show signs of success. Successive good harvests in grain production were achieved, considerable increase in rural household income was recorded, local markets flourished, and increasing numbers of farmers were released from the traditional agricultural sector. Typically, consumption spending by farmers made up two-thirds of all net additional sales of consumer goods in the country between 1978–84.8 Investment was now more readily available, thanks to a significant increase in savings in rural areas. By 1983, for instance, the savings of rural households reached 9.18 billion yuan, a more than ten-fold increase over 1978, representing an average growth of 58.4 per cent each year.9 In addition, local governments’ enthusiasm for rural enterprises was further fuelled by fiscal reforms. Policies towards rural industries began to take a drastic turn. The first signal came at the beginning of 1984 when the National Workshop on Commune and Brigade-Run Enterprises was held by the Ministry of Agriculture. The workshop produced a ‘Report on Promoting New Development of the Commune and Brigade-Run Enterprises’, which was later issued as the document of the Central Party Committee in association with the State Council. In that document, ‘commune and brigade-run enterprises’ were renamed ‘town and township enterprises’ (xiangzhen qiye) to reflect the institutional changes, especially the dissolution of the people’s commune system, in rural areas. Development of non-collective enterprises also received official endorsement in this document. The proliferation of noncollective industries thus led to a new pattern of ownership of rural industrial enterprises, the so-called ‘four wheel drive’ (si lun qu dong), referring to the four forms of ownership in rural enterprises, namely township enterprises, village enterprises, joint enterprises, and private enterprises. In 1985, for the first time the development of rural enterprises was incorporated into the national economic strategy in the seventh Five-Year Plan. In that same year, the ‘Spark Programme’ was initiated by the State Commission for Science and Technology, designated to help technological innovations in rural enterprises. Further, business co-operation and partnerships between regions in 1986 was encouraged under the policy of horizontal linkage. In addition, export orientation and enterprise groups were particularly supported in the rural industrial sector. Under these circumstances, the expansion of rural industry over 1984–8 looked unstoppable, with annual real rates of growth exceeding 28 per cent, despite a brief set-back during the credit squeeze in 1985.

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Financing China’s rural enterprises

The period of slowdown: 1989–90 In 1988, the national economy became overheated once again. Inflation appeared to be out of control, with the overall retail price index up to 18.5 per cent, almost triple the figure in 1987;10 over-issued currency by the central bank amounted to 68 billion yuan, an increase of 187.8 per cent over the previous year.11 This led to a painful readjustment of the national economy. Rural enterprises as a whole were singled out as a target in the economic austerity programme, being blamed particularly for their high growth and competition with urban industry. Difficulties for rural enterprises were compounded by political incidents in 1989 and the subsequent trade embargo imposed by Western governments. The slower growth of rural industrial enterprises triggered comprehensive readjustment. Enterprises were closed or production suspended because of unacceptably high energy consumption, poor product quality, or high pollution. For example, in 1989, 94 paper manufacturing enterprises in Zhejiang and 79 in Hunan provinces were closed because of pollution.12 The development of new products was widely encouraged and a system of quality control was nurtured at the enterprise level. Promising enterprises were helped to transfer into export-oriented production or to seek foreign investment and co-operation, which proved an extremely successful policy. In 1987, only 25,000 rural industrial enterprises exported more than half of their output; this number increased to 45,000 in 1989 and 57,800 in 1990. By 1990, export revenues of rural industrial enterprises made up one-third of the national total.13 Further reforms of the management system of rural industry were pushed forward, including the development of rural shareholding co-operatives. This new form of management was intended to clarify ownership and related responsibilities at the firm level, but it also showed promise in terms of fund-raising. The period of resurgence: 1991–4 From 1990, the rectification programme began to be relaxed and eventually ceased at the end of 1991. A rural industry friendly policy environment re-emerged. At the eighth plenary session of the Thirteenth Communist Party Central Committee Meeting in 1989, there were calls for active support measures for rural enterprises in strategic planning and better supervision. The credit squeeze on rural industry was gradually eased. Monthly working capital loans to rural enterprises by the Agricultural Bank of China saw an increase of 24.8 per cent in 1990, and the net decrease in capital loans from the Agricultural Bank of China in the first eight months was reversed in September, giving an average net increase of 7.9 per cent for the whole year.14 The restructuring programme, including adjustment of product mix, improved product quality, reforms of management systems, and further promotion of export orientation in rural industrial enterprises in 1988–9

Industrial growth and the pattern of financing

41

also helped increase their competitive edge and place it on a consolidated foundation. So when credit policies towards rural enterprises were significantly eased after 1990, rural industrial enterprises were soon back on the fast-growth track and firmly established themselves again as the driving force behind the new round of national economic growth. The new phase of development of rural industrial enterprises after 1990 was boosted by a number of new policies. The establishment of shareholding co-operatives were regulated by a guiding framework, the ‘Provisions on Farmers’ Shareholding Co-operatives’ in 1990, and a ‘Circular on Improving Shareholding Co-operatives’ in 1992, both issued by the Ministry of Agriculture. In the meantime, the re-organisation of enterprises in line with the newly-enacted Company Law was also encouraged. Following the success of exports by rural enterprises in the late 1980s, a national working conference on exports by rural enterprises was organised by the State Commission for Economic Planning in co-operation with the Ministry of Agriculture and the Ministry of Foreign Trade in Beijing in May, 1991. The conference resulted in a number of favourable policies: highly export-oriented enterprises were to be granted discretion over direct exports, key export production bases were to be financially supported under specific funds called ‘trade, industry and agriculture’ (mao, gong, nong), and 100 million yuan concessionary funds were allocated from the central government budget to assist in the technical upgrading of rural export producers.15 Small enterprises were encouraged to grow larger in order to exploit economies of scale. The Ministry of Agriculture encouraged prospective enterprises to develop into national key enterprises in 1990, and two years later formulated a policy framework to help key enterprises organise enterprise groups.16 Following the national conference on rural enterprises in the central and western regions in November 1992, the development of rural enterprises in inland provinces was given special attention. In the ‘Decisions on Speeding up Development of Rural Enterprises in the Central and Western Region’ issued in 1993, the State Council decided that 5 billion yuan credit funds would be allocated to support rural enterprises in the national credit plan each year between 1993 and 2000, and rural enterprises in the region would be entitled to collect 1 per cent of their revenues as technical upgrading and new product development funds.17

Growth and fluctuations It has been observed that the fast growth of rural industries in the period concerned was associated with boom and bust. Previous studies are correct in attributing this pattern of growth to the swings of policies on the rural industrial sector. But in general, the issues of cyclical patterns, the decomposition of cyclical factors, and the implications of growth fluctuation for financial management and financial risk have tended to be overlooked in studies of rural industries. However, for the financing of rural industries, these

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Financing China’s rural enterprises

Table 3.5 Cyclical patterns of national industry and rural industry National

Rural

Years

Growth rates

Cyclical features

Cycle numbers

Growth rates

Cyclical features

Cycle numbers

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

13.6 8.8 9.3 4.3 7.8 11.2 16.3 21.4 11.7 17.7 20.8 8.5 7.8 14.8 27.5 28.0 26.1

– Dn Up Dn Up Up Up Up Dn Up Up Dn Dn Up Up Up Dn

(1)

n.a. 8.8 20.0 9.9 12.1 16.9 31.0 36.2 31.9 20.7 32.7 9.1 11.2 19.1 61.2 55.1 30.3

– Dn Up Dn Up Up Up Dn Dn Dn Up Dn Up Up Up Up Dn

(1)

(2) (3)

(4)

(5)

(2) (3)

(4) (5)

Source: Derived from Table 3.1.

are the vital elements in understanding the dynamics of the rural industrial sector. In the analysis of the cyclical patterns of the rural industrial sector in the 1978–94 period, Imai’s (1994) approach to identifying a business cycle will be used for its simplicity and effectiveness. Here, a business cycle is defined as one that begins in the year following a trough, continues through an upswing, and ends in the next trough. Table 3.5 describes the cyclical patterns of national industry and rural industry, and divides each cycle into the years of upswing (Up) and downturn (Dn). Thus, five business cycles of 2–6 year lengths can be identified in the 1978–94 period. The first cycle began before 1978, and the fifth cycle was still in progress in 1994. Over the 1978–94 period, the timing of rural industrial cycles generally matched that of national industrial cycles, though the third cycle of rural industry ended one year later and the fifth cycle began one year earlier. There are two points that can be made about this cyclical pattern. First, in general the rural industrial sector is not immune to drastic changes in the national economy. When the national economy is booming, rural industries enjoy a favourable economic environment and expand at a rapid pace; but when the national economy retrenches, rural industries contract and the growth of output slows down. Second, the slight mis-match in the timing of rural industrial cycles and national industrial cycles in the late 1980s implies that rural industries had become such a strong sector by then that the national

Industrial growth and the pattern of financing

43

Table 3.6 Industrial growth and fluctuation, 1978–94 SD (%)

Growth rates (%) Periods

NI

RCI

NI

RCI

1978–89 1990–4

12.5 23.3

20.5 40.7

5.76 9.48

10.48 22.75

Notes: NI  national industry; RCI  rural collective industry. Source: Calculated from data in Table 3.4.

economy could no longer afford a lasting recession of this sector, as it had in the past. Thus the relaxation of policies tended to start with this sector. Moreover, compared with state-owned enterprises, this sector had also built up greater strength to pull itself out of the recession. Cycle numbers alone, however, do not say very much about the cyclical features of the sector. More strikingly, if the percentage difference between the years of the highest and lowest growth rates in a cycle is used as a measure, the amplitude of the rural industrial cycle is always greater than that of the national industrial cycle. This greater relative volatility and higher degree of cyclical instability of rural industries becomes clear when calculated in terms of standard deviation (Table 3.6). Standard deviation measures the variability of a set of observations. In the analysis of the rural industrial sector, the larger standard deviation indicates a greater variation of output growth. In the 1978–89 period, the standard deviation for rural industrial growth is 10.48 per cent, almost twice as large as the standard deviation of the national industrial growth as a whole, and throughout the 1990–4 period the standard deviation for rural industry increases to 22.75 per cent, this time more than double the figure for the national industry. A higher rate of fluctuation is always undesirable because it results in frustration, unpredictability, and difficulties in the use of production capacity and financial management, thus eventually incurring loss of efficiency. The cyclical patterns of rural industry can be further decomposed into macro-economic factors and micro-economic factors. Macro-economic factors are associated with changes in economic environment that are beyond the enterprise’s control; micro-economic factors relate to the enterprise’s own decision-making and is the direct consequence of business operations. To distinguish micro-economic factors, national industrial growth rates are applied to rural industry, and a series of estimated real output values are obtained for rural industry. Estimated real output is the output that would have occurred in rural industry if it had grown at the same rate as national industry during the period under review. Suppose, for example, that rural industrial output would have increased by 10 per cent if it had grown at the national growth rate that year. The difference between the estimated output for rural industry and the actual rural industrial output is therefore a measure

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Financing China’s rural enterprises

Table 3.7 Growth and risk of rural industry, 1985–94 RCI Periods

NI

RCI

Macro-effect

Micro-effect

1978–89 1990–4

5.76 9.48

10.48 22.75

5.76 9.48

8.45 18.84

Source: Calculated from Table 3.4.

of the extent to which micro-economic factors affected rural industry. Then by keeping the macro-economic risk constant, the standard deviation of the residual rates in both collective industrial enterprises is calculated to measure the magnitude of their micro-economic factors, which can be seen in Table 3.7. It is apparent that when macro-economic risk is kept constant, the standard deviation of residual rates in rural collective industry is always larger than that of the estimated macro-economic factors in both the 1978–89 and 1990–4 periods. This indicates that rural industry as a whole faces higher risk than national industry. That rural industry growth displays large amplitude in micro-economic fluctuations in the 1978–94 period confirms the previous finding by Zhou and Hu (1989) that rural industry magnifies the national economic fluctuations between 1975 and 1985. The timing of rural industrial cycles also implies that fluctuations in rural industrial growth may be triggered by macro-economic instability and further compounded by its own weaknesses, to which the weak financial position could be a contributing factor. Calculations from available data indicate that fluctuations in output also triggered profit fluctuations. In 1984–92, profit growth in rural industrial enterprises averaged 11.1 per cent, but this growth was in fact highly unstable, with the increase in profits soaring during economic booms but plunging in recessions. Throughout the 1984–92 period, the largest profit growth of 53 per cent occurred in 1992 and the worst growth record of 14.6 per cent in 1988. The standard deviation of profit growth in the rural industrial sector was 20.15 per cent, much larger than that of the output growth. The larger standard deviation of rural industrial profit growth indicates greater fluctuations in returns, thus a greater chance that the expected return will not be realised. Therefore, rural industry would be considered a riskier sector, according to this measure of risk. In short, the highly unstable growth of rural industries made profitability unpredictable, thus increasing difficulties in financial management and incurring greater risk in capital investment. Under these circumstances, a relatively conservative strategy of financial management should be adopted. As has been seen in Chapter 2, a high-risk business should avoid the use of too much debt, since a high-risk business that is associated with high debt finance would increase the possibility of business failure (Ward, 1996).

Industrial growth and the pattern of financing

45

Table 3.8 Comparative financial gearing (%) Years

Financial gearing

Sources

1984–5 1984–6 1985 1987–9 1989 1990 1991 1992 1993 1994

58.2 56.8 64.8 61.0 61.2 61.8 59.8 63.9 65.4 64.0

Zhou and Hu (1989), p.118 Wang (1990) Guo (1988) Zhang (1993) Almanac of China’s Rural Enterprises 1991, p. 213 Almanac of China’s Rural Enterprises 1991, p. 213 Almanac of China’s Rural Enterprises 1992, p. 214 Almanac of China’s Rural Enterprises 1993, p. 380 Almanac of China’s Rural Enterprises 1994, p. 380 Almanac of China’s Rural Enterprises 1995, p. 3

Table 3.9 Balance sheet of rural industries in selected years

Current assets Fixed assets Total assets Current liabilities Long-term liabilities Total liabilities Equity Total equity and liabilities Total liabilities/total assets (%) Current assets/current liabilities Current liabilities/total assets (%)

1984

1985

1992

1993

61.0 31.4 100.0 42.0 16.0

58.9 32.1 100.0 43.8 14.6

56.7 41.1 100.0 55.5 10.9

55.3 41.5 100.0 51.7 14.0

42.0 100.0 57.5 1.46 41.7

41.6 100.0 58.8 1.34 44.1

33.6 100.0 63.9 1.08 53.6

34.3 100.0 65.4 1.11 51.4

Sources: Zhou and Hu (1989), p. 118 for the data of 1984 and 1985; Almanac of China’s Rural Enterprises 1994, p. 380 for the data of 1992 and 1993.

Over-dependence upon debt financing Surprisingly, the financial management of rural industrial enterprises did not take the orthodox path, namely employing a relatively conservative strategy of financing. On the contrary, they were highly geared and seemed aggressive in financial management. Table 3.8 collates information about financial gearing in rural industries from the various sources available. It consistently shows that whether in the 1980s or in the early 1990s, financial gearing in rural industries as a whole was always high. A more complete picture of the financing of rural industries can be seen in Table 3.9. It should be noted that information for the 1980s and the 1990s is not strictly comparable, because the former information from the nation-wide investigation by Zhou and Hu (1989) referred to only 319 sample collective enterprises, while data for the period of 1990–4 come from the state’s statistical channel, covering the whole rural collective industrial sector.

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Financing China’s rural enterprises

Table 3.10 Working capital structure of rural industrial enterprises Sub-items Years

1989 1990 1991 1992

Sub-items

Year-end working capital (billion yuan)

Self-financed working capital (billion yuan)

Working capital loans

Working capital loans

(billion yuan)

Self-financed working capital (%)

159.8 195.9 257.5 352.2

33.1 40.3 58.4 70.6

59.6 75.6 97.8 167.3

20.7 20.6 22.7 20.0

37.3 38.6 38.0 47.5

(%)

Sources: Almanac of Rural Enterprises of China, various issues.

Bearing in mind this difference, some inferences can still be drawn from the table. In Table 3.9 as well as the calculations of financial gearing measured by total liabilities divided by total assets, two more indicators have been calculated to show the financial strength of rural industries. The first is the current ratio, which is calculated by dividing current assets by current liabilities. The current ratio provides the best single indicator of the extent to which the claims of short-term creditors are covered by assets that are expected to be convertible to cash quickly, and it is the most commonly used measure of short-term solvency. The second indicator is the short-term debt ratio, which is calculated by dividing current liabilities by total assets. The short-term debt ratio measures the percentage of short-term funds provided by creditors. Table 3.9 shows, first, that rural industrial enterprises had a high short-term debt ratio. In two separate periods the short-term debt ratio was between 41.7 and 53.6 per cent; this means their creditors supplied about half the rural enterprises’ total financing. Because these funds have a short-term maturity, the high value of the short-term debt ratio means there is an extremely strong need for the stable generation of cash flow stream and a lesser cushioning against creditors’ losses in the event of liquidation. In either case, both the enterprise and creditor face high potential financial risk. Second, rural industrial enterprises tended to have a weak liquidity position. The current ratio for the year 1984–5 is between 1.46 and 1.34, and around 1.10 for the year 1992–3. These figures are rather low compared to the benchmark of 2.0 times suggested by the Department of Finance in China. This result reinforces the prediction of high potential financial risk in the rural industrial sector. From the perspective of sources of funds, the high financial gearing was achieved through deeper dependence on short-term loans from banks and on borrowing from issuance of enterprise bonds, most of which were informal. First, the lack of working capital accumulated by enterprises themselves has resulted in constant shortages of funds for short-term investment and

Industrial growth and the pattern of financing

47

Table 3.11 Working capital loans of rural enterprises Sub-items Years

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1989 1990 1991 1992

Sub-items

Year-end working capital (billion yuan)

Self-financed working capital (billion yuan)

Working capital loans

Working capital loans

(billion yuan)

Self-financed working capital (%)

9.5 13.3 17.7 20.1 23.1 26.3 39.9 59.0 77.0 114.0 189.0 224.5 292.5 409.5

n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 40.7 47.8 67.4 85.3

1.43 2.29 3.65 4.57 5.30 6.35 12.87 18.06 26.54 37.58 83.2 98.6 125.7 184.1

n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 21.5 21.3 23.0 20.8

15.1 17.2 20.6 22.7 22.9 24.1 32.3 30.6 34.5 33.0 44.0 43.9 43.0 45.0

(%)

Notes: Bank loans for 1978–88 are estimated on the assumption that for each year 65% of bank loans were issued as working capital loans. Sources: Figures for 1978–87 from Rural Enterprises in Contemporary China, p. 571; figures for 1989–92 from Almanac of China’s Rural Enterprises, various issues.

built up pressures on the rural banking sector to make up the shortfall. As shown in Table 3.10, from 1989 to 1992 rural industrial enterprises financed only 20–22 per cent of the working capital required, leaving the rural banking sector to provide a large proportion of that shortage. In 1989 the Agricultural Bank of China and rural credit cooperatives both provided 80 per cent more of the finance for working capital than rural industrial enterprises did, and this figure rose to 137.5 per cent by 1992. The way rural industrial enterprises managed their working capital finance from 1989–92 can be traced back to the period 1978–89. Although the exact amount rural enterprises had invested in working capital cannot be estimated due to lack of information, it is clear that their dependence on working capital loans has deepened. In the case of total loans by the Agricultural Bank of China and rural credit co-operatives from 1978 to 1994, if working capital loans are assumed to make up 65 per cent of total loans as they did from 1978 to 1987,18 then the increasing dependence on bank loans to finance additional working capital demand can be demonstrated (Table 3.11). In 1978, the estimated share of working capital provided by the rural banking sector was only 15 per cent, but by the end of the 1980s this share had risen to 44 per cent, an almost three-fold increase. This in part explains why credit funds from the rural banking sector were always in high demand among rural industrial enterprises.

48

Financing China’s rural enterprises

To encourage rural industrial enterprises to self-finance working capital to a greater extent, since 1981 the rural financial sector has set a compulsory criterion for extending credit funds: at least 30 per cent of its total working capital should be provided by the enterprise itself. The rural financial institutions would issue working capital only if they were satisfied with the proportion of working capital that the enterprise had financed. However, in the event, rural industries did not accumulate their own working capital to the level that they were required to do so. With regard to fixed capital investment in rural industries, the enterprise accounting system identified eight sources of capital, as set out in Table 3.12. Of these, local government support funds and fiscal funds could be equity capital or concessionary loans, depending on government policy in different regions. The status of ‘fund-raising’ is equally difficult to define, and whether this source of capital is called debt or equity depends on whether bonds or shares are issued by the enterprises. External capital and foreign investment generally represent long-term commitment to the enterprises from outside investors. Under these definitions, Table 3.12 shows that over the 1986–94 period, enterprises tended to seek external capital and foreign investment as alternative equity and long-term capital to finance rapid-growth fixed assets, while at the same time maintaining a slight increase in the share of internal capital. In 1994, the share of internal capital exceeded that of bank loans for the first time, and together with external capital and foreign investment, the percentage of equity-like capital accounted for nearly half the total fixed capital investment. These three sources of capital made up only 36.5 per cent in 1986. Bank loans remained a vital source of capital, but its relative importance reduced sharply over time. A decrease in support funds and fiscal funds can be observed. Capital from both sources in the 1990s became almost negligible; the share from both sources made up only 3.8 per cent in 1994. By contrast, fund-raising gradually became an important tool to generate longterm capital. Borrowing from outside the rural banking sector is an alternative possibility, and the issuance of informal enterprise bonds has been popular. The public issuing of bonds was not officially approved until 1984, when the burgeoning of industrial growth had built up the shortage of capital in enterprises to such a degree that the search for alternative funds became inevitable. The emergence of enterprise bonds represented a breakthrough in China’s financial reform, but given the immature capital market as a whole, the use of enterprise bonds remained experimental and cautious. This can be seen from the fact that the total amount of bonds issued was strictly administered and the authorisation of enterprises to do so was highly selective. As a priority of central government, the introduction of enterprise bonds intended to resolve the financing dilemma of state-owned enterprises. This intention was reflected in the types of enterprise bonds that were predominant

Industrial growth and the pattern of financing

49

Table 3.12 Sources of fixed capital investment in rural collective enterprises 1986–94 (%) Years

Support Fiscal Bank External fundsa fundsb loans capitalc

Foreign investment

Retained Fund Others profits raisingd

1986 1987 1988 1989 1990 1991 1992 1993 1994

3.6 3.6 3.3 3.8 3.5 2.8 1.8 1.1 0.9

n.a. n.a. n.a. 3.1 10.8 4.3 5.9 8.3 9.0

28.4 26.5 27.1 23.4 27.4 29.6 27.6 28.7 31.6

Notes:

8.6 7.0 6.0 7.9 7.4 5.6 4.2 3.9 2.9

43.7 48.4 44.6 37.4 38.6 40.5 38.9 30.8 28.2

8.1 6.8 10.6 9.0 12.1 5.7 7.9 8.2 8.4

n.a. n.a. n.a. 4.8 3.2 3.4 5.5 8.1 9.5

7.6 7.7 8.3 10.5 8.7 8.2 8.3 10.9 9.6

a

Investment from local government’s support funds. The local government’s equity investment. c Investment from other enterprises. This source of funds was not separated from foreign investment until 1989. d Mostly issued in informal forms, e.g. borrowing from employees. Before 1989 this source of funds was counted as internal funds. Source: Almanac of China’s Rural Enterprises, various issues. b

in the 1980s: key state enterprise bonds, local enterprise bonds, and shortterm financial bonds. By the end of 1986, the total value of bonds issued by enterprises had reached 10 billion yuan.19 Rural industrial enterprises were very much at a disadvantage in the use of enterprise bonds. Because they were not actually entitled to issue bonds publicly they chose to raise funds internally. In the 1980s, China’s regulation of the securities market was restrictive because the government tightly controlled the number of enterprises that could issue bonds in any particular year; it also controlled the total value of funds that could be raised by issuing bonds. In the ‘Provisions Regarding the Management of Enterprise Bonds’ issued by the People’s Bank of China in 1987, only state-owned enterprises were authorised to issue enterprise bonds, and the State Council’s ‘Circular of Strengthening Management of Shares and Bonds’ in the same year made it even clearer that collective enterprises and individuals could not issue bonds.20 In reality, these regulations were not strictly enforced. With the support of local governments, a small number of rural industrial enterprises have been approved to issue bonds. But the procedure has proved to be tedious. First, the enterprise is required to draw up and circulate its charter, which is to include such information as the current operation of the enterprises, the net owned assets, purposes of bond issuance, economic performance projections, total par values of bonds, methods of interest and principal payment, and risk obligation. Second, if the enterprise intends to use the funds raised from bond issuance for fixed capital investment, the proposed investment project should first be approved. Finally, as an application procedure, the enterprise is

50

Financing China’s rural enterprises

required to submit a package of documents, including an application form, a certificate of business registration, a certificate of approval of bond issuance by the enterprise’s administrative institution, a certificate of approval of the fixed investment project by the government’s planning department, the audited financial reports for the past two years and the last quarter, and so on. The Company Law of 1993 sets a net-assets threshold for enterprises of bond issuance, for example at least 30 million yuan of net assets for a shareholding company and 60 million yuan for a liabilities-limited company. Given the restrictive management of formal bonds, it is little wonder that the use of bonds by rural enterprises developed slowly. In the 1981–9 period the total value of bonds issued in China was 167.8 billion yuan, but local enterprise bonds accounted for only 10.4 per cent; the total value of bonds issued in 1990–3 rose to 453.3 billion yuan, but the share of local enterprise bonds decreased slightly to 9.9 per cent.21 In the meantime, the People’s Bank of China estimated that unqualified fund-raising that was not approved by the Bank amounted to 15 billion yuan over the period 1987–9.22 Efforts have been made to control the use of informal enterprise bonds. In 1989 the State Taxation Administration issued a regulation regarding fundraising within enterprises. Interest rates on fund-raising within the enterprise were not allowed to be 40 per cent higher than that of a savings account with similar maturity in the bank. When the funds are used as working capital, only that part of the interest payments which is equal to the interest paid on a savings account in the bank can be counted as production costs, and the remaining interest should be paid out of after-tax profits. Since 1990, the application procedure for bond issuance has been overseen jointly by the People’s Bank of China and the State Planning Committee. Under this new procedure, the State Planning Committee is responsible for recommending desirable projects, setting the scale of investment and arranging related financing, while the People’s Bank of China oversees the issuance of bonds. Without access to equity and long-term capital, fund-raising both from within the enterprise and from outside remains a common financial management practice in enterprises across the country. Originally, fund-raising from within was mainly through the enterprise’s issuance of short-term or mediumterm debt. This kind of fund management practice varied from place to place: workers were asked to contribute a certain amount of capital to the firm at the time of their employment; salary payable would be delayed for a certain period of time, usually one month; and an enterprise bond could be issued to employees within the firm. Such fund-raising usually has short maturity and higher interest rates than the bank’s savings rate; this may on occasion subject the enterprise to additional pressure for the payment of interest and possibly the principal as well. Informal enterprise bonds may be used for fixed capital investment. In 1994, the share of informal bonds for fixed capital investment in rural enterprises was about 9.5 per cent, a large increase from less than 3 per cent in 1988 (Table 3.12). Fund-raising has been an important method of debt

Industrial growth and the pattern of financing

51

financing, but given the already over-dependence on working capital loans from rural financial institutions, the informal issuance of bonds could not resolve the more fundamental problem of financial stress resulting from disproportionate liability commitments in rural industrial enterprises. Moreover, the rapid development of informal issuance of bonds has inevitably circumvented the restrictions on rural credit and challenged the functions and operations of rural financial institutions, therefore raising many urgent questions about state credit control and macroeconomic management. In addition to issuing informal enterprise bonds, rural industrial enterprises have borrowed from outside the formal banking sector in various other ways. For example, the use of down payment of collateral for contracting (fengxian diya jin) is a variant of borrowing from employees. After the success of the household responsibility system in the late 1970s and early 1980s, a similar system was introduced as a method of making the enterprise an independent producer and taking responsibility for profit or loss. The first round of widespread introduction of the contract system began in the mid 1980s, and by the end of 1990 about 95 per cent of rural collective enterprises were run under this system.23 It has been observed, however, that under the contract system an agent is not subject to an even balance of rights and responsibilities. When the enterprise is making a profit, the contracting manager or employees can easily make a fortune after fulfilling the payment of the pre-stated profits, but when the reverse situation occurs, the agent does not fully take responsibility for the loss and risk. This has led to recognition of the wide-spread practice of down payment of collateral in the ‘Regulation concerning Contracting Responsibility System in Rural Enterprises’ issued by the Ministry of Agriculture in 1990. When a contract is made, the agent is asked to submit a down payment of collateral, the amount of which is decided by either the net assets or the equity capital of the enterprise. Under an employee contract scheme, the down payment of collateral each employee pays varies. In Peixian County, Jiangsu Province, for example, the down payment of collateral can vary from 300 yuan to 3,000 yuan. The difference in payments depends on the position of the employee, whether a manager, managerial staff, or a worker.24 Another example is the Bojian Township Construction Engineering Company, Tongbai County, Henan Province, where the down payment of collateral for a manager, deputy managers, heads of departments, and workers was 8,000, 6,000, 4,000 and 2,000 yuan respectively. This company had 920 employees in 1994, and the estimated down payment of collateral from workers alone reached 1.8 million yuan.25 The enterprise may use the whole or a portion of the down payment of collateral for circulating capital. Again, in Peixian County 30 per cent of the funds was kept by the economic department of the township, and the rest was given to the enterprise as working capital. Interest is paid to each employee at the end of the year at the same yearly rate of interest that the bank gives on the savings account; the cost of borrowing is included in the cost of production. When the contract expires,

52

Financing China’s rural enterprises

the funds are given back. The down payment of collateral is just one form of borrowing rural industrial enterprises have used outside the formal rural banking sector.

Conclusions This chapter has examined rural industrial growth in the 1978–94 period, focusing particularly on two contradictory aspects of the exceptional growth in China’s rural industrial sector after 1978, namely the high instability of growth on the one hand and on the other the over-dependence on debt in the pattern of financing. It has been found that the extraordinary growth of rural industries over the period has been associated with two unusual economic characteristics. First, fluctuations in industrial growth were considerable. While there was some correspondence between the timings of national industrial cycles and rural industrial cycles, the amplitude of rural industrial cycles was always larger. In addition, when fluctuations are decomposed into macro-economic and microeconomic factors, it seems that the micro-economic factors have played as big a part as the macro-economic factors in explaining fluctuations in the growth of rural industries. Unstable output growth, as predicted, also resulted in fluctuations in growth of profits, which had an even larger cyclical amplitude than that of the change in output growth. When measured by standard deviation, the high volatility of profitability implied a high financial risk in the rural industrial sector. In contrast to the predictions of orthodox financial theory, a relatively conservative strategy for the management of financing was not prevalent in rural industrial enterprises. Debt financing became the popular way to finance industrial growth, leading to high financial gearing throughout the 1980s and the early 1990s. Furthermore, aggressiveness in financial management became even more obvious in two respects, namely, a much lower current ratio than the expected standard and an extremely high short-term debt ratio, both of which indicate rather weak liquidity in rural industrial enterprises. It is found that this method of financial management was accomplished through the excessive use of working capital loans provided by the rural banking sector and of informal enterprise bonds and borrowing from employees and external investors. Funds from the informal rural financial sector had shorter maturity and bore higher interest, which in turn generated additional demand for borrowing and compounded the problem of liquidity. Instability and over-dependence on debt financing prevailed throughout the post-1978 period. This gives rise to two important questions. Why did rural industrial enterprises in a weak financial position employ a relatively aggressive strategy of financing? And how could the highly-geared enterprise sector, experiencing dramatic fluctuations, have absorbed financial risk and sustained output growth? These questions will be addressed in the following chapters.

4

Financial management of rural industries

This chapter explores issues surrounding the pattern of financing of rural enterprises from the perspective of enterprise financial management. It seeks first to find out what reasons have encouraged or forced rural enterprises to borrow so heavily that debt obligation appears to be beyond their debt capacity, and second to examine in what ways rural enterprises are able to take in high financial risk and move on. The first two sections of this chapter will investigate the implications of internal factors for the debt capacity of rural industrial enterprises,1 including factors such as sales stability, profitability and internal equity investment. The third section goes on to examine the effects of external factors on the financial management of enterprises. Three major external factors are brought into this equation: taxation policy and its impact on business borrowing; changes in real interest rates and the cost of borrowing; and softness of credit. The final section of the chapter examines the ability of rural industrial enterprises to resist the large financial threat posed by excessive dependence on debt financing.

Growth rates, profitability and debt capacity Growth rates and profitability both have a positive association with the debt capacity of an enterprise. An enterprise whose output growth is fast and relatively stable can safely take on more debt. Because interest payments as a fixed charge diminish relative to the size of output, a higher debt ratio can lead to a higher expected rate of return and thus increase the enterprise’s projected value. Similarly, a profitable enterprise tends to be financially healthy and thus can afford to take advantage of debt. This certainly does not mean that it needs to do so. On the contrary, an enterprise with very high rates of return on investment may use relatively little debt because its high rates of return enable it to do most of its financing with retained earnings. Under these circumstances, how much debt a profitable enterprise uses will be decided by the management attitudes of the company. For China’s rural industrial enterprises, it appears that neither output growth nor profit performance provide convincing grounds for understanding

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Financing China’s rural enterprises

the excessive use of debt. Indeed, rural industrial enterprises were highly profitable at the beginning of the reform period after 1978. The average rate of profit in rural industrial enterprises in the single year of 1978 was as high as 32 per cent (Naughton 1994a). In Griffin’s estimate (1984), the profit rates for the early period of rural reforms (1978–81), although slightly different, were just as impressive. As shown in Table 4.1, the profitability of rural industries between 1978 and 1981 was extraordinary. The profit/output ratio ranged between 16.4 and 21 per cent, and the rates of profit on assets were between 29.3 and 38.3 per cent. On such impressively high returns on investment, a new enterprise could recover its limited capital outlay in about four years. This profit-making performance indicates that in the early years, rural enterprises yielded a high return on capital and thus provided a large and quick pay-off to an investment, thereby encouraging further savings and capital accumulation in rural areas. The reasons for the exceptional profitability are complex and remain a subject of debate. Naughton (1994b) claimed that two particular factors have contributed to the good profit performance of rural industrial enterprises. First, most rural industrial enterprises were in manufacturing, where state price controls kept profitability high. Second, these industries entered niche markets that state-owned enterprises had failed to produce. Table 4.1 also shows that the impressive profit performance in rural industrial collective enterprises in the early period of development was not sustained, and over time there was a decrease in profitability in terms of profit on output and profit on assets.2 For example, profit on output reduced considerably from 20.5 per cent in 1978 to 11 per cent in 1984, and fell by another half to 4.8 per cent by 1992. Profitability measured by profit on assets performed no better in the same period. Compared to 38.3 per cent in 1978, profit on assets reduced by almost four-fifths to 8.7 per cent in 1992. The sharp reduction in profit margin in the rural industrial sector during this period was attributable to increasingly fierce domestic competition. As competition acted to equalise profits and eroded the huge profit margins, the debt capacity of rural industrial enterprises shrank, meaning that heavy borrowing would not make sense any more. In contrast to the deterioration in profit performance, output growth in rural industries picked up in the early 1980s and accelerated after the mid 1980s. But fast output growth over the period 1984–92 could not increase the debt capacity of rural enterprises, because the turbulent output growth and associated volatility of profitability observed in this period, incurred high risks in debt financing. A typical example here is the failure of a packaging maker that had operated for ten years in rural Jiangsu in 1997. This collectively-owned enterprise went bankrupt because it had a debt to equity ratio of 90 per cent and was unable to repay loans. Yin Zhu, the vice-general manager of the town’s economic development board, explained: ‘This type

Financial management of rural industries 55 Table 4.1 Profitability of rural industrial enterprises Years

Rate of profit on output (%)

Rate of profit on assets (%)

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

20.5 21.0 18.6 16.4 n.a. n.a. 11.0 9.7 8.3 6.6 6.4 5.2 4.6 4.5 4.8

38.3 36.8 34.4 29.3 n.a. n.a. n.a. n.a. n.a. n.a. 8.3 9.1 7.2 7.3 8.7

Notes: Rate of profit on assets is defined as after-tax profits divided by year-end working capital plus fixed capital at original value. Sources: Data for 1978–81 from Griffin (1984), p. 213. Others are calculated from Rural Enterprises in Contemporary China, p. 574 and Almanac of China’s Rural Enterprises, 1989–93, various volumes.

of company must operate in a fast-growing economy. When conditions are not so nice, they go bankrupt.’3 This example illustrates well the fact that financial gearing is a two-edged sword, as discussed in Chapter 2. Therefore, the over-dependence on debt observed in rural enterprises is not adequately explained by the factors such as fast output growth and profitability. In fact, the debt capacity of enterprises as a whole was gradually weakened by the combination of the fast shrinking return on investment and vulnerable growth.

Shortage of equity capital Since equity capital incurs no fixed periodic contractual cash payments to finance it, it provides a significant cushion against risk in the use of debt, thus enhancing an enterprise’s debt capacity. In this sense, it is more likely that the dependence of rural industrial enterprises on debt financing was determined by the shortage of equity capital they faced. Rural industrial enterprises were officially regarded as ‘farmers’ spontaneous activities’, to be financed mostly by farmers themselves. This policy stance emphasised the enterprises’ own responsibility in equity financing and led to a pattern of financing fundamentally different from that in state-owned enterprises. While capital formation in state-owned enterprises in the late 1970s and early 1980s was still almost fully financed through state resources, rural enterprises by contrast had to rely on collective accumulation at the township and village levels, loans

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Financing China’s rural enterprises

from the Agricultural Bank of China and rural credit cooperatives, and contributions from farmers who found full-time jobs in the sector. Figure 4.1 illustrates the sources of finance, based on the categories used in Chinese accounting practice for collective industrial enterprises in rural areas up to 1994, before a new system of accounting was introduced. In Figure 4.1, equity capital is divided broadly into two parts, capital investment funds and special funds. Capital investment funds refer to longterm investment in enterprises. They come from as many as seven different sources but three main ones are local government investment, retained profits of the enterprise, and equity investment from outside sources. As the founders of collective industrial enterprises, township governments and village administrative committees made contributions to enterprises, which could be in the form of capital provisions and/or collective land as enterprise premises. Special funds include two elements of before-tax profits, retained for specified purposes. The way special funds are treated as part of the equity capital reflects the traditional approach of Chinese financial accounting in the 1980s. By dividing the special funds into six categories, the state intended to make sure the various needs for investment, whether productive or nonproductive, would each have their own independent source and these would be exempted. On the other hand, by making separate accounts for each of the special funds, the state could more easily oversee the accumulation and the use of the funds. Obviously, not all categories can be rightly counted as equity capital, according to general accounting standards. Enterprise circulating funds are reserved for expanding the enterprise’s working capital; technical upgrading funds and capital maintenance funds are dedicated to fixed assets service. By contrast, welfare funds, bonus funds and education funds (for employee training) are all intended for non-productive uses; enterprises can use these funds only to relieve their short-term capital shortage, before they are used for their specified purpose. Internal equity capital As the founders of collective industrial enterprises, local governments tended to be the principal contributors of start-up capital, a practice confirmed by two previous surveys summarised in Table 4.2. In Table 4.2, the contribution of local governments’ equity capital accounted for 34–42 per cent. But after the start-up stage, the equity capital input by local governments in either short-term working capital or long-term investment reduced sharply to below 4 per cent, becoming almost negligible. Without the sustained provision of equity capital by local governments, rural industrial enterprises increased their reliance on self-finance through retained profits. In these two surveys, equity investment by enterprises themselves were as high as either 51 per cent in working capital or 63 per cent in long-term investment. Apart from retained profits, equity joint ventures

Financial management of rural industries 57 I

Equity capital

II Debt capital 1 Loans

2 Other credits

(i) Capital investment funds

• • • • • • •

Township investment Village investment State-owned enterprise investment External organisation investment State support fund Individual investment Enterprise accumulation

(ii) Special funds

• • • • • •

Technical up-grading fund Welfare fund Bonus fund Enterprise circulating fund Education fund Capital maintenance fee

(i) Bank loans

• Equipment loans • Circulating capital loans

(ii) Other loans

• Fiscal circulating fees • Loans from administrative department • Loans from other organisations • Loans from individuals • • • •

Prepayments Wages and salaries payable Trade credit Deferred fees

Figure 4.1 Sources of funds for rural industrial enterprises

among domestic enterprises and in particular with foreign enterprises, and shares or bond-like shares in shareholding enterprises, were not popular, especially before the first half of the 1980s. As the importance of retained profits increases, there are two factors that undermine the self-financing capacity of rural industries. One is the trend of decreasing profitability mentioned earlier, the other the distribution of net profits between local governments and enterprises. The distribution of profits between local governments and collective enterprises is largely shaped by the specific local government–enterprise relations that result from the characteristic nature of rural enterprises. In many ways, rural industrial enterprises are the legacy of the commune economy before 1978. They were founded to serve community interests and invested mainly through community accumulation. The change of title in 1984 did not transform the essential nature of these community enterprises. They remain collectively owned, that is, the entire community membership is the nominal owner but the local government is the de facto owner.

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Financing China’s rural enterprises

Table 4.2 Capital contributions by local governments New firms

LG BL SF

Existing firms Working capital

Long-term investment

A

B

A

B

A

B

33.5 38.2 n.a.

42.1 29.5 n.a.

2.4 32.9 27.1

3.9 19.7 51.2

2.0 22.5 62.6

n.a. n.a. n.a.

Notes: LG  local government investment, BL  bank loans, and SF  self-financing. Sources: Information in column A is from Zhou and Hu (1989) and information in column B is from Zhang (1993).

The implication of the nature of such rural enterprises is that embedded community interests take priority over the interests of the individual enterprise. The need to satisfy multiple community interests easily leads to over-collection of after-tax profits by local governments. According to the Ministry of Agriculture, at least 60 per cent of after-tax profits should be retained by enterprises.4 In reality, wide variations in practice can be observed. There is much evidence that in the 1980s, the central government’s stipulations were constantly transgressed and that local governments tended to leave too small a proportion of after-tax profits to enterprises. Over-collection of after-tax profits may take two forms, namely explicit remittance of profits and taxation from enterprises, and implicit charges on rural industries. The latter has been a controversial issue in the regulation of rural enterprises for many years. From 1989 to 1992, the nominal rates of profit retention in rural collective industrial enterprises varied between 60.4 per cent and 68.8 per cent (Table 4.3). Of the retained profits, 70–80 per cent were used for re-investment, the remaining profits were used in the areas of collective welfare, rural education, and so on. Deducting these unproductive investments, the net accumulation rate on average made up only 47.62 per cent of the entire after-tax profits over the period concerned. Even so, figures for net accumulation rates over the 1978–81 period look bad (Table 4.4). The demand for more investment and insufficient net accumulation in enterprises posed a serious problem for the actual financing capacity of enterprises. Local governments indeed used part of the enterprises’ profit remittance as support funds in one way or another, but the amount of investment in this source of funding decreased as well (see Table 3.12 in Chapter 3). This analysis of national statistics has been supported by evidence from numerous case studies. As Gray (1982) found in Wuxi, Jiangsu Province, in the distribution of all net profits made by rural industrial enterprises, 40 per cent went to supporting agriculture, 10 per cent to increasing farmers’ incomes, and only 50 per cent was ploughed back into the factories in the period 1977–9.5

Financial management of rural industries 59 Table 4.3 Distribution of after-tax profits in rural collective industries

Net profits (billion yuan) of which: profit remittance (%) profit retention (%) Use of retained profits in (i) productive reinvestment (%) (ii) collective welfare (%) (iii) rural education (%) (iv) others (%) Net accumulation rate (%)

1989

1990

1991

1992

17.75 38.1 61.9

16.92 34.5 65.5

21.32 31.2 68.8

36.96 39.6 60.4

70.2 11.8 4.5 13.5 43.5

70.2 11.6 5.0 13.2 46.0

70.6 11.0 4.8 13.6 48.5

80.6 11.9 6.8 0.7 48.7

Source: Almanac of China’s Rural Enterprises, 1989–93, various volumes.

Table 4.4 Uses of net profits in rural collective enterprises (%) Years

Reinvestment

Support agriculture

Rural welfare

Others

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987

35.0 38.8 39.7 37.9 41.2 43.0 47.3 46.3 50.0 53.0

29.9 25.7 19.2 14.6 12.4 11.5 5.1 5.1 4.2 4.5

4.5 4.7 5.7 6.4 8.1 9.7 12.2 11.5 9.0 9.6

30.5 30.8 35.4 41.0 38.2 35.8 35.4 37.0 36.7 32.8

Source: Rural Enterprises in Contemporary China (1991), p. 571.

Croll (1994) in her case study reported that for all village enterprises, profits were divided at the year’s end and distributed between bonuses for the managers and workers in the enterprises, investment in the maintenance and expansion of the enterprises, and in village funds, with 20 per cent for bonuses, 40 per cent for investment and 40 per cent for village funds.6 A survey in Zhejiang and Sichuan provinces (Zhang, 1998) found that in 1989, 35 per cent of enterprises were levied excessively by local governments, with charges potentially amounting up to 100 per cent of their whole net profits. Another investigation by the Ministry of Agriculture found that rural enterprises were charged more than 50 types of fee, of which 44.6 per cent were considered to be proper charges, 5.4 per cent to be improper, and 50 per cent to be unreasonable.7 Angry complaints were hardly surprising. As the saying goes: ‘statutory taxes and levies are slight, surtaxes are heavy, and informal but irrational charges are bottomless’ (yi sui qing, er sui zhong, san sui shi ge wudidong). The leakage of profits from enterprises became so serious that the Ministry of Agriculture had to reiterate in numerous

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Financing China’s rural enterprises

government documents and speeches the necessity of leaving 60 per cent of net profits to enterprises.8 The resulting lack of equity capital inevitably forces rural industrial enterprises to rely on debt financing, and this largely explained the prevalence of excessively high gearing in enterprises. In an investigation into the use of loans by rural industrial enterprises with outstanding loans of more than 200,000 yuan in 1995, the Tong County Branch of the Agricultural Bank found that the average financial gearing was as high as 76.7 per cent, with 62 per cent of the sample enterprises having financial gearing over 70 per cent.9 In short, the demand for equity capital resulting from the rapidity of business expansion and the leakage of profits through over-collection by local governments over the post 1978 period have clearly built up financial stress within enterprises, especially in those with spectacular growth performance. Additional cash flows each year were quickly soaked up by the rapid expansion of existing operations and new investments. Debt financing became a kind of compromise, which eventually led to the general trend of increased financial gearing observed in previous investigations. There are additional factors that complicate financial management in companies and increase their dependence on debt financing. Two are the increase in capital intensity and their weak position in controlling trade credit. Increase in capital intensity Rural industrial enterprises showed increasing capital intensity in the 1980s (Griffin 1984 and Wang 1990). The tendency towards capital intensification continued into the late 1980s and the early 1990s. In 1992, the average capital–labour ratio in rural industrial enterprises was 7,153 yuan in real terms, about 1.8 times greater than in 1987, or in other words, an annual growth rate of 12.2 per cent. Capital intensity increase in proportion to the expansion of businesses in size is highly anticipated, particularly when under-capitalisation of small enterprises is taken into account. Rural enterprises used to start up at an extremely small scale and manage to minimise their investment in fixed assets. Just as one investigation shows, second-hand equipment purchased by rural industrial enterprises accounted for up to 35–45 per cent of fixed capital investment over the years 1978–84.10 Once enterprises survive the start-up stage and expand, they need to make up the gap of under-capitalisation and increase their investment in the replacement and upgrading of fixed assets in order to improve efficiency. The growing capital intensity can also be attributed to a considerable rise in the investment threshold, that is, the average scale of financing for fixed capital investment projects in rural industrial enterprises. This is supported by evidence on the capital investment made by rural collective industries between

Financial management of rural industries 61 Table 4.5 Capital intensity in rural collective industries

Capital intensity (yuan per worker)

1987

1988

1989

1990

1991

1992

4,024

4,170

4,436

5,225

6,090

7,153

Notes: Values in this table are in real terms, deflated by the retail price index over the same period. Source: Almanac of China’s Rural Enterprises, various volumes between 1989–93.

1989 and 1994. It is estimated that the average new investment in fixed assets in rural industrial enterprises was 290,000 yuan in 1989 but increased to 920,000 yuan in 1994, of which the average replacement and up-grading investment amounted to 660,000 yuan in 1994, up from 220,000 yuan in 1989. Inflation may to some extent push up the investment threshold, but basically it is the necessity to keep a competitive edge through investment that has been the real concern for rural entrepreneurs. One example was observed in Chaoan County. The manager of the Anpu Sweets Factory explained that the threshold of investment in technical up-grading for his enterprise would be at least 10 million yuan, and only at that scale could the enterprise hope to stay ahead of any rival in the market for more than three years. Finally, industrial restructuring is another influential factor, perhaps the factor of paramount importance, given that capital intensity in industrial subsectors differs significantly. As indicated in Table 4.6, within the machine building subsector, capital intensity in electronic machinery is more than double that in ordinary machinery. In the subsector of metallurgy, ferrous metal processing has a capital intensity almost three times higher than that of metal products. For the chemical subsector, capital intensity in chemical fibres is triple than in plastic products. Therefore, a change of sectoral composition from relatively labour-intensive subsectors to relatively capital-intensive subsectors will push up the general level of capital intensity in industry as a whole. This is exactly the situation for collective rural industry. As mentioned earlier, machine building, building materials, metallurgy, textiles and chemicals were the five largest sectors in rural collective industry in 1994. Of these, the first two were established sectors prior to the 1980s while the other three saw the largest increase of output in collective enterprises over the period 1980–94. There was a decrease in output share of the building material sector, with considerable gains in relatively capital-intensive subsectors. In the sectors of machine building and chemical industries, again, it was the subsectors with relatively higher capital intensity that expanded at the expense of the more labour-intensive subsectors. Of course, despite all these changes, the capital intensity of rural industrial enterprises on average is still well below that of state-owned enterprises. In 1991, the capital–labour ratio in a typical state-owned enterprise was 24,288 yuan in real terms, while the same ratio in a rural industrial enterprise

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Financing China’s rural enterprises

Table 4.6 Capital intensity of selected industries Subsectors

National average Machine building Ordinary machinery Transportation equipment Electric machinery Electronic machinery Instruments Building material Metallurgy Ferrous metal mining Non-ferrous metal mining Ferrous metal processing Non-ferrous metal processing Metal products Textile Chemical Chemical material/products Pharmaceutical products Chemical fibres Rubber products Plastic products

Capital intensity

75,130 82,125 59,176 91,090 72,993 126,330 61,035 39,470 85,214 65,528 51,765 146,530 109,177 53,071 51,069 102,133 85,959 99,839 192,588 66,973 65,306

Shares of industrial output (%) 1980

1994

100.00 60.75 7.95 20.94 8.06 2.30

100.00 53.54 13.28 22.08 8.68 2.42

100.00 2.78 3.99 19.11 14.66 59.46

100.00 3.25 4.00 31.32 14.85 46.58

100.00 44.72 4.32 3.58 9.55 37.83

100.00 49.36 6.40 5.71 8.67 29.85

Sources: Capital intensity in the whole industry in this table refers to assets per employee. Employees are estimated on overall labour productivity (p. 401) and added-value of industry (p. 388) in China Statistics Yearbook (1995); data of total assets is from the same book (p. 389).

was 6,090 yuan, just one-quarter of the capital–labour ratio of a state-owned enterprise. Having said that, when fast output growth in rural industry begs for the injection of new capital, the tendency towards capital intensification requires enterprises to draw more deeply on their financial capacity, which sometimes may be insufficient to meet the demands on it. Net suppliers of trade credit Rural industrial enterprises are also under pressure to borrow more to finance trade credit because they are generally net suppliers of trade credit.11 On the one hand, many small rural industrial enterprises are the sub-contractors of state-owned enterprises, and the sums owed them but not yet paid (their ‘accounts receivable’) would increase if their urban counterparts experience difficulties in production and sales. On the other hand, they purchase materials from, and sell products to, a relatively competitive domestic market, without much help from the state

Financial management of rural industries 63 Table 4.7 Trade credit of rural collective enterprises (billion yuan) Years

Accounts receivable

Accounts payable

Balance

1988 1989 1990 1991 1992 1993

65.6 76.9 92.4 81.0 83.3 180.9

n.a. 74.2 87.5 n.a. 70.1 128.9

n.a. 2.7 4.9 n.a. 13.2 52.0

Source: Almanac of China’s Rural Enterprises, 1989–94, various volumes.

plan. In the 1980s, no more than 20 per cent of the sector’s production and marketing was covered by the state plan, whether directly or indirectly,12 whereas state-owned enterprises had most of their production arranged in the state plan. To market their products, rural industrial enterprises need to offer customer credit. This in turn brings with it a need for additional financing. In the area of foreign trade, most rural enterprises did not have their own channels into the international market, and also were not entitled to engage in direct trade with companies abroad. They had to rely on state foreign trade companies as agents to do business for them. For these reasons, they were usually in a poor position to negotiate conditions of short-term credit. As a result, they were more easily trapped in triangular debt because sums owed them could not be collected in time from state-owned enterprises and foreign trade companies. Table 4.7 shows rural collective enterprises had capital receivable of 76.9 billion yuan and accounts payable 74.2 billion in 1989, leaving them a balance of 2.7 billion yuan receivable in their account. By 1993, accounts receivable increased to 180.9 billion yuan against accounts payable of 128.9 billion yuan, the difference amounting to 52.0 billion yuan. In the years examined, the rural collective enterprises were actually net suppliers of credit. In sum, the phenomenon of debt dependence displayed by rural industrial enterprises has deep roots in these businesses. The critical factor is the overdistribution of net profits enforced by local governments to accommodate local community interests, coupled with the shrinkage of local government’s contribution to equity capital. In addition, rural enterprises with weakened debt capacity are desperate to find additional financing in order to cope with capital intensification in the sector and their reluctant role as net suppliers of credit to trade partners. This tricky financial position implies that if the fast growth in businesses is to be sustained, the financial management of enterprises has to be aggressive. No wonder continuous efforts were made from the very early stages of rural reform to develop new sources of external capital for rural enterprises and to improve their financial strength. One early case of share issuance in Zhanxiang Township Phoenix Corporation, Qionglai County, Sichuan

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Financing China’s rural enterprises

Province was reported by Griffin and Griffin (1984). By the mid 1980s the lack of equity capital became so serious that a new form of organisation in rural enterprises, shareholding co-operatives, emerged in a few places. These were later endorsed by the Ministry of Agriculture in the ‘Provision of Rural Shareholding Co-operative Enterprises’, issued in 1990.13 The introduction of the shareholding co-operative system into rural enterprises had a number of important purposes, such as the clarification of property rights, the introduction of a new incentive mechanism, and capital accumulation (Clegg 1998), but its potential for providing access to new equity financing was just too attractive to ignore. By the end of 1994, the number of rural shareholding co-operative enterprises across the country increased to 204,000, accounting for 12.4 per cent of rural collective enterprises. An equity capital of 105.65 billion yuan was raised, with 26.4 per cent of capital coming from individual investment, 17.4 per cent from institutional investors and 4.7 per cent from foreign companies.14 The primary importance of shareholding co-operatives is their role as a method of enterprise reform, in particular in the system of property ownership. However, from the financial management point of view, they served as another innovation by rural enterprises to accommodate their dual need to maintain their collective nature and to find new financial tools. Shareholding co-operative enterprises can now use equity capital from wider sources to relieve the pressure of capital shortage and to strengthen their financial position. In Tong County, Beijing, for example, 539 rural industrial enterprises converted to shareholding co-operative enterprises by 1994, that is, one-fifth of all rural enterprises in the county. These enterprises absorbed about 249 million yuan of equity capital in shares from employees and external investors, reducing their financial gearing from more than 70 per cent to 44.3 per cent. The improvement in the financial strength of Tong County’s shareholding co-operatives strongly indicates that the lack of equity capital has contributed to the the shaky financial structure prevalent in rural industrial enterprises.

Tax shields and soft credit Tax shields are a significant factor in favour of debt financing. China’s taxation system in the 1980s exhibited some particular generosity in the sense that rural industrial enterprises were allowed to repay both interest and principal on bank loans before calculating taxable profit and income tax payments. Although interest payments by businesses are commonly tax deductible in other countries, principal repayments are not, for the reason that repayment of principal is not a real business expense. In that way, Chinese tax accounting practice in effect allowed double counting of loan-financed investment costs, treating both principal repayments and depreciation as deductible from pre-tax profits. As a result, a large part of the cost of bank loans was absorbed by the state, in the form of lower tax receipts. This tax

Financial management of rural industries 65 Table 4.8 The average nominal and real interest rates (%) Years

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Nominal rates

Real rates

IR

WC

FA

WC

FA

2.0 6.0 2.4 1.9 1.5 2.8 8.8 6.0 7.3 18.5 17.8 2.1 2.9 5.4 13.2

5.04 5.04 5.28 5.40 5.40 5.40 5.76 7.92 7.92 9.00 9.00 9.63 9.00 8.37 9.54

3.24 3.24 3.24 5.04 5.04 7.56 9.36 9.36 9.36 9.36 9.36 7.80 9.81 9.09 11.25

2.91 0.91 2.81 3.43 3.84 2.53 2.79 1.81 0.58 8.02 7.47 7.38 5.93 2.82 3.23

1.22 2.60 0.82 3.08 3.49 4.63 0.51 3.17 1.92 7.71 7.16 5.58 6.72 3.50 1.72

Notes: (a) IR  inflation rates, measured according to retail price index (RPI); WC  loans for industrial working capital; FA  loans for fixed capital investment. (b) Real interest rates  (nominal rates  inflation rates)/(1  inflation rates). Sources: RPI from China Statistical Yearbook 1995, p. 233; others from Almanac of China’s Finance and Banking 1994, p. 491.

practice obviously had some positive association with the debt capacity of rural industrial enterprises and encouraged them to take advantage of a taxation system under gradual reform.15 Despite many changes after 1979, interest rates were low in real terms and did not fully reflect the real scarcity of credit funds in the financial market. Efforts to use interest-rate policy as tools of macro-economic management through reforming the governance of interest rates began in 1979, but a relatively comprehensive change in interest-rate management did not take place until 1982. Thereafter, the structure of interest rates underwent several adjustments, with nominal rates on industrial working capital and fixed capital loans being gradually raised to around 10 per cent. Even so, from 1979 to 1993 real interest rates on loans for industrial working capital and fixed capital investment were negative in five and four years respectively, and lower than 5 per cent in eight and nine years (Table 4.8). Compared with the general profitability of rural industrial enterprises and costs of other financial instruments, it is obvious that cheap loans from the rural banking sector were the best source of funds. With interest rates well below market clearing rates, the banking system was in effect forced to subsidise rural industrial enterprises and their investment projects (Naughton 1996). This partly explains why the demand for loans in rural industrial enterprises was always likely to escalate.

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Financing China’s rural enterprises

Moreover, rural industrial enterprises were willing to borrow because credit was soft. First, loans from the Agricultural Bank of China and rural credit co-operatives were less in demand for security, and repayments of both interest and principal could be bargained when enterprises were faced with insolvency. These features of bank credit funds provided an important cushion of risk absorption for rural industries when they were struck by unexpected changes in the policy environment. This relatively less stringent requirement for security or collateral by the Agricultural Bank of China and rural credit co-operatives can be illustrated by the management of the enterprise’s own capital.16 The Provisions published in 1985 required that rural financial institutions would finance 60 per cent of working capital with the enterprise’s own capital.17 The match funding for working capital was later reduced to 30–50 per cent when the Agricultural Bank revised regulations on loan management in 1987. The criteria for provision of working capital loans in this new document are clear. If the enterprise is unable to self-finance working capital to the level stated in the regulation when the loan application is approved, it should undertake to make up the gap within three years. If the company failed to do so, it would be ineligible for any additional loans and would be penalised by a 50 per cent surcharge.18 However, these regulations, already relaxed, appear not to be stringent enough to discipline the financial management of rural industrial enterprises. Evidence shows that working capital financed by rural industrial enterprises themselves accounted for only 20.1 to 22.7 per cent from 1989 to 1992,19 substantially below the requirement set in the 1987 regulations. This fact suggests that rural enterprises commonly leverage more loans against their own inability to invest. No wonder bank loans were favoured by rural industrial enterprises. A survey of 1,800 rural industrial enterprises in 1987 (see Table 4.9) revealed that loans from the Agricultural Bank of China and rural credit cooperatives were the two most favoured sources of funds (Guo, 1988). Second, bank loans were soft because credit contracts were not enforced, unreliable debt servicing was tolerated, and postponement and rescheduling were readily available. In other words, bankruptcy costs related to debt financing were insignificant. An early investigation found that during periods of insolvency rural industrial enterprises deferred their various creditors’ claims and resorted to delay or even refused to pay interests and principals to banks (Zhou and Hu 1989). As discussed in Chapter 2, bankruptcy costs comprise direct costs and indirect costs. The former refers to legal, accounting and other administrative costs incurred during enterprise liquidation, and the latter relates to costs imposed by the bank before bankruptcy actually occurs. While bankruptcy in the rural industrial sector was not generally enforced in the post-1978 period, rural financial reforms brought the issue of how to protect financial assets to the attention of rural financial institutions. A number of measures were adopted. For example, regulations covering loans to rural industry, taking

Financial management of rural industries 67 Table 4.9 Response to a questionnaire on financing preference Sources of funds

Frequency of response

Range

Loans from the ABC Loans from RCCs Borrowing from employees Appropriation from the township government Inter-enterprise borrowing Issuance of shares Borrowing from informal credit market

95.63 78.45 69.34 46.62 57.35 25–39 27–37

1 2 3 4 5 6 7

Source: Guo (1988), ‘Investment policies for the period of development’, Investment Research, No. 3, p. 5.

effect after 1982, stated that defaults on loan repayments by rural industrial enterprises would be penalised by a surcharge of 20 per cent.20 This policy was designed to increase the cost of excessive debt financing, discipline rural industrial enterprises in financial mismanagement, and protect the interests of rural financial institutions. The problem this policy encountered was that at times when direct bankruptcy costs were too low to change company’s attitude towards borrowing, indirect bankruptcy costs (in this case the interest penalty) proved to be in vain. Sjöberg and Zhang (1998) found from their survey in Zhejian and Sichuan that in terms of capital structure, loans taken out by the loss-making enterprises were twice as high as those by profit-making rural enterprises, and more loss-making enterprises than the profitable ones had increased borrowing from banks. The fact that twice as many loss-making enterprises received additional bank loans as did profitable rural enterprises during the period of credit squeeze was indicative of the softness of bank loans. Of course, from local banks’ point of view, if the bank withheld additional loans from distressed enterprises, these enterprises would fail and the bank would stand to lose money on the outstanding loans. In addition, closing unprofitable enterprises would in itself risk spreading insolvency, because the debts of these enterprises were guaranteed by other enterprises – themselves heavily indebted. As a result, banks paid the price for their incompetent credit management in the first place and had no choice but to tolerate the financial failure of many rural industrial enterprises. In short, China’s taxation and financial systems under conditions of dynamic reform in the 1980s and the early 1990s appeared to encourage enterprises to use loans as cheap funds because real interest rates were low and generous tax shields were offered. Meanwhile, the partially reformed financial system created soft credit and this became a loophole from the enterprises’ point of view. In the end, credit funds were used to enhance rural industrial enterprises’ debt capacity, which would not have occurred otherwise.

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Financing China’s rural enterprises

Financial weakness and risk absorption Dependence on debt financing leaves enterprises in a relatively weak financial position. Loans from rural banks may be cheap, but raising funds through informal methods may not be. When most capital is raised to finance shortterm investment needs, the short-term maturity of loans adds additional pressure on repayment. This situation is illustrated by two examples. The Anpu No. 1 Sweets Factory, Chaoan County, raised 3.8 million yuan through issuing informal bonds to its employees; the Victoria Group Company in the same county raised 200,000 yuan in the similar way. If the interest were charged at the rate applicable to working capital loans with one-year maturity from the Agricultural Bank of China (10.98% in this case), the funds raised would incur interest payments of 417,000 yuan and 22,000 yuan for the respective enterprises. In reality, the yearly interest rates paid by the Sweets Factory and the Victoria Company were as high as 14 per cent and 20 per cent, the actual interest payments by both enterprises amounted to 532,000 yuan and 40,000 yuan respectively, or 27.6–81.8 per cent more than what they would have paid in interest on loans from the bank. These estimates are set out in Table 4.10. The effect of the short-term maturity of informal bonds can be illustrated in the case of Anpu No. 1 Sweets Factory. This factory raised funds from employees from 1992 to 1994, with the cash contribution of each worker varying from 1,000 to 30,000 yuan. In total, 3.8 million yuan was raised, accounting for about 60 per cent of the factory’s working capital at that time. The maturity of loans was only three months, and at each Chinese New Year, 60 per cent of workers withdrew their principal, though some might lend the money to the factory again after the festival season. Therefore, if funds were not used properly, problems of liquidity would occur. Although their financial position was weak, rural industrial enterprises nevertheless demonstrated resilience and were able to sustain their fast growth. Some previous studies have claimed that failing rural industrial enterprises have gone bankrupt, demonstrating their hardened budget constraints. But the concept of bankruptcy in the Chinese context itself needs to be clarified. First, the term itself is not popular in Chinese business culture, and even after the new bankruptcy law was passed in the early 1990s, a loose notion of business failure is preferred. In official documents, the expression ‘business failure’ appears to refer to the following situations: the closure of enterprises; the cessation of operations; business merger; or change in the products manufactured (guan, ting, bin, zhuan). An enterprise can be ordered to stop operations for the time being because of temporary production difficulties or other reasons but may resume operations in due course. More frequently though, the local government prefers its failing subordinate enterprises to switch production lines or to be merged with profitable enterprises. At all events, only a small portion of enterprises are closed for good. Because previous surveys do not explicitly distinguish the type of

Financial management of rural industries 69 Table 4.10 Financial cost of enterprise bonds

Yearly interest rate on enterprise bonds (%) Funds raised (thousand yuan) Bank’s one-year lending rate (%) Expected interest payments (thousand yuan) Actual interest paid (thousand yuan) Additional interests paid (thousand yuan)

Case A

Case B

14 3800 10.98 417 532 115

20 200 10.98 22 40 18

Notes: A: Anpu No1 Sweets Factory; B: Victoria Group Company; bank one-year lending rate refers to circulating capital lending rate. Sources: Bank interest rates from Almanac of China’s Finance and Banking 1994, p. 491 and p. 493.

business failure, it is highly likely that this information overestimates the rate of business failure. This would explain why data relating to business failure is so inconsistent. One official from the Department of Rural Enterprises in the Ministry of Agriculture estimated, in an interview, that the failure rate of rural enterprises stood at 6–7 per cent in normal circumstances and might reach a little more than 10 per cent in periods of credit squeeze.21 Beijing and Zhejiang were estimated to have each closed down one quarter of their rural enterprises in 1989, whilst Jiangsu shut down 30 per cent of its rural enterprises in the same year.22 By contrast, He Kang, an ex-minister in charge of agriculture, said that for the entire country the failure rate of rural enterprises in 1989 was about 16.1 per cent, or 3 million enterprises in absolute terms.23 Another report estimated that 75,579 collective industrial enterprises were closed or stopped production nationwide in 1989, equivalent to a failure rate of 7.7 per cent.24 In 1993, 27,160 rural enterprises were reported to have been shut down, which made up only 0.11 per cent of all rural enterprises in the country.25 Not only is the concept of business failure inconsistent, but also the reasons for business closure are complicated. Some may be driven out of business as a result of management failure, some may be shut down due to financial stress, and finally some may be simply re-registered in order to take advantage of tax incentives offered specifically for new firms. Therefore, it is rather difficult to know exactly how many enterprises were shut down due to the failure of financial management. One thing is certain, however, that most rural industrial enterprises in weak financial positions have survived and bounced back again. How can this be achieved? Of course, many factors are responsible for the ability of rural industrial enterprises to absorb financial risk. Among them is the existence of a special bank–enterprise relations, which will be examined in the next chapter. Two other reasons stand out. One is the system of flexible labour management, the other is the issue of soft budget constraint.

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Financing China’s rural enterprises

Flexible labour management Flexible labour management is one of the advantages enjoyed by rural industrial enterprises. This flexibility is evident in employment management and in wage setting. Rural enterprises are relatively flexible in determining wage scales and their structure. With regard to wage structure, rural industrial enterprises generally employ three patterns: (a) Basic wage plus bonus: the scale of the basic wage depends on the employee’s skills and work experience. This may make up 50–80 per cent of the whole wage. The remaining 20–50 per cent is paid in bonuses that vary in accordance with work performance. (b) Piece rate system: piece rates prevail in small rural industrial enterprises, and it may apply to the worker’s entire work or only to above-quota productivity. (c) Basic wage plus position allowance plus bonus: this method differentiates between workers’ and staff earnings by payments specifically related to the position held and the responsibility taken. One of the important features in wage setting is that if a bonus constitutes a significant portion of the worker’s wage bill it creates a strong incentive to the worker to work hard. It also gives the enterprise some degree of flexibility in adjusting wage bills when sales growth does not meet the projected target during a difficult period. As confirmed by Gregory and Xiu (1995), the wage determination pattern in rural industries is productivity-related. Flexibility in wage setting has helped to keep labour costs low. It is true that the average wage per employee in rural industrial enterprises grew at a rate of 14.1 per cent over the 1984–92 period, higher than the growth rate in national industry as a whole, which grew at a rate of 12.9 per cent per annum in the same period. In absolute terms, however, the average wage in rural industries was still much lower than the national average level. In 1992, the yearly wage in a typical rural industrial enterprise was 1,083.4 yuan (in real terms), or only 61 per cent of the national level, which was 1,694.7 yuan. Woo (1993) also found there was a positive association between low labour compensation and better profit-making performance in rural industries. Labour compensation is composed of direct and indirect wage income. Direct wages are defined as total cash income paid to employees, such as basic wage, bonus and subsidies, and indirect wages include all non-cash benefits. According to his analysis, from 1984 to 1988 labour compensation in rural industries was not more than 39 per cent, but total labour compensation in state-owned enterprises was up to 55 per cent. The flexibility in labour management is just as important as flexible wage setting. Workers in rural industrial enterprises are not provided secure jobs as are their counterparts in state-owned enterprises, and they face being laidoff when necessary. As found by Zhou and Hu (1989), at the time when

Financial management of rural industries 71 production was suspended in some enterprises in 1984, only 2.7 per cent of employees remained employed and received payment, but most workers were laid off and returned to farming. They reported that 61 per cent of these workers retained their share of contracted farmland with their family while taking jobs in factories. Softened budget constraints That rural industrial enterprises can shrug off financial risk is also attributed to the special risk-resolving mechanism that is embedded in the distinctive local state–enterprise relations. As mentioned earlier, enterprises themselves are more the carriers of community objectives than they are profit maximisers. They turn over a lump sum of profits to the local government for the fulfilment of community functions and objectives, which weakens their financial position. But, in return, they benefited from softened constraints on their budgets, in particular the likelihood that they would be bailed out by local government or rural financial institutions in the case of insolvency. This point will be further discussed in the next two chapters.

Conclusions This chapter has examined the factors that have affected the debt capacity of rural industrial enterprises throughout the period concerned and has investigated their ability to withstand the financial risk resulting from overdependence on debts. It was found that both internal factors, whether phenomenal output growth or profitability, cannot be regarded as providing sufficient debt capacity in rural industrial enterprises to account for their excessive use of debts. The strongest factor working against use of debt was the instability of output growth and as a result the strong uncertainty of profitability and its drastic fluctuations over years. In addition, there was a dramatic fall in returns on capital, which further eroded the debt capacity of these enterprises. Thus, the tendency of rural industrial enterprises to make excessive use of debt financing cannot be explained by factors such as output growth and profitability. With regard to internal factors, it was found that the enterprises’ overdependence on debt is to be attributed to the persistent shortage of internal equity capital. This problem occurred not because of the general reluctance of the enterprises to increase equity investment but rather because of the overcollection of industrial profits by local governments. After profit remittance, rural industrial enterprises had to contribute further sums out of their net profits for investment in collective welfare and rural education. In the end, they could only manage to achieve a net accumulation rate of 44–49 per cent between 1989 and 1992, far below the bottom line of 60 per cent of after-tax profits demanded by the state regulations.

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On the capital demand side, rural industrial enterprises were found to be under a great pressure to invest. This pressure came first from a steady increase in capital intensity. Overall, capital intensification seems inevitable because: (a) rural industrial enterprises were undercapitalised at the start-up stage; (b) investment thresholds were rising; and (c) relatively capital-intensive industrial subsectors expanded gradually at the cost of relatively labourintensive ones. The pressure to invest also resulted from the generally weak position of rural industrial enterprises in the use of trade credit. In fact, they were net suppliers of trade credit. Therefore, the constant demand for new capital and the inability to accumulate capital created a huge gap in internal equity investment and made dependence on debt an inevitable choice. Furthermore, the taxation system and financial system under gradual reform had some loopholes that were exploited by rural industrial enterprises in their use of debt. With regard to taxation policy, there were generous tax shields: rural industrial enterprises were allowed to repay both interest and principal on bank loans before calculating taxable profits and income tax payments. In the financial sector, real interest rates never reflected the rates of market clearing because of the ongoing reform of the financial market, so that bank loans became extremely cheap funds. Equally important, bank loans were soft because of the scope for bargaining over credit contracts and bankruptcy costs. These external factors influencing the debt capacity of an enterprise were instrumental in encouraging the excessive use of debt in the rural industrial sector. Despite their unusual pattern of financing, rural industrial enterprises have withstood well the financial risks resulting from over-dependence on debt and have shown an amazing resilience. But this resilience cannot be explained by their ability to absorb financial risk alone. It has also to be traced elsewhere, to the broader framework of the community risk-sharing mechanism to be examined in the next two chapters. However, as far as the rural industrial sector is concerned, there were two particular factors that have reduced the implications of financial risk. First, flexible labour management gave rural enterprises the vital cushion they needed to survive: wages were performancerelated, and jobs were not secured for life. Second, budget constraints in rural industrial enterprises were softened due to their services to local community objectives through the contribution of considerable profits. The implication of soft budget constraints for enterprises was that they could expect to be bailed out if their financial management failed. In the end, rural industrial enterprises were not wholly responsible for financial risk and thus their concern over it was significantly reduced.

5

The financial management of rural financial institutions

The rural financial sector has been the main provider of loans to rural industrial enterprises over the post-1978 period, and so the persistence of debt-dependence in rural industrial enterprises has very much to do with banking management in the rural financial sector. Because the rural financial sector before 1996 was dominated by the Agricultural Bank of China and the rural credit co-operatives, the analysis of the rural financial sector in this chapter will focus on the behaviour of the Agricultural Bank of China and the rural credit co-operatives. This chapter examines the relationship between rural financial institutions under dynamic reform and the pattern of financing in rural industries. It first analyses the changes in lending policy in the rural financial sector to do with incentive structures, liabilities portfolios, and special local government–bank relations. The chapter then examines the reasons why rural financial institutions can afford to extend sizeable credit funds to rural industries that are prone to dramatic fluctuation and are already highly indebted. Answers are sought for the following questions. Why are rural financial institutions so keen to engage with rural industrial enterprises? What has made the Agricultural Bank of China and rural credit co-operatives change their policy priorities? What effects have the local government–bank relations had on resource allocation in the rural financial market? How does dynamic reform in the rural financial system affect loan management in rural financial institutions? Finally, who bears the financial risk? The first section briefly outlines the restructuring of the rural financial sector after 1978. The next three sections examine factors involved in the changes in lending priorities within rural financial institutions. The second section focuses on the trade-off between yield and risk. The third section explores reasons for changes in loan management from the perspective of internal motives, namely changes in incentive structures and liabilities portfolios, while the fourth section investigates the motivations for this policy change from the perspective of local government–bank relations. The fifth section examines the consequences of local competitive credit creation for the increase in financial risk in both rural enterprises and the banking

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Financing China’s rural enterprises

sector. The final section examines how rural financial institutions are able to absorb financial risk.

The restructuring of rural finance Before 1978 the rural financial sector in China had rarely played a significant role in the financial intermediation in rural areas. For about three decades, the formal rural financial institutions, represented by the Agricultural Bank of China and the rural credit co-operatives, experienced highs and lows of development, but only rural credit co-operatives survived by the end of the 1970s. The lack of development in rural finance before 1978 generally mirrored the weak and superficial role of the financial sector in the national economy. In the pre-reform period China had a rather simplified financial system under the regime of a planned economy. The money market and security market were not developed, while the banking system as a whole was essentially a monobank system, in that the People’s Bank of China was an all-inclusive state bank and the centre for cash, credit and settlement. Other banks, such as the People’s Construction Bank of China, the Bank of China and the Agricultural Bank of China (while it existed), were effectively administrative organs of the central government to facilitate and supervise financial flows required for the implementation of plans. Business operations of state banks were simple, in that bank loans were primarily extended as revolving funds for enterprises to cover their extraordinary and temporary needs for working capital; fixed capital was provided by the state budget as a grant. The restructuring of rural finance took place in 19791 in response to the considerable changes in national economic development strategies and the introduction of rural reforms, both of which would gradually enhance the financial sector’s position in the national economy. In rural areas, the introduction of the household responsibility system in agricultural production and later the resurgence of rural non-agricultural activities called for the development of the rural financial system. After resuming their control over production and investment following the dissolution of the commune system, many rural households now needed liquidity for production, consumption, or longer-term credit to finance investment and construction. At the same time, households had much higher cash incomes from the rapid improvement in agricultural production, some of them having a surplus of cash beyond their needs of consumption, production, and investment. More importantly, the sustained rapid growth of rural industries produced an unprecedented demand for financial services. All these changes provided much greater opportunities for an active rural financial sector to provide intermediation for resource mobilisation and allocation. The significant restructuring of the rural financial system started with the re-establishment of the Agricultural Bank of China in March 1979.2 Designated as one of the four specialised state banks3 in the new-look

The financial management of rural financial institutions

75

banking sector in China, the Agricultural Bank of China, under the supervision of the People’s Bank of China, assumed responsibility for rural credit management. Its main functions were agricultural lending management, supervision of rural credit co-operatives, and accountant training for local governments.4 The Agricultural Bank of China’s business operations extended to both policy-related and commercially-oriented operations. Policy-related lending, which consistently made up over 60 per cent of the bank’s loan portfolio,5 included loans to collective agricultural organisations, purchases of agricultural and sideline products, purchases of grain, and purchases of other major agricultural production materials. Lending to rural enterprise was a relatively new but fast growing business at the time. In parallel with the re-establishment of the Agricultural Bank of China, from the late 1970s the organisation and business development of rural credit co-operatives were widely restructured. Rural credit co-operatives were originally organised in the early 1950s as farmers’ credit co-operatives, with a commitment to serving their members. Nevertheless, the co-operative principle was abandoned during the period of rural collectivisation in the late 1950s. In 1952, rural credit co-operatives were converted into the financial management units of the people’s communes, in accordance with ‘Regulations Regarding Several Issues of Rural Credit Co-operatives’ issued by the People’s Bank of China.6 This change effectively severed the connection between rural credit co-operatives and their household members, and financial services to individual members in support to agricultural production ceased. It was not until 1977 that rural credit co-operatives were re-confirmed as rural collective financial organisations by the People’s Bank of China, when the restructuring of the rural financial system took place. Soon after the Agricultural Bank of China was re-established, rural credit co-operatives became the grass-roots organisations of the Agricultural Bank of China, which supervised their financial management. During the period of rural finance restructuring, non-bank financial institutions emerged in different regions, with rural co-operative fund associations (RCFAs, nongcun hezhuo jijinhui) being the major new development.7 Initially, rural co-operative fund associations emerged spontaneously in only a few provinces, such as Heilongjiang, Liaoning and Jiangsu between 1984 and 1986, but they soon flourished across the country when the Ministry of Agriculture endorsed them in the document entitled ‘The Circular regarding the Standardisation and Institutionalisation of the Rural Co-operative Fund Associations’ in December 1992 (Wen and Zhu, 1994). A rural co-operative fund association is essentially a non-profit institution, designated as a vehicle for managing collective funds previously in the hands of the commune hierarchy and for raising new funds for investment in agriculture and rural infrastructure. Funds in the rural co-operative fund associations usually come from the following sources: (a) collective accumulation by the former production brigade or production team; (b) repayments by farmers of outstanding loans to township or village governments;

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Financing China’s rural enterprises

(c) depreciation allowances for collective assets; (d) compensation fees for use of land; (e) a variety of public funds and management fees; and (f) appreciation of collective grain reserves. The first three items were estimated to account for about 80 per cent of funds in the rural co-operative fund associations.8 At the end of 1993, there were 128,400 rural co-operative fund associations across the country, with capital of 20 billion yuan (Huang, 1995). Rural co-operative fund associations are supposed to focus primarily on the provision of agricultural loans to eligible members of the association in rural areas. In reality, however, they have shown much greater interest in doing business with rural enterprises. For this reason, the emergence of nonfinancial institutions in rural areas means a new source of competition in the rural financial market for rural household savings and for profitable opportunities for loans to rural industrial enterprises.9 Private lending in the rural financial market, though firmly opposed by the government, existed for many years. The private financial sector was particularly active in trading with small private industrial enterprises. A survey of private enterprises in 1992 found 33.8 per cent of new rural private enterprises with more than seven employees obtained their start-up capital from private loans, and the percentage rose to 47.7 per cent after they entered the growth stage. For individual enterprises employing less than seven workers, 45–51 per cent had private borrowings.10 The most significant changes in the financial system came in 1995. First, a legal framework for commercialising state specialised banks and other banks was laid down in the Commercial Bank Law. This law states that banks must be independent entities, take responsibility for their own businesses and operate in accordance with the principle of asset-liability management. Later, the policy-related operations of the Agricultural Bank of China were transferred to the Agricultural Development Bank (ADB), a newly created policy-oriented bank, which was specifically designed to deal with policyrelated loans in order to support the country’s reserves of grain, cotton and edible oil, purchases of farm and ancillary products, and agricultural development. By the mid 1990s the Agricultural Bank of China, the Agricultural Development Bank and rural credit co-operatives together constituted the backbone of the new rural financial system in China. Figure 5.1 illustrates the typical structure of rural finance at county level. In 1995, the rural financial sector consisted of the Agricultural Bank of China, the rural credit co-operatives, the Agricultural Development Bank, non-bank financial institutions such as rural co-operative fund associations, and informal financial institutions such as moneylenders. Other state-owned banks such as the Industrial and Commercial Bank of China and the Bank of China also played some part in rural finance. At county level, the structure of the Agricultural Bank of China branches may differ because of the level of development of the local economy and demands for local financial services. Branches in some regions may have a

The financial management of rural financial institutions

Agricultural Bank of China

Director’s Office

Credit Co-operative Department

77

Lending Department

Deposit Department

Business Office

Saving Stations

Planning Department

Accounting Department

Personnel Department

Association of RCCs

Credit Co-operative

Branch of RCCs

Saving Stations

Agricultural Development Bank

Non-bank Institutions

Other Banks

Figure 5.1 The structure of rural finance in Chaoan County, Guangdong Province

more complex organisational structure than those in other regions. It can be seen from Figure 5.1 that in Chaoan County, the county branch of the Agricultural Bank of China had a director’s office and six departments, each dealing with one aspect of financial business. The affiliation of the credit co-operative department with the county branch reflected the controversial relationship between the Agricultural Bank of China and rural credit co-operatives. The main responsibility of this department was to supervise, on

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Financing China’s rural enterprises

behalf of the local branch, the financial activities of rural credit co-operatives through the county credit co-operative association. The changes in the rural financial sector had considerable consequences. This sector increasingly exerted its impact on economic growth in the rural areas of China.11 Taken together, the Agricultural Bank of China and rural credit co-operatives made up around half the number of employees12 and business offices in China’s financial sector as a whole in 1993, and dealt with about one-third of the total deposits and loans in the sector in 1992.

A lending strategy of trade-off between yield and risk As discussed in the last chapter, rural industrial enterprises that are heavily indebted borrow most of their funds from rural financial institutions. This is clearly illustrated in Table 5.1, which shows the growth of loans extended to rural enterprise from 1979 to 1992.13 In the pre-reform period, the paramount priority in loan management in rural financial institutions was to support agriculture and related activities, and only a rather small share of credit funds was extended to non-agricultural activities. This policy changed in the period of 1979–92. Loans to rural enterprise from the Agricultural Bank of China and rural credit co-operatives together amounted to 205.43 billion yuan by 1992, an almost five-fold rise over 1979 in real terms. This was achieved by a faster growth in credit funds to rural enterprises than the growth of credit funds for the whole financial sector in China. As a result, the share of loans taken by rural enterprises in total credit funds rose from 2.6 per cent in 1979 to 9.5 per cent in 1992. Within the rural financial sector, while credit funds to rural enterprises extended by the Agricultural Bank of China increased steadily, funds from rural credit co-operatives contributed more significantly to the expansion of credit funds available to rural industrial enterprises (Table 5.2). By 1992, loans to rural enterprises extended by rural credit co-operatives amounted to 147.18 billion yuan in nominal terms, about three times more than loans provided by the Agricultural Bank of China. The greater availability of credit funds to rural industrial enterprises from rural financial institutions in general reflected an overall improved economic policy environment for this sector in the post-1978 period. The quota of credit funds that were earmarked for lending to rural industries in the national credit funds plan increased, providing more funds to financial institutions for trading with rural enterprises. At the same time, rural financial institutions were allowed to extend additional funds to the rural industrial sector, provided they could attract more deposits. Yet, at the micro-level, as shall be seen later, the changes of policy priorities within the rural financial sector itself from agriculture to rural enterprises was driven by the banks’ pursuit of profits. This illustrates a lending strategy of trade-off between yield and risks in loan management.

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Table 5.1 Loans to rural enterprises, 1979–92 Year

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Total credit fundsa

Annual growth

Loans to REsb

Annual growth

Share of loans to REs

(billion yuan)

(%)

(billion yuan)

(%)

(%)

203.96 241.43 276.47 305.23 343.11 441.96 590.55 759.04 903.24 1055.13 1240.93 1516.64 1804.40 2161.55

– 11.7 11.8 8.3 10.7 25.3 22.8 21.2 10.9 1.4 0.1 19.7 13.4 13.7

5.22 8.05 9.76 11.57 14.03 29.33 35.24 55.38 70.94 84.79 99.09 122.29 150.57 205.43

– 45.6 18.3 16.4 19.5 103.4 10.4 48.3 19.4 1.0 0.8 20.7 19.7 30.0

2.56 3.33 3.53 3.79 4.09 6.64 5.97 7.30 7.85 8.04 7.99 8.06 8.34 9.50

Notes: (a) Loans include those extended by the Agricultural Bank of China and rural credit co-operatives only. (b) Annual growth rates in this table are calculated by deflating nominal values with the retail price index from China Statistics Yearbook 1995, p. 233. Sources: a Figures for 1979–86 from Finance in Contemporary China, p. 681; figures for 1987–91 from China Statistics Yearbook 1992, p. 656; and figures for 1992 from China Statistics Yearbook 1995, p. 572. b Figures for 1979–86 from Finance in Contemporary China, p. 683; figures for 1987–8 from Almanac of China’s Rural Finance 1991, p. 97; and figures for 1989–92 from China Rural Statistics Yearbook 1993, p. 286 and p. 288.

From the point of view of rural financial institutions, in the highly segmented financial market of the country as a whole, the rural banking sector is designated to provide financial services to customers in rural areas, whether in agriculture or non-agricultural activities. Financial institutions then have to decide where they can make money, given their own interests increasingly depend on it. There are two reasons that have made doing business with rural industrial enterprises extremely attractive. First, as indicated before, rural industrial enterprises perform better overall than agricultural activities in making profits, albeit rather unpredictably between years. In rural areas, this sector offers the best prospects for making money quickly. Second, rural industry loans can be charged higher interest rates than other loan categories. Table 5.3 shows, for example, rural enterprises were charged 9.18 per cent for working capital loans, and 10.80–12.24 per cent for equipment loans, depending on the maturity. By contrast, loans for agriculture, purchases of grain, cotton and soybean, and also of sugar were only charged 6.48–8.46 per cent. Loans for

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Financing China’s rural enterprises

Table 5.2 Sources of loans of rural enterprises Year

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Loans (billion yuan)

Proportion (%)

RCCs

ABC

RCCs

ABC

1.21 1.42 3.11 3.55 4.23 6.01 13.50 16.44 26.59 35.93 45.61 57.19 76.07 100.73 147.18

2.12 3.80 4.94 6.21 7.34 8.02 15.83 18.80 28.79 35.01 40.77 42.06 46.22 49.84 58.25

36.4 27.2 38.6 36.4 36.6 42.9 46.0 46.7 48.0 50.7 52.8 57.6 62.2 66.9 71.6

63.6 72.8 61.4 63.6 63.4 57.1 54.0 53.5 52.0 49.3 47.2 42.4 37.8 33.1 28.4

Sources: Figures for 1978–84 from Rural Finance in Contemporary China, p. 683 and China Statistics Yearbook 1992, p. 659; 1985–90 figures from Almanac of China’s Rural Finance 1991, p. 28 and p. 70; and figures for 1991–2 from China Rural Statistics Yearbook 1993, p. 286 and p. 288.

poverty alleviation had the lowest interest rates, being only 2.88 per cent. Loans to farmers could demand comparatively good rates, but the costs of processing a large number of applications for small loans proved too high to be as attractive as loans to rural industrial enterprises. Therefore, only by putting money into rural industrial enterprises will financial institutions be likely to cover the huge costs resulting from savings generation and to make profits. There are negative aspects, however. Because rural industrial enterprises are highly geared and vulnerable to macro-economic changes, providing a disproportionate amount of credit funds to them would incur higher risks of repayment default, thus violating the principles of prudential management. As Table 5.3 shows, over the 1986–90 period rural financial institutions had higher rates of repayment on principal/interest in lending for purchases of agricultural products and lending to farmers than in working capital loans and equipment loans to rural enterprises. There is also evidence that serious default on interest and principal payments occur in the rural industrial sector during periods of credit squeeze. For instance, in the Tong County Branch of the Agricultural Bank, when the monetary policy was tightened in the country in 1994, bad loans related to rural enterprises increased to 24.4 per cent of the total loans issued in the county branch, and the outstanding interest by rural industrial enterprises grew 182 per cent over the previous year.14 The default was so bad that the normal financial business of the county branch was seriously hit. Staff at

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81

Table 5.3 Interest rates and rates of repayment in rural financial institutions Loan category

1 Working capital to rural enterprises 2 Equipment loans to rural enterprises Years to maturity: 1 to 3 Years to maturity: 4 to 5 Years to maturity: more than 5 3 Agricultural 4 Purchase of grain, cotton, and soybean 5 Purchase of sugar 6 Development loans to underdeveloped regions 7 Farmers 8 Poverty alleviation 9 Welfare 10 Rural credit co-operatives’ reserves 11 Rural credit co-operatives’ deposits

Yearly interest rate (%) (1992) 9.18 10.80 12.06 12.24 6.48 8.46 7.74 5.76 9.36 2.88 7.92 7.56 8.64

Rate of repayment (%) (1986–90) 86.49 37.84 n.a. n.a. n.a. 82.83 90.50 90.50 50.56 87.68 20.70 n.a. n.a. n.a.

Sources: Almanac of China’s Finance and Banking 1994, pp. 504–5, Almanac of China’s Rural Finance 1991, p. 134.

the county branch, whether directors or loan officers, had to commit themselves to a firm target of interest collection each month, or face the penalty of a big bonus deduction. What happened in Tong County Branch was not at all exceptional. Despite this, rural financial institutions would otherwise think that they had a stake in the future of the relatively profitable enterprises by extending funds to the rural industrial sector. As a means of self-protection, rural financial institutions extended the majority of credit funds on terms of short maturity and required rapid repayment in order to recover loans as quickly as possible. Rapid repayment permits faster recycling of funds, thus enabling financial institutions to develop new business in an increasingly competitive environment. This policy is reflected in the loans portfolio of the rural financial sector. As shown in Table 5.4, in 1986 the Agricultural Bank of China and rural credit co-operatives extended 68.68 and 82.02 per cent respectively of their funds to rural enterprises as working capital loans. Already proportionately very high, working capital loans increased to 71.35 and 86.81 per cent in both institutions by 1990. Undoubtedly, lending for short-term needs has been a traditional practice in China’s banking sector. In the pre-reform period, investment in fixed assets was entirely allocated through state budgetary grants to projects that were approved and included in the economic plan, either at the central or local level. Banks dealt with only two kinds of loans: normal working capital quotas (pre-agreed match funding to businesses for normal requirements), and temporary capital funds or non-quota working capital (for unanticipated

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Financing China’s rural enterprises

Table 5.4 Loans portfolio of the rural financial sector (%) Years

Total

Working capital

Fixed capital

Othersa

1986 1987 1988 1989 1990

100.00 100.00 100.00 100.00 100.00

68.68 69.01 68.69 70.14 71.35

25.18 24.56 24.85 23.33 22.45

6.14 6.43 6.46 6.53 6.20

1986 1987 1988 1989 1990

100.00 100.00 100.00 100.00 100.00

82.02 78.69 80.06 84.49 86.81

17.98 21.31 19.94 15.51 13.19

ABC

RCCs

Notes: a Mainly small electricity loans in rural areas. Source: Almanac of China’s Rural Finance 1991, p. 31 and p. 73.

requirements). It was not until 1979 that the banking sector in China began to extend loans for fixed capital investment. Emphasis on short-term loans also conforms to banks’ short time-scale in making money. Loans for long-term investment in fixed assets can incur higher risk because the success of the project is far more difficult to assess; short-term loans are safer because information on existing production and on profit performance of the enterprise is easier to collect and assess. Therefore, lending for short-term needs satisfies the needs for self-protection and profitmaking in the financial sector. From the standpoint of rural industrial enterprises, short maturity of liabilities involves a greater interest rate risk than long maturity, and, in combination with the requirement for rapid repayment, it keeps the enterprise’s debt capacity low and liquidity tight, thus increasing the risk associated with any given level of debt. If a project financed by loans fails to meet the expected targets for sales growth and profitability, or fails because of unexpected external economic influences, the short maturity imposed by rural financial institutions will create real liquidity problems for the enterprise. Thus although short maturity of loans may serve the short-term interests of rural financial institutions, it piles up pressure upon enterprises and increases the possibility of default and insolvency.

New incentive structure and liabilities portfolio One result of partial financial reform was that rural financial institutions pursued their own interests. Although the reforms have not succeeded in converting state-owned and collective financial institutions into commercial ones, reforms did introduce some elements of commercial banking management and hence changes in the incentive structure and liabilities portfolio.

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New incentive structure The incentive structure in the rural financial sector changed after the introduction of the profit retention system into the Agricultural Bank of China in 1983 as a pilot scheme in the overall financial reform. China’s traditional credit management system before 1978 was characterised by tight central control over deposits and lending (the tong shou tong zhi system). Under that system, deposits taken by all banks at the grass-roots level were, through a hierarchical administrative system, eventually turned over to the head office of the People’s Bank of China, while credit was allocated in a top–down system according to the credit plan of the central government. This system of financial management suppressed incentives in the banking sector and sidelined the role of the banking sector in financial intermediation. The responsibility of banks was to oversee the allocation of appropriation and to grant working capital in accordance with government administrative directives. The financial performance of the bank had nothing to do with employees’ earnings. The profit-retention scheme, with its focus on the change in incentive structure, aimed to relax this rigid management system and to improve the performance of financial institutions. In this scheme, after negotiating the rate of profit retention with the Ministry of Finance, the head office of the Agricultural Bank of China disaggregated the pre-set target downwards to county branches. The profit-retention scheme evolved into the contractresponsibility system later in 1988, under which a single target for profit retention was replaced by multiple economic targets, including deposit reserves, purchase of government bonds, lending ceilings, and so on. The new scheme was termed ‘three guarantees and one linkage’ (san bao yi gua): (a) guarantee the remittance of pre-determined profits; (b) guarantee credit control targets; (c) guarantee financial performance measured by rate of return on assets and return on credit funds; and finally link retained profits with overall business performance. Under the contract responsibility system, the Agricultural Bank of China as a whole was obliged in the first place to fulfil commitment of pre-stated taxes and profits to the central budget each year, which in 1988, for instance, was 2.45 billion yuan. Above-quota taxes and profits would then be shared, with one-tenth going to the central government budget and the rest being retained by the Bank.15 Within the Agricultural Bank of China, sub-contracting arrangements that stipulated similar commitments to major financial parameters were made from the top down to branches at the local levels. The after-tax profit retained by banks can be used to expand financial business and to fund employee welfare and bonuses. As an integral part of the reform, the branches of the Agricultural Bank were devolved as cost-accounting units or profit centres, with the rights to handling personnel, finance and business matters, albeit subject to some constraints. With the introduction of the profit-sharing

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scheme and later the contract responsibility system, the branches became increasingly seriously concerned with the performance of their business. They began to adjust their priorities in loan management and extended a disproportionate amount of credit funds to rural industrial enterprises. In the meantime, the bank formulated new regulations for financial management in order to provide a sound foundation for the management of rural industry loans. From 1985 to 1988, for example, the Agricultural Bank of China issued at least six regulations or provisions.16 As regards fixed capital investment loans, the general criteria for the assessment of loan applications were: (a) prospects of the product market; (b) supply of raw materials, utilities and construction materials; (c) suitability of technology; (d) financial results, sales, profits, etc.; (e) availability of the borrower’s own funds; and (f) plans approved (project proposals and reports of feasibility research examined by relevant administrative departments). All these regulations and provisions also applied to rural credit co-operatives. Furthermore, credit rating practices were introduced. Local branches at the county level set up credit rating evaluation teams, each team being responsible for assessing once a year the credit ratings of enterprises that opened accounts with the Agricultural Bank or rural credit co-operatives. The credit ratings consisted of four grades, and enterprises graded as first class could enjoy priority in getting loans from financial institutions. These new polices and regulations were a move in the right direction, but unfortunately they were not seriously enforced because of the problem of partial financial reform, as will be discussed in the next section. These changes in credit management had two effects. The extra funds generated were allocated to banks at all levels provided they fulfilled the pre-stated credit target, so that if funds were used properly, the banks would benefit directly, not only in terms of business development but also the improvement of employees’ welfare. It is specifically the concern with individual benefit that has placed an unprecedented emphasis on savings mobilisation and its better use. Liabilities portfolio As a new incentive structure was created in the rural financial institutions to link employees’ benefits with financial performance, the liabilities portfolio in the banking sector changed as well. This change resulted from the decentralisation of credit management in the banking sector that started in 1979. The focal point of the new system was to link loans with locallygenerated savings and to control the balance between local loanable funds and loans issued. In this new system, local loanable credit funds encompass two parts: credit funds ratified and provided by the higher financial authority, and savings generated locally. Surplus funds occur when the local loanable funds are greater then the year-end loans issued, and vice versa; this is called ‘balance in surplus or in deficit’. Either case would be stated in the contract of

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the financial institution at the lower level and would become the target of financial control. This system required that each local bank draw up a contract with the higher financial authority, including a commitment to control this ‘balance’. After that, the more savings the local banks could attract, the more loans they could extend. With state credit funds being relatively hard to increase, local savings became the most important source of funds.17 It was this decentralisation of credit management, beginning in 1979, that motivated local banks to pay unprecedented attention to the generation of savings. In addition to general credit funds for capital investment and working capital loans, there were a number of special funds to support rural enterprises initiated by the central government for specific policy purposes.18 The distribution of special funds was determined by both the government departments responsible and an appointed state bank. They were package loans for the approved projects and were open to competition from the regions. These loans could become a supplementary source of funds if local project tenders won the grants. The amount of special funds for any region varied from year to year, depending on the quality of local tenders and the ability of the local government to bargain with the state department for the inclusion of their projects in the state plan. With regard to the generation of savings, deposit accounts in the Agricultural Bank of China and rural credit co-operatives were categorised as follows: industrial and commercial deposits; agricultural deposits; and personal deposits. Industrial and commercial deposits were from commercial businesses and industrial enterprises in rural areas; agricultural deposits were composed of three main sources, namely, state-owned agricultural institutions, collective agricultural entities, and individual agricultural businesses; and individual deposits came from rural households. Different categories of deposits in rural financial institutions differed in terms of the interest they bore. In general, there were five kinds of fixed deposits, with a maturity of half a year, one year, two years, three years, and five years. So changes in deposit composition inevitably lead to corresponding changes in cost structure. From the financial institutions’ point of view, deposits from industry and commerce and agriculture were more attractive than individual deposits in terms of interest. Between 1979 and 1987, only current accounts were available to institutional depositors, with interest rates of 1.8 per cent. In the same period, interest rates on current deposit accounts offered to individuals increased from between 2.16 and 3.6 per cent in 1979 to between 2.88 and 6.12 per cent in 1987; interest rates on one-year fixed-deposit accounts to individuals rose from 3.96 per cent in 1979 to between 6.12 and 8.28 per cent in 1987. Apparently, the cost of attracting deposits from institutional savers were rather low. Fixed-deposit accounts became available to institutions after 1983, but again interest rates on such accounts were much lower (only 5.04 per cent in 1987) than corresponding individual fixed-deposit accounts. This

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Table 5.5 Deposit structure of the ABC and RCCs

ABC 1989 1990 1991 1992 RCCs 1989 1990 1991 1992 Notes:

Deposits

Enterprisesa

Agricultureb

Individuals

100.00 100.00 100.00 100.00

23.57 21.77 21.52 23.61

25.15 32.33 30.96 28.65

41.28 45.90 47.53 47.75

100.00 100.00 100.00 100.00

7.57 6.99 7.07 8.68

7.85 7.15 7.42 8.87

84.58 85.86 85.51 82.45

a

Deposits from rural enterprises and administrative institutions. Deposits from agricultural businesses. Source: China Rural Statistics Yearbook 1993, pp. 287–8. b

situation has not changed significantly, despite several adjustments of interest rates for institutional deposits since 1988.19 However, after the dissolution of the people’s commune system in rural areas, the collective agricultural sector dwindled in the 1980s, and savings from this source stagnated as a result. This stagnation was even more striking when compared with the rapid growth of savings from rural households. As McKinnon (1994) pointed out, because farmers did not have access to bank credit, their desired stock of liquid assets was too small in relation to their current income flow, and they began building up their cash and savings deposits relative to their rising incomes. Under these circumstances, deposits from farmers emerged to become the major source of funds for both the Agricultural Bank of China and rural credit co-operatives. By 1992, the share of personal deposits in the Agricultural Bank of China accounted for almost half the Bank’s total deposits; for rural credit co-operatives, the percentage of individual deposits was even higher (Table 5.5), accounting for over 80 per cent of their total deposits over 1989–92. There is no doubt that costs in the generation of savings rises as a result of the disproportionate increase of rural household deposits in the bank’s deposit composition. Expenses increase further due to individual depositors’ preference for fixed-deposit accounts. As shown in Table 5.6, fixed deposits in the Agricultural Bank of China made up 78.9 per cent in 1986, and grew steadily to 84.96 per cent in 1990. The situation in rural credit co-operatives was no different. The share of fixed deposits increased from 70.47 per cent in 1986 to 79.01 per cent in 1990. As fixed deposits bear higher interest rates, the greater the share of fixed deposits, the higher the cost they incur. Competition for savings also drives interest rates higher. In rural areas, not only did the Agricultural Bank of China and rural credit co-operatives compete with one another for deposits, but rural enterprises and non-

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Table 5.6 Composition of deposits (%)

ABC Current deposits Fixed deposits RCCs Current deposits Fixed deposits

1986

1987

1988

1989

1990

21.10 78.90

23.44 76.56

25.98 74.02

17.40 82.60

15.04 84.96

29.53 70.47

29.57 70.43

30.71 69.29

23.60 76.40

20.99 79.41

Source: Almanac of China’s Rural Finance 1991, p. 27 and p. 73.

financial institutions such as rural co-operative fund associations also attracted funds away from both financial institutions through the issuance of attractive shares, bonds, or by offering savings account. The increase in interest rates tended to take a few hidden forms: illegally raising interest rates by 20 to 50 per cent above the official rate; raising interest rates in a hidden way, for example, paying interest on the principal higher than the amount of deposit actually taken; and awarding a bonus or consumer goods in addition to payment of interest (Zhang 1994). No wonder the competition for savings was termed the ‘deposit war’ or the ‘interest rate war’. It became even worse for both the Agricultural Bank of China and rural credit co-operatives because they were restricted to using a certain proportion of their funds in a commercial manner. Local branches of the Agricultural Bank had to devote part of their funds, which were locally generated at a higher cost, to policy-related loans with lower interest earnings. Rural credit co-operatives were required to place two kinds of funds in the Agricultural Bank of China in the form of deposit reserves and re-deposit funds. Since both funds were paid low interest, rural credit co-operatives had to bear financial loss as a result. Finally, index-linked deposits were another vital cost-push factor. Indexlinked deposits on fixed-deposit accounts were first introduced from 10 September 1988 to 1 December 1991 in order to ease the worry of individual savers about the safety of their funds in banks when inflation in the country soared. There were two index-linked accounts on offer, a three-year and a five-year fixed-term deposit account. If the inflation index was equal to or lower than existing interest rates, fixed deposit accounts would be paid at the existing rates; if the inflation index rose higher, the bank paid an extra rate above existing rates to cover inflation-induced risk. Index-linked deposits were re-introduced on 1 March 1993 and stood for about one year. This monetary policy undoubtedly helped restore the confidence of savers in the banking sector, but at the cost of banks’ interests because they had to bear the price of paying additional interest. According to one estimate by the Agricultural Bank of China, for example, rural credit co-operatives alone paid out an extra 400 million yuan in interest in 1989 on index-linked deposits.20

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In short, the introduction of incentive-based reform programmes in the rural financial sector provided an impetus for rural financial institutions to make profits. The decentralisation of the credit management system relegated some powers of decision-making about the use of credit funds to local financial institutions and also caused change in liabilities portfolios. This change resulted in a considerable rise in the cost of the acquisition of deposits, and further contributed to bias in loan management towards higher-return but risky enterprises.

Local government–bank relations The switching of loan priority in rural financial institutions is also affected by the existence of a distinct local government–bank relation. As will be seen in the next chapter, the fiscal reforms of the 1980s strengthened local governments’ interest in the development of rural industrial enterprises, but at the same time their ability to finance these enterprises was constrained by their own budgets. They thus resorted to rural financial institutions for funding. Rural financial institutions found it hard to resist this request. There are three factors that explain this special local government–bank relation. Banks as a quasi-fiscal agent Despite financial reforms after 1978, banks remained not entirely autonomous profit-seeking entities, operating to a greater or lesser extent as a quasifiscal mechanism. This inextricable relationship with local governments is undoubtedly the legacy of the previous economic system, in which the banking sector was primarily used as a fiscal agent to fulfil the government’s multiple objectives. In other words, the role and functions of the banking sector were linked with the financing of government and carried out on behalf of government. A popular saying vividly illustrates this local government–bank relation: the planning commission makes the order (a list of investment projects), and then the bank settles the bill (provides the match funding for the projects). Decentralisation of decision-making has led to some degree of autonomy for the Agricultural Bank of China. Banks became interested in examining the profitability of enterprises and evaluating the feasibility of proposed loan projects. This was called ‘differential treatment, supporting only the best’. But this independence was found by the World Bank (1988) to be limited: local government officials still strongly influence credit decisions made by the Agricultural Bank of China. As a result, local government policy objectives permeate the activities of the banking system. Interdependence Decentralisation also created the sense of interdependence between local banks and local governments. In an economy characterised by the shortage

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of credit funds, local governments need rural financial institutions to provide as many credit funds as possible to supplement the local budget and support their ambitious development programmes, while rural financial institutions need the local government’s help to fulfil their policy objectives and co-ordinate their financial businesses in the local community. Under these circumstances, decentralisation intensified an already segmented rural financial market on the one hand, and invited local governments to become co-administrators, together with the monetary authority on the other. Local branches of the Agricultural Bank of China and rural credit co-operatives began to co-operate with local governments in the preparation of the credit plan. Local governments tended to give some consideration in decisionmaking to non-economic criteria and used the banking system as a fiscal agent to carry out some of the related decisions. In the end, rural financial institutions extended credit in response to administrative requests from local governments. In this way, rural financial institutions were implicitly or explicitly integrated into the domain of local developmental state. It would not be fair to ignore some positive aspects of the local government’s involvement in local financial affairs. First, local governments have an information advantage with regard to the enterprises they found and administer, as argued by Oi (1992) and Naughton (1994a, 1994b). It is not unusual for loan officers in rural financial institutions to have to rely on unaudited financial statements that only crudely summarised the enterprise’s brief operating history; they seldom received carefully prepared financial projections by the applicant. Based on such limited supporting information, the loan officers cannot easily analyse the credit risk of the proposed loans. Especially if the application is for a small amount of funds, the pre-unit costs of analysis and administration of the requested loan are likely to exceed those for a large loan to a prime borrower. Hence, first, with the help of the local government, local banks are better able to evaluate credit ratings of enterprises, assess the risk of new businesses and select qualified projects. Second, local governments serve as a guarantor for enterprises they control, which in some ways eases the difficulties of small firms in finding suitable security. Third, the involvement of local governments helps lower transaction costs when the weak financial market is likely to dim the prospect of any institutional arrangements for borrowing. In short, local governments’ information advantage helps reduce the constraint of information asymmetry as a result of dynamic reform in the financial market, while their authority over their enterprises and in the whole local community also helps ensure the fulfilment of financial contracts. Hence, local government–bank relations help reduce agency costs, to the benefit of the local banks. There are two additional reasons why local banks work so closely to local government and are so keen to take part in local investment. First, local governments are influential in the banks’ personnel management (Ma 1997). Although local bank directors are appointed by the bank’s authority at a

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higher level, local government has to be consulted before appointments are made. More importantly, evaluation of the performance of the local director for the purpose of promotion is dependent on the local government. The head of a local bank branch who is performing in the interests of the local government often receives significant reward from the local authorities in the form of future promotion. Second, many non-wage benefits, from children’s education to staff housing provided to local bank staff, are paid for by the local government (Liew 1997). Mutual interests in competitive credit creation In the partial reform environment, local governments and rural financial institutions shared similar interests and benefits in local competitive credit creation. As mentioned earlier, the pre-determined quota of credit funds assigned to local banks and rural credit co-operatives set the ceiling to which rural financial institutions could grant loans each year. Meanwhile, the earnings of financial institutions were closely linked with the volume of credit funds they extended in loans and they would even gain from over-issuing credit if they could find excuses to do so. However, a small but steady flow of new lending and interest capitalisation to non-performing borrowers resulted in gradual erosion of the true capital of banks. To cover the problems and to gain from the increase of credit funds, it was in the interests of both the local government and rural financial institutions to lobby together for a higher quota of credit funds in the state’s credit plan. Equally importantly, they would also request additional loans from the local centre of the People’s Bank of China, using shortage of policy-related credit funds as the reason. This is because loans extended by the local centre of the People’s Bank of China bear low interest. This phenomenon may be called ‘local competitive credit creation’: local government and local banks together in each region strive for a higher quota of credit funds, more discounted loans and more additional credit funds to relieve the shortage of local funds. This is done regardless of the resulting consequence, namely the huge inflationary pressure on the macro-economy. Here, bank–local government relations should be put in the broader context of the financial system. In particular, the role of local centres of the People’s Bank of China should be taken into account. Because the hierarchy of the People’s Bank of China was organised in accord with the administrative structure, local centres were set up from the provincial capital down to almost every county. For many years, therefore, local governments were able to exert influence on local financial affairs through the appointment of personnel, the setting of credit fund quota and the allocation of credit funds. Local governments forced the local centre of the People’s Bank of China to ask for more funds and special loans, while in the meantime relaxing financial supervision over the financial institutions and financial activities within its administration (Chen 1994).

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Part of this problem results from the confusion of functions between the head office of the People’s Bank of China and its local branches. Until the introduction of the Central Bank Law in 1994, local branches could do whatever their head office did, in particular provide additional loans to branches of the specialised banks. This created a loophole in the monetary management system. One report observed, ‘in a recent meeting with a powerful provincial governor, the official from the central bank found that the provincial boss was on the governor’s side of the table, not his’.21 As the local centre of the central bank stepped in to provide support for liquidity, local branches of the specialised banks were thus able to leverage loans indirectly from the central bank. Since government officials wanted the banking system to extend more credit to their priority projects, they created constant pressure for more rapid growth of credit and hence of money supply as well. In fact, there are parallels with the behaviour of provincial branches of the People’s Bank of China in extending credit to provincial enterprises in excess of the centrally determined policy at the lower levels. This was an important feature of credit policy evolution in China at least until 1989. In effect, the special local government–bank relations subordinated rural financial institutions to the local governments. In some cases, this led to excessive intervention by local governments in the financial business of local banks, and this influenced the change in local policy in favour of rural enterprises.

Undesirable consequences and financial risk Among the undesirable consequences resulting from local competitive credit creation across the country was the over-issuance of credit by the state financial authority and repeated boosts to inflationary pressure. Without proper policy instruments to tackle this problem, the state financial authority resorted to a policy of credit squeezes, which in turn resulted in a very uncertain and inconsistent monetary policy environment and drastic fluctuations in the supply of credit. The growth of rural enterprise loans shown in Table 5.1 illustrates these consequences. From 1979 to 1992 cyclical fluctuations in the growth of credit funds to rural enterprises were larger than rural industrial cycles. The standard deviation and coefficient of variation of the growth of credit funds to rural enterprises are 27.32 and 1.12 respectively, both of which are much higher than the indices of rural industrial growth. This cyclical pattern of credit fund provision reflected not only the difficulties of the financial sector in credit management under dynamic reform but also the inconsistency of macro-economic policy. The high degree of uncertainty in the supply of credit year after year gave rise to serious problems in the financial management of the rural industries. It obstructed both the management of the working capital stream and longer term investment in rural industries. It also forced some enterprises to hoard

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funds when credit management in the banks became slack, thus encroaching on lending to other enterprises. As a result, uncertainty in the financial market exaggerated the shortage of credit funds, while sudden changes in credit policy imposed unexpected financial risks on rural industries. The failure of financial management in rural industries in turn damaged the interests of the rural banking sector itself. In a sense, part of the financial risk associated with rural industrial lending was of the financial sector’s own making. Local competitive credit creation might satisfy highly geared enterprises’ thirst for loans, and allow rural financial institutions and local governments to benefit from additional funds available to them. But the local gains were at the cost of a stable monetary policy environment, with an undesirable inflationary economy as a direct consequence. A turbulent monetary policy may hurt enterprises first because market demand becomes unpredictable, sales growth fluctuates violently, and the shortage of funds becomes unbearable. As economic conditions at the enterprise level deteriorate, default rates rises eventually. To protect themselves in such an uncertain environment, rural financial institutions would be more likely to extend loans with shorter maturity and to demand quick repayment. This further worsens the financial management of enterprises and increases the likelihood of default. In the end, the banking system’s behaviour itself amplifies the rural industrial upturn and downturn and consequently damages its own interests. This might explain in part why bad loans have become such a serious problem for the Agricultural Bank of China and rural credit co-operatives, and why the overall financial performance of both financial institutions has been poor. According to a national survey carried out by the head office of the Agricultural Bank of China in 1987, bad loans made up 17.5 per cent of the total amount of loans by the Agricultural Bank of China, about five percentage points higher than the Industrial and Commercial Bank of China and the Bank of China; a quarter of the bad loans were more than one year overdue.22 In addition, according to Zhang (1994), about a fifth of rural credit co-operatives operated at a loss in 1985. In 1993, the Tong County branch of the Agricultural Bank carried out an investigation of every loan of 500,000 yuan and over. They found that problem loans on average made up 29.3 per cent of all bank loans and that in the four rural credit co-operative surveyed, problem loans accounted for 31.5 per cent.23 In that investigation, the rural credit co-operatives in Niubaotun Township were found to be the worst. These co-operatives had extended loans of 36.92 million yuan to rural industrial enterprises, and by 1993 its problem loans were up to 19.71 million yuan, or 53.8 per cent of total loans, with the outstanding interest alone amounting to 9.38 million yuan.24 Moreover, as seen in Table 5.7, the Agricultural Bank of China and rural credit co-operatives also have poor overall financial performance. For example, in 1993, for every 100 yuan operating revenue, the Agricultural Bank of China and rural credit co-operatives earned no more than 8.5 and 1.3 yuan

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Table 5.7 Performance of selected banking sectors (1993)

Profit/operating revenue ratio (%) Profit/assets ratio (%) Profit/equity ratio (%) Profit per employees, yuan/per person

ICBC

ABC

BoC

CBC

RCCs

8.2 0.42 9.3 14,809

1.8 0.40 8.5 5,109

17.0 0.71 16.5 n.a.

4.4 0.27 6.5 7,291

n.a. 0.15 1.3 1,515

Notes: ICBC  Industrial and Commercial Bank of China, ABC  Agricultural Bank of China, BoC  Bank of China, CBC  Construction Bank of China, RCCs  rural credit co-operatives. Source: Almanac of China’s Finance and Banking 1994, pp. 509–13, pp. 516–17, and p. 553.

after-tax profits respectively. The average profit earned per employee was only 5,109 yuan in the Agricultural Bank of China and 1,515 yuan in rural credit co-operatives (in the case of rural credit co-operatives, only full-time staff are counted).

The rural financial sector under dynamic reform How could the financial sector continue to ignore the principles of prudent management, and how could enterprises’ abuse of rational debt financing have been sustained without affecting either party involved? These questions can be properly understood only when the environment of dynamic reform in the financial system is taken into account. Among other factors, the soft budget constraint on rural financial institutions was vital. Despite the substantial changes that had occurred, rural financial institutions continue to be characterised by such soft budget constraints, which to a great extent resulted from the nature of dynamic reform in the financial system. First of all, soft budget constraint is associated with the financial institutions’ controversial dual role. Financial reforms over the 1980s placed emphasis on the incentive structure of financial institutions, but overall, the Agricultural Bank of China and rural credit co-operatives did not and could not take full responsibility for profits and losses. The reason lay in the conflict between the two roles of these institutions. As a financial agent of the government in the rural areas, the Agricultural Bank of China was assigned to implement the state’s monetary policy in general and the state’s rural credit policies in particular. In order to comply with the anti-inflation policy throughout most of the 1980s and the early 1990s and to guarantee credit funds for agricultural development and rural infrastructure, the Agricultural Bank of China often had to suppress its own commercial interests in loan management in favour of other social and political considerations. On the other hand, however, financial reforms gradually pushed the Agricultural Bank of China into becoming a commercial financial institution, with an intensified self-interest in maximising profit and in managing the use of credit funds on commercial principles. In some circumstances, both objectives could

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not be accommodated with ease, and often the Agricultural Bank of China’s controversial dual role in the rural financial market made it difficult to clarify the conflict between profit and non-profit tasks. Rural credit co-operatives were not responsible for their profits and losses either. Unlike the Agricultural Bank of China, they were not acting on behalf of the government financial administration in rural areas, but as mentioned earlier, they were the grass-roots financial units of the state bank, and their operations had long been restricted by the state mandatory credit plan. Prior to 1979, rural credit co-operatives were used mainly to mobilise rural savings into urban industrial development via the People’s Bank of China, with only one fifth of their deposits being retained for rural development. After 1979, rural credit co-operatives played a greater part, particularly in commercial lending in rural areas. But the difficulty they faced was that the relationship between the Agricultural Bank of China and rural credit co-operatives was not yet streamlined, with the latter being treated as collective rather than co-operative financial institutions. Hence, in organisational arrangements, rural credit co-operatives were closely integrated into the network of the Agricultural Bank of China. The People’s Bank of China delegated to the Agricultural Bank of China the power to manage and oversee rural credit co-operatives. In many regions, the county association office of rural credit co-operatives and the local branch of the Agricultural Bank of China either had two titles but the same group of staff or were closely affiliated with the Agricultural Bank of China’s county branch, with the local director of the Agricultural Bank being the head of the county association office. In financial operations, rural credit co-operatives were obliged to re-deposit 30 per cent of their total deposits with the Agricultural Bank of China throughout the 1980s, and 19.2 per cent in 1992.25 Those re-deposit funds bore low interest and were used to make up the shortfall in the state’s fiscal investment in the procurement of agricultural products and financing of rural infrastructure. In this indirect fashion, rural credit co-operatives were forced to make a large contribution to the policy-related financing of rural development. In 1993, rural credit co-operatives contributed over 26.5 per cent of the Agricultural Bank of China’s total deposits. With the high cost of savings generated from farmers on the one hand and the leakage of funds to the Agricultural Bank of China on the other, many rural credit co-operatives found the costs too high to absorb. In lending operations, the Agricultural Bank of China set the rules and oversaw the application of the regulations, while in the meantime local branches of the Agricultural Bank of China competed with rural credit co-operatives for similar customers and similar investment opportunities in rural areas. This contradictory arrangement made it even harder for rural credit co-operatives to do business. Moreover, each time a credit squeeze was implemented, they had to follow stringent monetary policies of tightening credit, no matter what the implications were. Two examples can illustrate the lack of independence of rural credit co-operatives: the involuntary use of the

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index-linked deposit scheme, and the zero increase in lending for fixed capital investment imposed universally by the central monetary authority in 1985. From 1984 attempts were made to re-establish rural credit co-operatives as farmers’ co-operative organisations. The purpose was to restore in the rural credit co-operatives the system of democratic management, flexible operation and independence from the Agricultural Bank of China. New farmer members were invited to participate, a new management system for the credit co-operatives was proposed, and county associations of local rural credit co-operatives were set up in many places to develop inter-regional linkages between credit co-operatives. As a result of these changes, the business operations of rural credit co-operatives began to separate from the Agricultural Bank of China. Rural credit co-operatives gained some independence in running their businesses. First, they were not obliged to place surplus funds with the Agricultural Bank of China; second, they were allowed to float interest rates within the approved margins; third, the rate of redeposit was reduced. In general, however, the reform of the rural credit co-operatives did not succeed. County association offices continued to be affiliated with the Agricultural Bank of China’s county branch and chaired by the director of the Agricultural Bank of China at that level. There is no doubt that rural credit co-operatives have suffered from their subordination to the Agricultural Bank of China and the resulting distorted financial management. They were crippled by a system designed to mobilise capital for the state’s non-economic purposes in rural areas. However, they also had something to gain from the financial protection provided by the Agricultural Bank of China, virtually on behalf of the monetary authority, because the Agricultural Bank of China would extend subsidies to those credit co-operatives that incurred operating losses or had difficulties in breaking even in the 1980s. In short, the Agricultural Bank of China and rural credit co-operatives might have been granted some degree of independence, but the freedoms of these banks were still severely circumscribed. They might therefore not have the ability or incentive to maximise long-term profits for the bank rather than short-term benefit for themselves, or would not be concerned if they made losses because both could expect to obtain assistance from the monetary authorities should there be any liquidity or solvency problems. Therefore, considerations of prudential management and economic responsibility for decisions regarding lending were still only limited. This explains why credit was soft and rural industrial enterprises rated it high in their financing strategy, and this makes sense of why rural financial institutions were able to endure excessive risk-taking and with it the financial defaults they incurred.

Conclusions This chapter has examined the relationship between loan management in the rural financial sector, consisting mainly of the Agricultural Bank of

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China and rural credit co-operatives, and its implications for the pattern of financing of rural industries in the 1978–94 period. The rural financial sector was deeply involved in the growth of the rural economy. In particular, its contribution to the fast-growing rural industrial sector was enormous. Each year, more and more credit funds were channelled into rural industrial enterprises by rural financial institutions. This phenomenon reflected an overall improved economic policy environment in the post-1978 period. But the analysis in this chapter has argued that at the micro-level there were genuine reasons for rural financial institutions to be enthusiastic about giving priority to rural industrial lending. On the one hand, rural industrial enterprises performed better than agricultural activities in making profits, despite drastic fluctuations in profitability over years. On the other hand, loans to rural industry could demand higher rates of interest than any other loan category. So the prospect of making money quickly was appealing. The switching to a lending strategy of trade-off between yield and risk was essentially motivated by the changes in incentives and liabilities portfolios. These changes were the outcome of a financial system in dynamic reform. Because the profit-sharing scheme and its later development focused on the incentive side of banking management, local financial institutions became seriously concerned with the performance of their financial businesses. Meanwhile, changes in the credit management system emphasised delegation of responsibilities and rights. In particular, the new credit management system linked loans with locally-generated savings and led to significant change in liabilities portfolios. While rural financial institutions enjoyed some independence in loan management, they had to bear the rising cost of their generation of savings. As a result, changes in both incentives and liabilities portfolios contributed to the bias in loan management towards higher-return but risky enterprises. The change in lending policy was also influenced by the special local government–bank relations. First, rural financial institutions did not become autonomous financial entities but operated as a quasi fiscal agent on behalf of local governments. They were used as a policy tool to satisfy the expansionary drive of local governments. Second, financial decentralisation intensified the interdependence between local financial institutions and local governments. From the financial institutions’ point of view, the information advantage of local governments helped to reduce agency costs resulting from an economic system in dynamic reform. Third and finally, the mutual interests of rural financial institutions and local governments were realised through engagement in local competition credit creation, that is, they lobbied together for a higher quota of credit funds, more discounted loans and more additional credit funds to relieve the shortage of local loanable funds. These local government–bank relations, however, produced undesirable consequences and increased financial risk within the enterprises. This is because competitive credit creation led to the over-issuance of credit at

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national level and built up inflationary pressures in the macro-economy. The frequent changes in monetary policy aimed at tackling this inflation resulted in drastic fluctuations in credit provision, leading to turbulent instability in the macro-economy. To protect their own interests, rural financial institutions tended to extend loans with short maturity and require rapid repayment. This created further difficulties for the financial management of the enterprises and led to a higher default rate, which adversely affected the performance of the rural financial sector. Although rural financial institutions faced higher risks in switching policy, in fact they were not risk-bearers. Rural financial institutions served a dual role, such that their budget constraints could be softened. This was possible simply because the financial system was only partially reformed. Under these circumstances, they were able to provide soft credit to rural industries and play a part in the functioning of the community risk-sharing mechanism, as shall be seen in the next chapter. Therefore, the dynamic reform of the financial system provides the explanation of why rural industrial enterprises in the 1980s could finance their fast growth through over-dependence on debt financing without higher rates of business failure. It also explains why rural financial institutions could withstand the financial risks.

6

Local state capacity and community risk-sharing

The last chapter discussed the consequences of dynamic reform within the rural financial institutions for the pattern of financing of rural industries. These were mixed. The debt capacity of rural industries seems to have been strengthened by soft credit but weakened by loans with short maturity and requiring rapid repayment. The willingness of rural financial institutions to accept risk in exchange for short-term profits increased the availability of loans to rural industries, but instability of credit provision as a result of local competitive credit creation made the financial management of rural industries more difficult and increased financial risk. However, local government–bank relations favoured rural industries and provided businesses with a helpful cushion against risk. This leads to the final issue addressed by this study: the role of local government in the financing of rural industries. Local governments were the main activists in promoting rural industrialisation after 1978. Previous studies (Byrd and Lin 1990, Oi 1992, among others) have convincingly demonstrated the significance of fiscal reforms in the early 1980s for local government involvement in the development of rural industrial enterprises. The pattern of financing displayed in the rural industrial sector and the way rural industries absorb financial risk was found to be closely linked to the functioning of local governments. Why are rural industrial start-ups born with financial weakness? Why are rural enterprises haunted by their weak financial position throughout their development? How do local governments help them to accommodate financial risk? How does the community mechanism of risk-sharing function? And finally is the balancing operation in local community with small industrial base possible? To answer these questions, this chapter examines two aspects of local state capacity. In the World Development Report 1997, the World Bank (1997) defines state capacity as ‘the ability to undertake and promote collective actions efficiently, such as law and order, public health, and basic infrastructure’. Obviously, local governments have narrower responsibilities and obligations than those of the central government as envisaged in this definition. This chapter will focus on local financial capacity and local institutional capacity.

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The chapter investigates the under-capitalisation of rural enterprises from a local government perspective, and the community mechanism for risksharing to help failing enterprises. The first section explores the implications of the expansionary drive by local governments to promote existing enterprises in the growth stage. The second section investigates the imbalance between local governments’ revenue capacity and their financial responsibilities, and the impact of this imbalance on the financing of enterprises. The third section goes on to examine the effect of local competitive tax evasion on the debt capacity of enterprises and its undesirable consequence, while the final section analyses the community mechanism for risk-sharing and its role in the financing of rural industries over the period 1978–94.

The expansionary drive As has been seen throughout the 1980s and early 1990s, rural industrial enterprises, whether new firms or existing ones, exhibited the common characteristics of financial weakness as a consequence of being highly indebted. This problem was associated with insufficient funds available for start-up investment and equity finance provided by local governments. This phenomenon can be arguably attributed to the strong expansionary drive by local governments: the ambition of local governments over-stretched their financial muscle and reduced each enterprise’s chance of full financing within a given local budget. Such expansionary drives seem to be a salient feature of socialist economies (Kornai 1986). Wong (1987) has argued that in China the expansion was driven by methods such as local governments using decentralised funds for investment in increased production; this had been possible since 1984, when the authority to manage fixed capital investment was relegated to lower administrative levels. This expansionary drive can be explained by at least three factors. First, it stemmed from the overwhelming pressure to create jobs for the huge surplus of farmers just released from the agricultural sector. Job creation has been cited as the paramount objective of local governments in setting up industrial enterprises by numerous previous studies, for instance Byrd and Lin (1990). As discussed in Chapter 4, new enterprises tend to be relatively more labourintensive and have greater opportunities to substitute labour for capital than enterprises in later stages of development. So the incentive to set up more new enterprises is related to the pressure to create more jobs in the industrial sector. Second, on the demand side, expansion was driven by the market boom of the late 1980s. This boom was deeply rooted in the long-standing shortage economy, another salient feature of socialist economies according to Kornai (1998), in which there was an imbalance between demand for commodities and their supply. This state of shortage became worse as a result of a rapid increase in rural purchasing power, together with the central government’s incompetence in controlling institutional purchasing and the irrational

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over-distribution of profits by state-owned enterprises. As an early investigation (CESRRI, 1987) found, the growth in production of the whole manufacturing sector lagged far behind the growth of consumption funds. This mismatch in the consumer goods market triggered a strong drive to excessive industrial investment, because entry into that market was easier and profitable. Third and finally, the expansionary drive was fuelled by soft bank loans. The thirst for investment was not a new phenomenon in the socialist economy. The difference was that the traditional expansionary drive up to 1978 was more closely associated with increased fiscal investment, whereas the new drive was mainly motivated by soft bank loans after the new system of ‘substitution of loans for budgetary appropriation’ was introduced in 1979–80. Local governments thus pressurised local banks to extend additional credit funds to industrial enterprises. In this way, as discussed in the last chapter, they supplemented their tight budgets with credit funds and pursued local benefits at the cost of macro-economic stability. This expansionary drive worsened the financial strains that already existed in local government budgets, and made it impossible for local governments to match the enterprises’ requirement of equity capital and to improve the financial strength of each individual enterprise.

The financial capacity of local governments The expansionary drive is only one factor that gave rise to financial strain in local government budgets. A more fundamental problem is attributable to the imbalance between the revenue capacity of local governments and their expenditure responsibilities. The structural condition of local state capacity in the 1980s and early 1990s can be traced to the pre-reform system, specifically to the dualistic development strategy of ‘walking on two legs’ in the 1960s and 1970s, which called for a self-reliant rural sector. According to the dualistic development strategy, the countryside had to take care of itself, without imposing financial burdens on the urban sector or the central government. All rural services were funded from collective accumulation, but to encourage savings and investment, the countryside was left largely untaxed, and rural enterprises were exempted from virtually all direct and indirect taxes (Wong 1988, 1990). This logic of local self-reliance remained dominant in the post-1978 period, despite remarkable changes in the rural political and economic system after the introduction of rural economic reforms. The new problem facing local governments was that the main sources of revenue available under the previous system were now either considerably reduced or lost altogether, while spending on local services remained consistent. Local governments ended up with an imbalance in financial capacity and responsibilities. It is understandable that local governments should resort to rural industrial profits to make up the shortfall in their budget. Thus the over-collection of industrial

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profits in combination with the lack of equity capital investment contributed to the weakening of the financial position of rural industrial enterprises. The revenue capacity of local governments The change in the revenue capacity of local governments occurred in the late 1970s and early 1980s when the household responsibility system was introduced and the commune system was dissolved. First, investment by central government in agriculture diminished steadily in relative terms. From 1978 to 1988, for example, the percentage of agricultural investment expenditure in the central government budget decreased from 13.6 per cent to only 7.9 per cent.1 The increasing gap left was expected to be made up by local governments. Moreover, the central government had once allocated an annual funding of 700 million yuan to support the people’s communes, at least half of which was earmarked for investment in rural enterprises; this source of funds was phased out after 1980. Second, the management of collective assets and public accumulation was badly damaged by the drastic change in the rural administrative system. At the time when rural reforms were launched in 1978, fixed assets at all three levels (commune, brigade and production team) were valued at an estimated 80 billion yuan and public accumulation funds at 8.71 billion yuan (Zhan and Liu 1984). However, these financial resources were not well managed and protected. In the establishment of the new form of organisation based on the household unit, assets were sold to individual households or groups of households without being properly valued. The money thus obtained was not re-invested but held in the form of idle balances. Local governments in some areas ended up with serious losses of collective assets and public accumulation.2 Third, labour mobilisation on a large scale was no longer available to local governments as it used to be.3 The implications for local budgets were enormous because labour substitution for capital in rural construction was once the vital means used by local governments to supplement the shortage of funds in local budgets. It was estimated by Griffin (1984) that at its peak in the 1970s labour accumulation in construction activities accounted for more than 20 per cent of rural labour time or more than 100 million workers.4 Finally, intergovernmental transfers from central government to local governments were once a significant source of funds for purposes such as social and disaster relief, price subsidies for the production of grain, cotton and oil, and special subsidies for rural health and education. Again, revenues from intergovernmental transfers fell in real terms from the early 1980s. According to Wong (1997), in Puding County, Guizhou Province, for example, subsidies financed about 80 per cent of the county’s budget through the mid 1980s, but this fell to just 40 per cent in 1993. Despite all these changes in local government budgets on the revenue side, local governments could not reduce their expenditure if they were to

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maintain at normal standards the economic and social development of their jurisdictional communities. Indeed, they found it very hard to prevent their additional expenditure from spiralling as inflation grew. Under these circumstances, the introduction of the fiscal contracting system in 1984 gave them a chance to restructure their budget. As the commune system was replaced by a new system, the township was soon made an independent entity in the public finance system. At the same time a system of fiscal contracting was introduced.5 Four types of revenue-sharing arrangements in the fiscal contracting system were used at the township level, with the most common form being the fixed-rate remittance of incremental revenues.6 Under the new system, town and township finance consisted of three sources of income: budgetary revenue, extra-budgetary revenue (yusuanwai zijin), and local self-raised funds (zichou zijin). Budgetary revenues were allocated by the next higher level of government and used for earmarked purposes. Having collected tax revenues on behalf of the state, town and township governments received a pre-set quota of budgetary revenue ratified by the county financial administration. In general, the fixed quota of tax revenue was determined by the county tax office, being calculated from the tax income of a base year together with a pre-determined annual increase. Under the taxation system in the 1980s, production tax, VAT and turnover tax on industrial and commercial enterprises were the three most important tax incomes shared among local, regional and central administrations. Of the other taxes, the following were under the control of the township and town: slaughter tax, urban maintenance and construction tax, free-market transaction tax, animal transaction tax, contract tax, vehicle and vessel transaction tax. One of the characteristics of budgetary revenue is that it tends to be used for earmarked purposes, for instance, spending on agriculture, town development, administrative expenses, rural education, social welfare expenditures, and aid and relief. In principle, local governments do not have discretion over these expenditures. However, in practice there are loopholes. First, local governments can treat the cost accounting in enterprises loosely. As Oi (1994) found, income tax rates are not negotiable, but the tax an enterprise pays can be reduced by inflating costs, thus decreasing profits. In Chaoan County, for example, key enterprises were allowed to count as valid costs the higher wage bill and higher rate of depreciation.7 Second, local governments can use the power of granting tax reductions and exemptions as an alternative to altering the amount of revenue turned over to the state. These issues will be examined further in the fourth section of this chapter. According to the state regulations, extra-budgetary revenues at the township level were regarded as funds not counted in the budgetary revenues but collected and used by local governments, institutions, and administrative organisations. The three main sources of such extra-budgetary revenues are local surtaxes, special funds to do with enterprises, and funds for non-profit

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and administrative units. Of these, local surtaxes provide the largest revenues to local governments. Local surtaxes are charges for the use of local infrastructure and services, and should be sanctioned by the county’s finance bureau; revenues thus generated are shared between the county government and all other responsible institutions. Because extra-budgetary revenues are collected and managed by each individual administrative unit that is responsible for providing the service, some of the local extra-budgetary revenues can become ‘pocket money’ (xiao jin ku) of the administrative departments concerned. Local governments would meet strong opposition and face resistance to any attempt to take them over. Excluding state-owned enterprise funds, the division of extra-budgetary revenue in 1993 was found to be about 10 per cent went to local governments and 90 per cent to local administrative units (Wong 1997). The extrabudgetary revenue became the area that local governments were able to manipulate in order to encroach on revenues that would otherwise accrue to or be shared with the central government. After local surtaxes, the next largest source of extra-budgetary revenues at local government level was the accumulation and retention of collective funds.8 Collective funds are the revenue that township and village governments collect from rural households for the administration of contracts. They include public accumulation funds,9 public welfare funds (support to vulnerable families and subsidies on nursing homes), and management fees (for administrative spending, management of contracts, maintenance of irrigation systems, and subsidies for rural part-time accountants). In practice, local governments have firm control and the final say only over the collection and use of self-raised funds. The township self-raised funds mainly consisted of profits remitted by local collective enterprises. In some areas, for example in Shandong, township governments imposed a ‘unified levy’ (tongchou fei) to finance five services: rural education, militia training, cadre subsidies, and old-age and welfare support (Wong 1997). Local governments have full discretion over the use of self-raised funds, and in a sense this source of funds constitutes the decisive part of income in determining the local government’s financial capacity. As far as self-raised funds are concerned, the critical factor that determines the income distribution between enterprises and local governments is the ratio of profit remittance. The Ministry of Agriculture declared that at least 60 per cent of after-tax profits should be retained by the enterprises.10 As seen in Chapter 4, however, the central government’s stipulation has not been strictly observed. In terms of fiscal relations, some township economies are very similar to the previous national centrally managed economy, in which enterprises’ profits were part of the government’s budget (Fan 1998). Local governments under severe fiscal strain tend to impose a variety of user fees and charges. A number of surveys have indicated that rural industrial enterprises paid substantial taxes and levies. It is not unusual for them to pay

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fees in order to retain their rights to co-operative medical care, collective grain rations, subsidised education, water, electricity, etc. An investigation by the Ministry of Agriculture in the early 1990s found that rural enterprises were charged more than 50 different fees, of which only 44.6 per cent were considered proper, 5.4 per cent improper and 50 per cent unreasonable.11 The financial responsibilities of local governments Despite some flexibility in extracting local self-raised revenues, imbalances between expenditure and revenue in local government budgets persist. Between 1979 and 1993, local expenditure responsibilities included the basic plant construction and technical improvement of locally-owned enterprises and their new product development; rural production assistance, agricultural development and water conservation at the local level; small town construction and maintenance; education, health, culture, and social services; social welfare and pensions; administrative expenditures; and a range of price subsidies. Most of these expenditures had to be funded out of a tight local budget, in which a large portion of revenues was self-raised (Ma 1997). As Wong (1997) found, budgetary outlays at the county level were roughly divided into social services (40–45 per cent), administration (20–30 per cent) and capital expenditure (10–15 per cent). At the township level, the major expenditures of budgetary revenues were culture, education, and health (40–55 per cent), administration (15–20 per cent) and welfare assistance (25 per cent); while at the village level, expenditure responsibilities consisted of salary or subsidy payments to village cadres, social welfare for the aged and infirm, and sometimes supplementary educational or health-care expenditures. As mentioned earlier, after the transformation of the communes, townships lost the right to appropriate a portion of agricultural output for investment and social services. Furthermore, they could no longer mobilise labour for public health and infrastructure works, because they were not permitted to use labour and resources without adequate compensation. Most townships and villages were not able to replace these lost resources with revenue from taxing households, and many faced severe financial problems. According to a survey by the Operation and Management Station of the Ministry of Agriculture, some 15 per cent of villages in 1989 did not have any revenues, and many more had budget deficits and could only maintain public works on a very small scale by borrowing (Shi 1995). On the expenditure side, the shift to household farming and the disbanding of agricultural collectives in the early 1980s meant local governments had to find new ways of financing public services, such as education, health care, old-age support, and welfare for poor families, which previously had been financed from collective public accumulation funds. In other words, while the countryside, as usual, had to provide for itself, this time the financing mechanisms provided by collective agriculture were gone.

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There were three major challenges on the expenditure side. First, there was a chronic shortage of funds for agricultural investment because of the shrinkage of state investment and farmers’ lack of interest in agricultural investment. Local governments were reduced to taking overall responsibility for covering the shortage of funds. The major source of funds they could confidently rely on were rural enterprise profits, under the provision for ‘using industry to support agriculture’ (yi gong bu nong). As shown in Table 4.5, rural industrial enterprises contributed 12–19 per cent and around 5 per cent of their net profits to the agricultural sector in the periods 1980–3 and 1984–7 respectively. Furthermore, there was a severe shortage of state funds for both education and health, so local governments had to generate funds to contribute towards the cost of facilities and personnel. According to Croll (1994), in Wuxi village in 1990 profits from industry contributed 530,000 yuan to the village funds. However, 470,000 yuan went to agricultural investment, and 60,000 yuan was allocated to welfare, including public health (25,000 yuan), single-child family benefits (20,000 yuan), investments for those over sixty years of age (13–15,000 yuan), aid for retired village cadres (3,000 yuan) and help given to those households in difficulty (3,000 yuan). A large sum, 15,000–20,000 yuan, was spent on village buildings and the village environment, and 25,000 yuan was given to the primary school. Tang et al. (1994) also found that construction for the rural health care system relied very much on the contribution of rural industrial profits. Finally, users’ demand for improvement of the local infrastructure is another factor that contributed to the imbalanced local budget and affected the allocation of local government funds.12 On the one hand, the development of rural industries demands thorough improvement of local infrastructure because adequate quantity and reliability of infrastructure are key factors in the improvement of users’ productivity and also in the ability of the local community to compete in external markets. The reality is, however, that the improvement of existing local infrastructure tended to lag far behind the development of rural enterprises and thus gave rise to a severe shortage in power supply, a poor system of local roads, and so on. Therefore, infrastructure investment has always been in very great demand. The task of improving infrastructure is extremely demanding, however, because investment in local infrastructure requires relatively large capital inputs with a return over long time spans. As investment in local nonproductive projects increased considerably, pumping investment back into collective enterprises was reduced. In Fengxi Township, Chaoan County, investment in local telecommunications projects was made by the county government, while the township government was responsible for investing in road works, electricity projects and a water supply system. Between 1990–94 the township government invested over 21 million yuan in road improvement, 20 million yuan in a water supply factory and 5 million yuan in a petrol station.13

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On the other hand, the emergence of non-collective industries also imposes pressure on local governments to expand public investment in order to improve local economic conditions, thus contributing to the shortage of funds in the local budget for collective industrial enterprises. The advantage of collective industry over private enterprises had been its compatibility with the political-economic ideology that called for the dominance of the public economy in much of the 1980s. However, as ideological purity gradually gave way to economic pragmatism, private and individual enterprises emerged as the most dynamic sector in rural areas (see Table 3.2). These enterprises contributed to the local economy in job creation, improvement of rural household net income and government revenues, all of which accord well with local government development goals. In particular, tax revenues from individual and private enterprises became a very lucrative source of income for local governments. For example, Oi (1992) found that taxes on the private sector accounted for close to a quarter of all taxes collected in one Shandong County in 1990.14 Given their significant presence in the local economy, it is understandable that private enterprises should demand that the local government play a relatively neutral role as the governing body of the local community rather than as the protector of collective enterprises. In sum, the persistent weak financial position of rural industrial enterprises in the 1980s and 1990s is in part the result of the imbalance between revenue capacity and responsibilities at local administrative levels. At the same time the significance of some traditional revenues was reduced, what remained intact were the major expenditures and the idea of local self-reliance. While this motivated local governments to promote the development of rural industries, it also forced them to drain profits from the enterprises they administered in order to make up the shortfalls in their revenues. In this process, direct investment by local governments, particularly in existing enterprises, became insignificant. But, as will now be seen, indirect support was widely offered as an alternative.

Competitive tax evasion As discussed before, there were loopholes in the taxation system between 1978 and 1994. By exploiting the weaknesses in this system, local governments could divert part of the tax revenues away from the state budget, to use for their own purposes or direct towards enterprises. This practice has been called ‘competitive tax evasion’ (Liew 1997). In contrast to tax evasion by enterprises, competitive tax evasion means that local governments vary their tax collection efforts in order to influence effective local tax rates. This is done largely at the cost of the central government, because these actions reduce the level of revenues remitted to it (Bahl 1998). The essential enabling condition for competitive tax evasion is lax tax collection. This includes excessive preferential treatment of local tax, inflating costs by accelerating depreciation, and tolerance of illegal tax evasion by enterprises.

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Tax reduction and exemption This practice becomes possible because the authority to grant tax reductions and exemptions is delegated to as low as county level. Under the fiscal contract system, tax rates and tax bases were normally set by the central government and only the central government had the authority to abolish old taxes, introduce new ones and change tax rates. For centrally-fixed and shared taxes, only the central government could offer tax concessions and exemptions. The revenue-sharing system stipulated that local governments could offer tax exemptions and reductions only on locally-fixed items, while exemptions or reductions on centrally-fixed and central-local shared items were subject to approval by the centre, except for those areas where special policies applied. However, because local governments are the tax agents for the central government, they are able to influence effective tax rates by varying their tax collection efforts, thus taking advantage of the weaknesses in the taxation system in the economic transition period. The declining tax ratio reflects this transfer of funds. Because local governments have control over local enterprises, they have incurred no direct and immediate costs by engaging in competitive tax evasion. On the contrary, tax reductions and exemptions have double benefits for the local economy. For the local enterprises, this favourable treatment helps them to improve their cash flow in their initial stage of development, while for the local government it means less revenue is turned over to the state. Overall, it expands the local gain on taxation. In Chaoan County, for example, 4,579 enterprises together retained 78 million yuan more profits through such favourable taxation arrangements over the period 1981–8, and between 1992–4, 45 enterprises together gained 10.3 million yuan through reductions in turnover tax and income tax.15 From data available for township and village industrial enterprises in selected years, it can be seen that rural industrial enterprises enjoy much lower tax rates than other sectors. One early report estimated that in 1991 and 1992, the effective income tax rate was between 29.01 and 33.39 per cent for profitable state-owned industries, 21.20 and 25.3 per cent for collective enterprises, and 27.76 and 29.7 per cent for private enterprises (Wang 1994). But in the 1989–92 period the average effective tax rate paid by rural industrial enterprises was only 19.48 per cent. It is estimated that rural industrial enterprises should have paid income tax of 24.45 billion yuan, but in fact paid just 14.29 billion yuan, thus retaining 10.15 billion yuan over the period. In terms of turnover tax, the payable tax over the same period was 90.15 billion yuan but the actual payments were 67.95 billion yuan, which made rural industrial enterprises 22.21 billion yuan better off.16 The gains from both income tax and turnover tax by rural industrial enterprises are surely the result of loose tax administration by local governments.

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Accelerating depreciation Competitive tax evasion is also fostered by local governments’ loose attitude towards depreciation. By allowing enterprises to inflate costs through depreciating capital assets at a faster rate than the official benchmark, local governments give the enterprises they administer the privilege of reducing their tax bills, thereby equipping themselves with additional finance. As seen in Table 6.1, between 1989 and 1992 the average rate of depreciation in rural industrial enterprises rose from 7.98 per cent in 1989 to 9.04 per cent by 1992, and depreciation funds made up 42–48 per cent of the cash flows of these enterprises. Overall, depreciation rates in rural industrial enterprises were much higher than in state-owned enterprises and urban collective enterprises, whose rates were only 4.26 per cent and 5.73 per cent respectively in 1991.17 There is some evidence that fast growing enterprises depreciate their capital assets at faster rates. One example is the Dongbao Arts & Crafts Ceramics Co. Ltd in Fenxi Township, Chaoan County, which is a joint venture company set up in 1992. By the end of 1995 the company had fixed assets of 4.5 million yuan, and sales earnings of 18 million yuan, 38.5 per cent higher than the previous year. The company depreciated its capital assets at a rate of 18 per cent, and expected to recover its investment in five years. Anpu No.1 Sweet Factory in Anpu Township of the same county provides another example of using an accelerated rate of depreciation to boost the enterprise’s technical up-grading and to increase its cash flow. The factory had fixed assets of 10 million yuan and produced output of 16 million yuan in 1994. The rate of depreciation in this factory was as high as 33 per cent. Illegal tax evasion by enterprises Finally, lax collection of taxes may mean that local governments endure or tolerate wide-spread illegal tax evasion by enterprises, which further damages the interests of the centre. While reports on tax arrears are scant, they seem to be substantial and have been on the rise. A national survey revealed that in 1988, total tax evasion by private enterprises alone throughout the country amounted to over 18 billion yuan and that 70–80 per cent of private enterprises in China were estimated to be involved in tax evasion.18 Serious efforts to crack down on tax evasion have been made every one or two years nation-wide, but the situation as a whole has not dramatically changed.19 From a total of 10 billion yuan at the end of 1994, tax arrears totalled over 25 billion yuan by the third quarter of 1995 (Atinic and Hofman 1998). There are a number of ways that enterprises may evade taxes. For very small firms, the most obvious way is simply to register at the local bureau of industry and commerce but not at the local tax department. Tax exemption regulations can also be manipulated. Because tax regulations usually grant tax incentives to various specific enterprises over a certain period

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Table 6.1 Depreciation in rural industrial enterprises Years

Rates of depreciation (%)

Depreciation funds (billion yuan)

Contribution to cash flow (%)

1989 1990 1991 1992

7.98 7.94 8.79 9.04

13.09 15.14 20.12 27.10

42.4 47.2 48.6 42.3

Notes: Cash flow is defined as net income (after-tax profit) plus depreciation (Weston and Brigham 1993). Sources: Almanac of China’s Rural Enterprises, 1989–93, various volumes.

of time, enterprises are able to exploit the potential of this policy through re-registration. In other words, as the tax exemption expires, they change their appearance and apply for registration anew, using this pretext to avoid paying state taxes. They may also opt for attaching themselves to collective enterprises, so-called ‘wearing a red hat’ (dai hong mao), in order to claim various benefits, including preferential tax treatment. Other common methods have been to avoid setting up an accounting system and not to issue receipts so the government cannot accurately assess the taxable incomes. Outcome of competitive tax evasion The prevalence of competitive tax evasion observed in the 1980s and early 1990s had serious consequences. First, while competitive tax evasion altered the distribution of taxable revenues in favour of local governments, it contributed, to a great extent, to the state’s fiscal decline. This indeed has become a major policy concern of the reform period since 1978. It is estimated that government revenues declined from over 34 per cent of gross national product (GNP) in 1978 to less than 12 per cent in 1995 (Atinc and Hofman 1998). Of course, the state’s fiscal decline can only partly be explained by lax collection and exemptions from taxes invited by the intergovernmental fiscal contract and facilitated by the decentralised tax administration system. But the reduced budgetary resources undoubtedly weakened a budget system that was still geared toward financing the state’s economic development plan, while the proliferation of extra-budgetary and self-raised funds increasingly undermined the macro- and micro-economic functions of the budget. Second, competitive tax evasion, together with competitive credit creation, generates huge inflationary pressure. Local governments’ tax reductions and exemptions in themselves would have had no negative impact on their own total budgetary and extra-budgetary revenues. However, a failure by the central government to raise sufficient tax revenue has implications for fiscal deficits and, depending on how these are financed, would have had varying

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impacts on inflation. Therefore, competitive tax evasion leaves the state to absorb the decline of fiscal revenues and forces all sub-national regions to share the negative impact of macro-economic fluctuations. It was for this reason that in 1994 a major fiscal reform took place, re-shaping all aspects of the inter-governmental tax system. The tax structure was altered, changing the size of the total revenue pie to be allocated; tax administration responsibilities were re-allocated to remove some of the ability of local governments to use ‘back-door’ approaches to revenue mobilisation; the freedom of local governments to negotiate tax incentives with local enterprises was sharply curtailed; and the formula by which revenues were divided between the central and local governments was revised (Bahl 1998).

The community risk-sharing mechanism The components of the community risk-sharing mechanism The analysis so far has demonstrated the relationship between the weak financial position of rural enterprises and the lack of equity capital investment by local governments. Local governments invested relatively significantly only in new enterprises; existing enterprises were reduced to relying on other sources of funds, rendering them especially susceptible to business and financial risks. The last two chapters have shown that enterprises survived well over the post-1978 period because the budget constraints in both collective industrial enterprises and rural financial institutions were soft and because the rural financial sector was integrated into the community riskbearing mechanism as a vital part of it. Above all, local governments played a most important role in the functioning of the community mechanism of risk-sharing. One widely discussed mechanism of community risk-sharing is the financial balancing operation between enterprises. In this arrangement, local governments act as organiser of the capital market within their community while such markets are absent. By drawing together part of collective enterprises’ after-tax profits, local governments use their powers of profit redistribution to support fast-growing enterprises, to bail out enterprises in temporary difficulties, and to write off failed investment in some projects. In other words, local governments spread the risk by having the entire local community absorb the cost of failure. As discussed in Chapter 2, however, Walder (1995) on the basis of his investigations, questioned the possibility that such a mechanism could operate at the township and village level given their small and less-diversified industrial base. Three key indicators in Walder’s analysis have been used to construct Table 6.2. The first indicator (the number of rural industrial enterprises per jurisdiction) reflects the overall level of rural industrial development; the next two serve to assess the possibility of re-distribution of industrial profits at the administrative level concerned.

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Table 6.2 Collective enterprises and output by administrative jurisdiction

The country (1985)1 (1994)2 Guangdonga,3 Chaoan4 Fengxi, Chaoan5 Fenger Village, Fengxi5 Liu Village, Xinxian, Henan6 Zhongshan, Guangdongb,7 Qiuai Township, Jin County, Ningbo, Zhejiang c,8

(Number of enterprises per jurisdiction

Output per jurisdiction (in millions of yuan)

Output per enterprise (in millions of yuan)

Township Village

Township

Village

Township

Village

10.0 8.8 18.3 15.5

2.0 1.5 n.a. 7.7

31.0 31.3 107.0 31.8

3.3 1.7 n.a. 4.1

3.0 3.6 5.8 2.0

1.6 1.1 n.a. 0.5

24.0

12.0

66.1

8.5

2.8

0.7

n.a.

6.0

n.a.

4.6

n.a.

0.8

n.a.

28.0

n.a.

310.0

n.a.

11.1

n.a.

n.a.

94.7

n.a.

4.4

n.a.

55.0

9.2

532.9

9.7

2.6

24.1

Notes: Figures in this table refer to 1994 except where stated otherwise. a 1995. b 1990. c 1993. Sources: 1 Walder (1995), p. 277. 2 China Statistics Yearbook 1995, p. 17, pp. 363–5. 3 Guangdong Statistics Yearbook 1997, p. 59, p. 273. 4 From Chaoan Statistical Bureau. 5 From fieldwork. 6 China Township Enterprises, 1995, No. 3, p. 25. 7 Almanac of China’s Rural Enterprises 1991, p. 366. 8 Almanac of China’s Rural Enterprises 1994, p. 534.

The figures in the first row reading across Table 6.2, drawn from Walder’s calculations, show that the industrial base, whether at the township level or village level, was extremely small in terms of the number of enterprises. In 1985, on average, there were only ten enterprises in the township jurisdictions; the number of enterprises at the village level was even smaller, only two enterprises on average. In the township jurisdiction, a typical enterprise produced an output of 3 million yuan; in all, total industrial output at this level averaged 31 million yuan. Down at village level, total industrial output averaged only 3.3 million yuan. If the rate of profit on output in 1985 is estimated using the national average rate of 9.7 per cent (see Table 5.1), then the gross industrial profits at the respective levels were about 3.2 million yuan and 340,000 yuan. Therefore, Walder is right to argue that the margin for manoeuvre in the balancing operations at both levels is very limited.

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When the figures for 1994 are added in the table, it can be seen that there was no significant change between 1985 and 1994 in all three indicators. The slight reduction in the average number of collective enterprises at the township and village levels may be attributed to the privatisation of collective enterprises in some regions in the 1990s. The 1994 figures seem to support Walder’s (1995) argument that the industrial base at the grass-roots administrative levels is too small to allow ‘massive balancing operations’. But the inference from the national figures for 1985 and 1994 should be taken with caution, given the fact that the development of rural industries was extremely uneven in the period of 1978–94, as discussed in Chapter 4. However, these spatial differences are completely obscured by the figures calculated at national level. As can be seen in Table 6.2,20 Qiuai Township had 55 township-owned enterprises, which produced an industrial output of 533 million yuan in 1993. Many counties in the western part of China are scarcely on a par with this performance. Liu Village, Henan Province, was another star village in terms of rural industrial development. In 1994, its 28 enterprises produced an output of 310 million yuan. Of course, each case may represent one extreme of the spectrum of rural industrial development in developed areas. So in the case of Fengxi Township the number of collective enterprises, whether at the township or village level, were larger than the national average, and correspondingly the township and every village produced more industrial output (66.1 and 8.5 million yuan respectively). All these cases display a common characteristic: there are a lot more collectively-owned enterprises with a higher industrial output than the national averages shown in the first two rows of the table. This means the industrial base in relatively developed regions was not necessarily as small as the national figures suggest, which indicates that balancing operations are very likely in these regions. In other words, at a certain level of rural industrial development, local community risk-sharing with re-distribution of industrial profits as a major component can indeed be set up and can function reasonably well. On this point, Byrd (1990) and Oi (1992) are correct to emphasise the significance of profit re-distribution in the mechanism of community risk-sharing. The information in Table 6.2 also suggests that while rural areas in the relatively less developed regions tend to have fewer collective enterprises, many localities are in fact not very likely to have begun to develop rural industries. Rural areas in such regions may still be far from the early stages of rural industrialisation and remain dependent on agriculture. This is certainly the case with vast areas of poverty-stricken regions in inland areas. Under these circumstances, it is meaningless to discuss issues related to rural enterprises in those regions, not to mention a community risk-sharing mechanism. However, there are still places in relatively less developed regions that have developed rural industrial enterprises at a fast pace and from humble origins. Accordingly they share some characteristics of rural industrial development

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with relatively developed regions. According to Byrd (1990) and Oi (1992), because of the fiscal predation that is likely to occur in underdeveloped regions, the operation of a community risk-sharing mechanism appears impossible. As Byrd (1990) found in his study, some local governments in those regions imposed levies so extensively on the industrial enterprises they administered that some enterprises had even paid the levies with their depreciation allowance, when these enterprises did not make sufficient profits or were loss-making. As a result, the foundations of sustained industrial development in those areas were undermined and the growth of the whole community economy was endangered. Whether or not the supposed extensive levies on rural industrial enterprises led to financial predation, particularly in less-developed regions, is inconclusive; in any event, it is not supported by statistics at the highly aggregative notional level. Ody (1992) found no evidence to support the prediction of fiscal predation in his analysis of provincial difference in effective tax rates because the higher rates were generally not found in less-developed areas. In fact, it should be stated that profit re-distribution or balancing operations are only part of the mechanism of community risk-sharing. The mechanism arguably includes two other important components, namely the rural financial institutions under dynamic reform (as discussed in Chapter 5) and the rural collective land system. It is likely that, in the relatively less developed regions, rural financial institutions and the collective land system may make more sense within the local community and thus matter much more. Existing studies tend to overemphasise the importance of industrial profit redistribution in the mechanism of community risk-sharing. In fact, all three components have supplemented each other and have jointly created a coherent and unique mechanism of community risk-sharing. As far as the collective land system is concerned, land in China since the end of the commune system has been collectively owned but farmed individually on 15-year contracts.21 As Pei (1998) has argued, this land system is the deeprooted element of the institutions of agrarian society. In the case of China, the collective land system has meant that land can not only generate revenues via land contract fees for local governments, but it also has an insurance function on which a living at subsistence level can depend.22 In the period of the household responsibility system the method by which collective land was distributed to households had two considerations. First, a portion of the land distributed to households was referred to as ‘grain ration land’, or kouliang di. This portion of the land was distributed on a per capita basis, with adjustments for age and sex. The grain ration land was meant to allow households to produce sufficient grain to meet their self-consumption requirements. Second, another portion of the land distributed to households was referred to as ‘contract land’, or chengbao di. Contract land was distributed according to a combination of household population and household labour force. It was intended primarily for commercial production, especially for the fulfilment of the production contract made with the state.

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Given the existence of the ‘grain ration land’, when the balancing operation does not work or cannot be implemented and decisions to lay off workers temporarily have to be made, these redundant workers at least have the land as an insurance against job insecurity. As Zhou and Hu (1989) rightly stated, ‘the loss of jobs in enterprises affected only these workers’ income level, but not their livelihood at large. . . . the land contracted to each household became ‘insurance’ for farmers when they were laid off . . . during the suspension of production’ (p. 131). The local institutional capacity The ability of local governments to create a local risk-bearing mechanism is strengthened by their powerful institutional capacity. The institutional foundation in rural China over the post-reform period does not come from nowhere but, as Christiansen and Zhang (1998) indicate, the basic political and administrative post-reform structures in rural areas were framed by the Land Reform of 1949–53, and during the various collectivisation movements. Of all the historical settings, the most important has been the legacy of the former commune system. The three-tier commune system was significantly reorganised during 1962–3. Small production teams (29–50 households) were established as basic production and accounting units. Several production teams formed a production brigade and several brigades formed a commune. Officials at the different levels of the commune system were entrusted with the responsibility, though varied, for implementation of policies and programmes of the government and monitoring their effects. Other duties included the collection of taxes, the maintenance of public security, the collection of data, the provision of extension services, and the improvement of local living standards.23 In effect, the commune system represented an amalgamation of three units – political, administrative and economic. The institutional structure before 1978 might have failed in terms of the steady improvement of agricultural production and productivity, due to the overemphasis on egalitarian ideology and the neglect of material incentives. However, when the commune system was dismantled in 1984, the organisational framework did not disappear overnight. After the dissolution of the commune system, a new local political structure below county level was introduced that included the establishment of the township (formerly the commune) and the administrative village (formerly the production brigade). The format of rural institutions with the new names of township/town and village may look somewhat different at first glance, but in their top–down structure, their combination of the three basic functions, and their selection of heads of local government, have not dramatically changed at all. In particular, the new township governments were set up to assume the government and administrative functions formerly vested in the commune, and the former brigades, now called villages, are still not a separate level of government. However, village administration committees have both

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115

County Bureau of Rural Enterprise

Township Economic Committee

Industrial and Transportation Office

Business Management

Technical Assistance

Finance/Accounting

Township Enterprises

Marketing

Utilisation of Foreign Funds

Village Economic Corporation

Village Enterprises

Figure 6.1 The local institutional structure in Chaoan County

government and community functions. One aim of the rural reforms was to separate political and economic authority at the local level by re-defining the scope of local government’s authority and controls, but this has never really been fulfilled. An obvious change in the new institutions is that their economic functions have been reinforced. As far as the promotion of rural industries is concerned, a three-tier institutional foundation has been formed as shown in Figure 6.1, using Chaoan County as an example. At the top level, the acting administration is the County Rural Enterprises Bureau. It has dual responsibilities: the management, supervision and co-ordination of local rural enterprises on behalf of the county government, and the implementation of the policies and programmes of the Ministry of Agriculture. At the township level, there is an economic committee made up of the party secretary, a vice-director of the township who is responsible for industrial

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affairs, and the head of industrial and transport office. This is the decisionmaking body, and policies with a township-scale impact are decided by the committee. The daily management and co-ordination of industries are shouldered by the industrial and transport office. This office is subdivided into five departments, which have the following major responsibilities: management of responsibility contracts; development planning of rural enterprises; management of product quality; technical standardisation; technological upgrading; auditing; accountant training; marketing; promotion of foreign investment and preparation of joint ventures. At the village level, the administrative structure looks simpler. The village office is responsible for non-economic affairs, while the economic corporation is responsible for management of rural enterprises. In sum, town and township governments take on the functions of planning, and guidance and development of markets, as well as co-ordination, supervision and control at the macro-level. The economic objectives local governments are determined to achieve are to provide employment opportunities for surplus rural labour, to raise local living standards and to increase their own financial revenue.24 This system has an inherent advantage in the creation of a local riskbearing mechanism. First, the institutions at grass-roots level have installed in the vital party and administrative positions their most competent farmers from the limited local pool of talent. One previous survey found that well over half of the managers in 262 collective enterprises were holding or had once held local party or government positions, and the proportion in the 368 non-collective enterprises was nearly one-fifth.25 In many areas, this personnel management creates a local economy with strong leaders in charge. These leaders appear to have had the authority to make things happen. Second, since an effective system of economic management was laid down during the People’s Commune period, management skills from business planning through marketing to financing were practised for some time. In particular, under the former planning system, with the harsh environment it maintained for rural non-agricultural activities, hard lessons were learnt as to how to set up non-agricultural activities and how to play economic and even political games to survive. The former collective organisation educated farmers in ideas of co-operation, and for many years the commune system practised them in its approaches to development. As a result, the co-operative legacy of the former system has naturally given rise to the risk-sharing mechanism, whether implicitly or explicitly.

Conclusions This chapter has examined, from a local state capacity perspective, the role of local governments in the financial management of rural industries through the organisation of the mechanism of community risk-sharing.

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117

From the early 1980s, the local fiscal system was reformed and a contracting system was introduced. Together with this, the system of the taxation administration was decentralised. This gave local governments some flexibility to restructure their tight budgets and support their developmental needs. It has been argued that there were two important factors that contributed to the persistently weak financial position in rural industrial enterprises in the 1980s and 1990s. These factors were the expansionary drive of local governments, and the imbalance between the revenue capacity and responsibilities at these administrative levels. On the revenue side, some traditional sources of income were either lost or diminished. On the expenditure side, the principle of local self-reliance remained intact. This principle demanded that local governments at least maintain, if not improve, the social services they were assigned. In particular, there were three expenditure requirements that increased the imbalance in revenue capacity and responsibilities, and contributed to financial strains in local budgets. These were agricultural investment, investment in rural social services and rural education, and investment in local infrastructure. In these areas the demand for funds was huge and was mostly financed out of local industrial profits. The shortage of funds in local governments was further worsened by their expansionary drive. In the end, they failed to invest significant amounts in enterprises that they administered and had to drain industrial profits to make up the gap in local budgets. Therefore, the lack of equity capital investment combined with the over-collection of industrial profits contributed to the over-dependence on debt in rural industries. However, it is important to recognise that in the period concerned, local governments were engaged in competitive tax evasion, varying their tax collection efforts in order to influence local effective tax rates. This was accomplished by excessive offering of tax reductions and exemptions to rural enterprises, allowing the depreciation of capital assets at faster than official rates to inflate costs, and tolerating illegal tax evasion by enterprises. Competitive tax evasion altered the distribution of taxable revenues in favour of local governments and the enterprises they governed, but it also contributed to a great extent to the state’s fiscal decline. The undesirable consequence which thus occurred increased the inflationary pressure at the macro-level and contributed to macro-economic instability, which in turn affected the financial management of enterprises. The community mechanism of risk-sharing meant that an entire community would share financial risks faced by individual enterprises. Walder (1995) claimed a local economy with a small rural industrial base was unable to engage in balancing operations. In contrast to his argument, this chapter argued that local governments at the township and village level in many regions were likely to maintain balancing operations within their communities, although their industrial base might not be as large as that at the county level and above. More importantly, it was argued that the risk-sharing mechanism in fact included two other important components, namely the

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Financing China’s rural enterprises

involvement of the rural financial institutions and the collective land system. The re-distribution of industrial profits and soft credit from rural financial institutions could be seen to provide a short-term cushion against risk, but it was the collective land system that provided what was virtually an essential insurance function for the local community. Finally, this chapter has argued that the institutional capacity of local governments constituted the administrative basis for the community mechanism of risk-bearing. This is because when the commune system was dismantled in the early 1980s, the merits of its institutional arrangements were retained and modified: an effective system of economic management was inherited, entrepreneurial officials were promoted and reinforced, and the spirit of co-operation was preserved.

7

Conclusions

This book has used the conceptual approach of reform dynamics to analyse the paradox associated with the pattern of financing in China’s rural industrial enterprises. This paradox concerns the conflict between the supposed hard budget constraint on rural industries and the fact of overdependence on debt observed in these enterprises, and how local governments are able to organise the local community risk-sharing mechanism. The book has demonstrated, first, that the over-dependence on debt financing found in rural industrial enterprises is to be attributed to factors such as the lack of internal equity capital, the existence of soft taxation and soft credit, risk-taking preferences in the loan management of rural financial institutions, and the inability of local governments to invest in enterprises. Second, it has shown how a community risk-sharing mechanism became possible in an environment of reform dynamics. This mechanism involves soft credit and balancing operations as the vital instruments for bailing out failing enterprises, a flexible rural labour market as a cushion against financial risk, and finally the collective land system that serves an insurance function. Nevertheless, this mechanism also entails some undesirable consequences that are external to the community and involve part of the local financial risks being channelled into the macro-economy. In resolving the paradox mentioned above, this book has examined three interrelated issues regarding the financing of rural industries. These are: the pattern of financing in the rural industrial sector and its implications from the perspective of the industrial cycle; the reasons for over-dependence upon debt capacity in rural enterprises in the wider context of businesses, financial institutions and local governments; and the mechanism of local community risk-sharing and risk absorption and its institutional foundations. Industrial growth and the pattern of financing While highlighting the unprecedented growth of rural industrial enterprises over the post-1978 period, this book has paid particular attention to the fluctuations of rural industrial growth and the implications of this for the pattern of financing in the rural industrial sector. To describe the cyclical

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Financing China’s rural enterprises

character of rural industrial growth, industrial cycles were identified and standard deviation used to measure the relative volatility and degree of cyclical instability. The results showed there is a match between the number of industrial cycles encountered by rural industries and by national industry as a whole, but the amplitude of the rural industrial cycle is always greater than that of the national industrial cycle. Using national growth as a benchmark, the standard deviation of rural industrial output growth was almost twice as large as the national average in the 1978–89 period and more than double the national figure for the period 1990–4. Moreover, the volatility in profit growth is even worse, with the standard deviation always showing a greater margin than that of output growth. This shows that while rural industries were profitable from a longer-term point of view, in the short term the prospect of profitability in the rural industrial sector is both uncertain and unpredictable, implying higher financial risk. The fluctuations of rural industrial growth have their origin in macro-economic instability, but as this study has shown, microeconomic factors also mattered, of which the behaviours of enterprises, rural financial institutions and local government as a whole were significant contributing elements. Against this background of growth instability, rural industrial enterprises have been widely found to show an unusually aggressive pattern of financing. They are highly geared, in that rural enterprises display a much lower current ratio as well as an extremely high short-term debt ratio. This book called this phenomenon ‘over-dependence on debts’. It was found that rural industrial enterprises become highly indebted because they have disproportionate borrowing from local rural financial institutions, together with dependence on informal fund-raising, for instance the issuing of informal enterprise bonds. This pattern of financing indicates a rather weak liquidity position in these enterprises and is problematic in the context of a notably uncertain economic environment. Accordingly, this pattern of financing stands out as in apparent contradiction to the projection of the ‘hard budget constraint’ advocates. A paradoxical question is thus raised: why did rural industrial enterprises that should have been conservative in financial management become so highly indebted? Debt capacity and its determinants How much debt an enterprise can appropriately use normally depends on its debt capacity. In this study, the determinants of debt capacity were divided into internal and external factors. Internal factors are factors enterprises are able to control, while external factors are factors whose operation is determined outside the control of enterprises. It was found that there is a weak correlation between the excessive borrowing and the debt capacity in the rural industrial sector. Hence, the pattern of financing in the rural industrial sector is virtually entirely determined by external factors.

Conclusions

121

The internal factors This study has examined the implications of internal factors such as output growth, profitability and internal equity capital investment for the debt capacity of enterprises. First of all, it was found that neither output growth nor profitability can constitute a solid foundation of debt capacity to support the over-dependence on debt in rural industrial enterprises. In addition to the dramatic fall in return on capital, other important elements that would discourage the excessive use of debt are the instability of rural industrial output growth and, as a result, the strong uncertainty of profitability over years. Furthermore, over-dependence on debt financing results from the shortage of internal equity capital. For rural industrial enterprises, equity capital from local governments and from retained profits of their own are the two major sources of funds. But equity investment in new industrial enterprises from local governments was always insufficient in the first place, and this source of investment was reduced to only marginal significance when industrial firms expanded into their growth stage. Under these circumstances, the financial position of rural industrial enterprises was weak from the very beginning, and this financial weakness haunted enterprises in their later stages of development. This created a large gap to be filled by internal equity capital investment. The self-financing of equity capital through retained profits, however, is constrained by the persistent over-collection of industrial profits by local governments. Local governments demand profits from the enterprises they administer first because they are the owners of these enterprises, and second because they have wider community objectives to fulfil. While rural industrial enterprises faced on the one hand the draining of industrial profits, on the other they were under great pressure to invest. These pressures included additional investment requirements resulting from capital intensification and the supply of trade credit. Such pressures created further tension between the availability of retained profits and the demand for equity capital. Without sufficient injections of equity capital, rural industrial enterprises were reduced to relying heavily on debt financing, although they in fact lacked the ability to borrow on such a disproportionate scale. The external factors The external factors determining the debt capacity of enterprises proved more complicated and had mixed outcomes. First, both the taxation system and the financial system under dynamic reform had loopholes that rural industrial enterprises could exploit in their use of debt. The taxation system provided a generous tax shield: rural industrial enterprises were allowed to repay both interest and principal on bank loans before calculating taxable profits and income tax payments. In the financial sector, real interest rates never reflected

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rates at the level of market clearing; thus bank loans become relatively cheap funds. Equally important, bankruptcy costs relating to the use of debt were insignificant because bank loans were soft and there were very good prospects that failing enterprises would be bailed out. Both systematic factors obviously uncharacteristically favoured the debt capacity of enterprises and encouraged them to borrow. Second, the rural financial institutions were more likely than ever before to extend loans to rural industries, despite the likelihood of default. This study found there are three reasons to explain this switching of policy priority in loan management of rural financial institutions. First, there were significant changes in incentives in the rural financial sector. With the introduction of profit-retention and the profit-sharing scheme in the early 1980s, rural financial institutions were willing to improve their loan management and to make profits because employees’ welfare and bonuses had become closely linked to retained profits. This financial reform, while giving financial institutions stronger incentives to improve financial performance, entailed a short-termism in loan management. Second, as the rural financial institutions become interested in making profits, the change in liabilities portfolios began to pile up pressure on financial institutions to alter their methods of loan management. Within the new liabilities portfolios, deposits from individuals were dominant, with a large proportion of such deposits being time deposits. In addition, local competition for savings drove interest rates high. In some periods, rural financial institutions had to offer indexed deposits. Because the new liabilities portfolios were characterised by higher than average interest, rural financial institutions had to seek profitable lending for funds raised at high cost. In the end, from the financial institution’s point of view, extending loans to rural industrial enterprises represented a trade-off between yield and risk. Moreover, in order to protect themselves, rural financial institutions opted for extending loans with short maturity and requiring quick repayment. There is one further factor that affects rural financial institutions’ trading with rural industrial enterprises, namely local government–bank relations as shaped by the legacy of the planning system and financial decentralisation. First of all, financial institutions are still perceived as a fiscal agent of local government, and the fiscal decentralisation and financial reforms strengthen the interdependence between local financial institutions and local governments. Each party depends on the other to fulfil its objectives. In other words, local governments expect local financial institutions to support their priority projects; local banks need local governments to economise on their agency costs. In addition, both parties gain from their co-operation in pursuit of ‘competitive local credit creation’. For these reasons, there is a tendency for rural financial institutions to provide soft credit, and when problems in the rural financial sector occur, the regional centre of the People’s Bank of China is pressurised to provide subsidies.

Conclusions

123

Finally, local governments played a mixed role in determining the debt capacity of enterprises. On the one hand, local governments’ over-collection of industrial profits and inability to invest weaken the debt capacity of enterprises, as mentioned before. This problem of profit drainage can be explained in terms of local state capacity. It was found that after 1978 local governments experienced an imbalance between their revenue capacity and their responsibilities. Some traditional sources of revenue collection were either lost or reduced, while at the same time the financing of social services had to be maintained under the principle of local self-reliance. In addition, there was an expansionary drive by local governments. Hence financial strains on local government budgets were not sustained but intensified. These financial strains prevented local governments from investing in enterprises they administered and forced these governments to drain industrial profits in order to make up the gap in the local budget. On the other hand, local governments were able to take advantage of the decentralisation in the fiscal system and to engage in ‘competitive tax evasion’ in order to provide alternative support for rural industrial enterprises. The essence of competitive tax evasion is lax tax collection, including excessive tax exemptions and reductions, accelerated depreciation in enterprises and tolerance of illegal tax evasion. These practices allowed rural enterprises to recover some lost ground in profit-making and improve their debt capacity in an unorthodox manner. One of the conclusions of this study is that the weak correlation between debt capacity and the pattern of financing in the rural industrial sector should be addressed in the broader context of the local economy. In fact, there are three parties playing a part in determining the debt capacity of rural industries: rural enterprises themselves, rural financial institutions, and local governments. Each party has its own distinct interests, and their interdependence results in mutual benefit in some circumstances, but cancels each other out in others. The implication of this conclusion is that the performance of rural industries cannot adequately be explained by arguments based on marketisation (Rawski 1996), at least with regard to the rural financial market. Mechanisms of risk-sharing and risk absorption There is no doubt that over-dependence on debt results in poor financial health and higher financial risk in rural industrial enterprises. But there are more factors behind debt-related financial risk. First, part of the risk is of the financial institutions’ own making. Partial financial reform introduced the profit-sharing mechanism into rural financial institutions but without clarifying corresponding responsibilities and obligations. Thus this system created the unique mechanism of local competitive credit creation. In other words, local financial institutions, with the firm support of local governments, competed fiercely for higher credit quotas within the state credit plan, more

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interest-subsidised funds or policy-related funds, and more additional credit funds. Local competitive credit creation results in an undesirable consequence, notably inflating demand for credit funds at the local level and leading to the over-issuance of credit funds nation-wide. The state financial authority was frequently forced to adjust its monetary policy in order to cool down the inflationary pressure. The lack of consistency in monetary policies thus obstructed the financial management of rural industrial enterprises. It forced enterprises to hoard funds, thereby reducing other enterprises’ opportunities to borrow and incurring unnecessary costs. As a result, highly uncertain monetary policies increased the financial risk of borrowing. Furthermore, the financial system in dynamic reform created a short-term view within the rural financial institutions in loan management, favouring short maturity and rapid repayment. The short-term view in loan management focuses exclusively on making money quickly over a very short time span. This is done in order to maximise the economic and social benefits for financial institutions themselves, rather than to promote healthy long-term business development. The short maturity in liabilities and rapid repayment requirement keep the enterprise’s debt capacity low and liquidity tight. Thus the risk associated with any given level of debt increases. Accordingly, when facing an uncertain macro-economic environment, enterprises with heavy borrowing would find it difficult to service debts out of their unstable cash flow stream. The default rate would be liable to increase and in the end both enterprises and financial institutions would suffer. The undesirable consequences of local competitive tax evasion also increase financial risk in the use of debt. On the one hand, competitive tax evasion alters the distribution of taxable revenues in favour of local government and the enterprises they administer; it greatly contributes to the decline of state revenues. If the central government chose to borrow from the central bank to make up its tight budget, this policy could easily set off inflationary pressure and lead to frequent and sudden U-turns in policies. On the other hand, a proliferation of extra-budgetary and self-raised revenues motivates local governments and enterprises to pursue expansion, which added to the inflationary pressures. This study has shown there is no doubt that the rural industrial development in the post-1978 period contributed enormously to the fast growth of the national economy, in which local governments together with rural financial institutions played active parts. This confirms the argument from local state corporatism put forward by Oi (1992), Byrd and Lin (1990) and others. It also indicates, however, that in the reform period enterprises, rural financial institutions and local governments all tended to exploit weaknesses in the economic system and were under pressure to pursue short-term interests. Their activities produced undesirable consequences external to the community and contributed to inconsistent macro-economic policies and macro-economic instability, which were both observed in the period concerned. Therefore, this study does not reject the arguments

Conclusions

125

about the inefficiency in local government involvement advanced by Wong (1987). However, rural industrial enterprises were almost always able to stave off the threat of financial risk. For rural industries, the community mechanism of risk-sharing and risk absorption was vital. First, the system of community risk-sharing was established through the local government’s financial balancing operations, namely the re-distribution of local industrial profits within the community. This mechanism was consolidated by the unique institutional capacity of local governments. Talented people were in charge of local affairs and the co-operative ideology of the former commune system was inherited. With this institutional capacity as the administrative basis of community risk-sharing, local government used profits pooled from enterprises to subsidise or bail out failing enterprises. Second, local financial institutions were drawn into this mechanism through providing soft credit. Third, a flexible rural labour market provided some cushion effect. The flexibility of the local labour market has two sides. One is a mechanism of wage determination that is productivity-related, the other is flexible labour management. Finally, the collective land system provided the essential insurance function. This insurance function proved decisive because it gave rural industrial enterprises an advantage: employees from rural households had land and agricultural activities as a significant cushion against job insecurity. This community mechanism of risk-sharing undoubtedly softened the budget constraints of rural industries and helped them successfully to withstand financial risk resulting from their over-dependence on debt. Hence their amazing resilience. Therefore, this analysis confirms the possibility that a community risk-sharing mechanism can operate in a local economy with a relatively small industrial base. Accordingly, this study argues that the view of local risk-sharing taken by Walder (1995) is too narrow to appreciate the whole mechanism. It also contends that the essence of this mechanism is the existence of soft budget constraint in rural industries and financial institutions. The community mechanism of risk-sharing originated from the conflicting objectives imposed on local enterprises by local governments. Because the enterprise’s objective of profit maximisation was subordinated to the multiple objectives of local governments, enterprises contributed a lump sum of profits to local governments for the fulfilment of community objectives. Rural industries were drained of equity capital by the over-collection of profits but in return benefited from the softening of their budget constraint. Rural financial institutions could function as an integral part of the community mechanism of risk-sharing because they themselves were not risk-bearers either. The root of the soft budget constraint in rural financial institutions lies in their controversial dual role in the rural financial market. The Agricultural Bank of China acted as the financial agent of both government and commercial-oriented financial institutions in the rural areas.

126

Financing China’s rural enterprises

Although the Agricultural Bank of China was revitalised to make profits in commercial banking, it was required to implement policy-related lending and even to subsidise that kind of activity. For their part, rural credit co-operatives did not streamline their relationship with the Agricultural Bank of China. They had to deposit with the Agricultural Bank a sizeable portion of the funds they attracted and to absorb high costs themselves. The loan management of rural credit co-operatives has also been strongly influenced by the Agricultural Bank. The financial system under dynamic reform therefore circumscribed the independence of financial institutions but in return the financial institutions had their own budget constraints softened. By arguing that it is necessary to see the community mechanism of risksharing within a broader context, this study also concludes that this mechanism alone could not provide a cushion strong enough to absorb financial risk in enterprises. In reality, part of the financial risk was passed into the wider economy and so shared by other regions through externality effects. Above all, this study has argued that the pattern of financing of rural industrial enterprises in China over the post-1978 period has been the outcome of an economic system in dynamic reform.

Notes

Chapter 1 1 Rural social output in China is the value of all goods produced in rural areas and is an appropriate indicator to reflect the level of rural development. Data for rural social output was regularly published in China Statistical Yearbook prior to 1992 but not so after 1992. Here, rural social output is estimated by combining together rural output of farming, forestry, animal husbandry and fishery from China Statistical Yearbook 1995, p. 332 and the total output of rural enterprises from Almanac of China’s Rural Enterprises 1995, p. 93. 2 China Statistics Yearbook 1995, p. 364. 3 Quoted from an article by Liu Jian, Minister of Agriculture, in Almanac of China’s Rural Enterprises 1995, p. 10. 4 Tong County is recently renamed Tongzhou District of Beijing. 5 The mu is the basic measure unit of land in China, and one mu of land equals 0.0667 hectares. Chapter 2 1 The concept ‘corporatism’ used in the local state corporatism differs from that used in politics. Corporatism in politics addresses the working relationship between the state and the associations representing interest group (Unger and Chan, 1996). In Oi’s discussion (1992), the term corporatism is intended to convey both a ‘corporate’ and a ‘corporatist’ meaning. 2 In a study by Aston Business School (1991), financial market failure is broken into three types. Supply-side market failure is defined as proposals that are turned down for reasons not connected with the viability of the proposal itself. Demand-side market failure is where firms do not make proper use of the financial opportunities available. Complete market failure is where firms have not been offered any finance for reasons unrelated to the viability of the proposal itself or the business. Chapter 3 1 Almanac of China’s Rural Enterprises 1994, p. 5. 2 See the list of new public companies in 1993 in Almanac of China’s Finance and Banking 1994, p. 487. 3 Rural Enterprises in Contemporary China, p. 106. 4 There are in-depth investigation of the Southern Jiangsu model and the Wenzhou model in western literature. See Dong (1988) for both models; Nolan and Dong (1990) for the Wenzhou model; and Byrd and Lin (1990) for the other patterns. 5 Rural Enterprises in Contemporary China 1991, p. 94.

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6 Ibid., p. 562. Another possible factor may be that investment in rural areas was switched into agricultural activities thanks to the restoration of farmers’ confidence in farming under the new management system, as argued by Islam (1991). 7 In part, the increase in output between 1983 and 1984 was exaggerated due to changed statistical enumeration. 8 New Stage of National Economic Growth and Rural Development, p. 59. 9 Calculated from Almanac of China’s Finance and Banking 1994, p. 443. 10 China Statistical Yearbook 1995, p. 233. 11 Ibid., p. 574. 12 Almanac of China’s Rural Enterprises 1990, p. 34. 13 There has been a comprehensive report of the development of exports from rural enterprises over the period of the seventh Five-Year Plan (1986–90), see Almanac of China’s Rural Enterprises 1991, pp. 279–84. 14 Almanac of Rural Finance Statistics 1991, p. 5 and p. 105. 15 See the conference documents in Almanac of China’s Rural Enterprises 1992, pp. 91–103. 16 ‘Provisions Regarding Organising and Developing Enterprise Groups’ by the Ministry of Agriculture in Almanac of China’s Rural Enterprises 1993, pp. 101–3 and pp. 138–40. 17 ‘Decisions on Speeding Up Development of Rural Enterprises in the Central and Western Region’ by the State Council in Almanac of China’s Rural Enterprises 1994, pp. 127–30. 18 Without question, this is an arbitrary assumption. As will be seen in Chapter 4, the proportion of working capital loans displayed a tendency to increase from 69 per cent in 1986 to 87 per cent in 1990. It is reasonable to assume that this same ratio would have been lower before 1986, so the parameter of 65 per cent reflects this consideration. 19 Encyclopaedia in Financial Market, p. 814. 20 See both government documents in Encyclopaedia in Financial Market, pp. 1641–3. 21 Almanac of China’s Finance and Banking 1994, pp. 455–6. 22 Encyclopaedia in Financial Market, p. 814. 23 Almanac of China’s Rural Enterprises 1991, p. 205. 24 Ibid., p. 207. 25 China Township Enterprises, No. 3, 1995, p. 32. Chapter 4 1 The concept of debt capacity used here does not imply an absolute limit but rather a rational limit to the amount the enterprise is able to borrow. 2 Due to the decline in rural industrial profitability, there was a divergence in profitability between rural industrial enterprises and state-owned enterprises. This phenomenon has been termed ‘profit equalisation’ (Naughton 1994b). 3 See the cover story of ‘Demand Crunch’, in Far Eastern Economic Review, 15 January 1998. 4 ‘Regulations Regarding Financial Management of Rural Enterprises’, in Almanac of China’s Rural Enterprises 1978–87, p. 516. This principle was later reiterated in ‘Regulations on Rural Collective Enterprises in China’, which came into effect on 1 July 1990, see Almanac of China’s Rural Enterprises 1991, p. 111. 5 Jack Gray (1982), ‘Rural Enterprises in China, 1977–79’ in China’s New Development Strategy, p. 217. 6 Croll (1994), From Heaven to Earth, p. 109. 7 China Township Enterprises, No. 11, 1995, p. 5. 8 Official documents and speeches given by the Ministers of Agriculture can be found in Almanac of China’s Rural Enterprises, various issues after 1989.

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9 Figures from Geng Xuan (1995), ‘A report of an investigation into fund management in rural industrial enterprises’, the Agricultural Bank Tong County Branch, mimeo, No. 3. 10 Zhou (1987), p. 61. 11 Trade credit can be an important source of funds in financing working capital for rural industrial enterprises. This is exemplified by two cases in Chaoan County. When it was set up in 1985, the Kanghui Group Company in Anpu Township had to find 40,000 yuan start-up capital to cover the costs of building construction and for circulating capital. Most of this was received through advance payments from other parties. Later on, this fast-growing company kept using trade credit to enhance its financial capacity. The demand for working capital amounted to 10 million yuan in 1994, and most of it was still financed by trade credit. By 1995, the company had developed into an institution engaged in a wider range of activities in manufacturing and trade, and had set up subsidiaries in Fujian and Hubei Provinces. The Nanyang Print Company also benefited from the use of trade credit. Located in the same township, the company was set up in 1970, employing 50–60 workers, but now produces an output of 20 million yuan in 1994. The company has a long-term partner in Hong Kong, which is the company’s materials supplier. After a close relationship between them was built up, the company used deferred payables to the Hong Kong partner as a major way of financing its working capital. 12 Rural Enterprises in Contemporary China (1991), p. 377. 13 A few studies have contributed to the discussion on rural shareholding enterprises. See Tung (1994), Clegg (1996, 1998), and Vermeer (1996). 14 Almanac of China’s Rural Enterprises 1995, pp. 280–1. 15 This, however, is only one aspect of the story. Banking regulations that did not give enterprises equal access to bank loans offset the excessive demand of enterprises for loans to some extent. As a result, tax shields have played a minor role in determining the debt capacity of rural industrial enterprises. The reform of the taxation system in 1995 abandoned the policy that had allowed the before-tax repayment of bank loans. 16 According to the Agricultural Bank of China’s definition, the enterprise’s own capital include the enterprise’s self-accumulation funds, external borrowings from other channels apart from banks, land compensation fees, and government interest-free grants. See the Agricultural Bank of China’s Regulations (1987) in Lending Management of Rural Industry, p. 515. 17 ‘Provisions on Collective Industrial Enterprise Lending’ in Management of Loans to Rural Industry, p. 534. 18 See the Agricultural Bank of China’s Regulations (1987) in Management of Loans to Rural Industry, pp. 515–16. 19 Calculated from information in Almanac of China’s Rural Enterprises, various issues. 20 Qi (1987), p. 79. 21 Sing Tao Daily (European edition), 19 December 1994. 22 Zhang Yi, ‘Keeping confidence, active adjustment to go through the difficulties’, Almanac of China’s Rural Enterprises, p. 243. 23 Ibid., p. 6. 24 MaJiesan, ‘An extraordinary year’,Almanac of China’s Rural Enterprises 1990,p.20. 25 Almanac of China’s Rural Enterprises 1994, p. 376. Chapter 5 1 The development of the financial sector achieved considerable success. In the first place, the money market, mainly inter-bank markets, was gradually constructed. In

130

2

3 4 5 6

7

8 9

Notes

1987, 29 cities opened up short-term markets for enterprise bonds. This signalled the emergence of bond markets. In 1986, an internal foreign-exchange market was set up. Before the end of 1993, the foreign-exchange market existed in the form of foreign-exchange swap centres. There were 119 foreign-exchange swap centres in big and medium-sized cities. The centres acted as agents for transactions between local enterprises (including foreign-owned enterprises). Above all, the most exciting advance in the construction of financial markets came in 1991, when the Shanghai Securities Exchange (SSE) was established. For more detailed analysis on reforms to the financial system in China, see Tam (1995). This is the fourth time that the Agricultural Bank of China had been re-established since 1949. It was first established as the Agricultural Co-operative Bank in 1951 and was disbanded one year later. A bank with the current name was re-established in 1955 but soon closed in 1957. In 1963, the Agricultural Bank of China was established again but did not have any better fortune than before, and the closure came in 1965. For more details, see Shang (ed.) (1989), pp. 317–20. Apart from the Agricultural Bank of China, the three other state-owned specialised banks were the Industrial and Commercial Bank of China (ICBC), the People’s Construction Bank of China (PCBC), and the Bank of China (BoC). For a more precise description of the construction of the Agricultural Bank of China, see Tam (1986). Reforms and Development of Rural Finance in China, p. 29. The regulation stated that rural credit co-operatives were collective financial units in rural areas; the financial management would be overseen by the People’s Bank of China; and full-time staff of rural credit co-operatives would be entitled to the same benefits as the staff of the communes. For details, see Rural Finance in Contemporary China, p. 455. Within the rural financial sector, China Agribusiness Development Trust and Investment Corporation (CADTIC) was a unique institution. When it was set up in April 1988, CADTIC was one of the three large non-financial institutions (the other two were the China International Trust and Investment Corporation (CITIC) and the Everbright Corporation) under the State Council (and later the Ministry of Agriculture). It was designated as an intermediary for disbursement of loans – mainly to the agricultural sector – from such bodies as the World Bank. CADTIC expanded quickly and in just five to six years’ time it had set up 13 subsidiary organisations across the country, mostly in the prosperous coastal cities. As of 1993, CADTIC extended loans of 700 million yuan to nearly 2,000 rural enterprises (Almanac of China’s Finance and Banking 1994, p. 99). In addition, two shareholding investment companies – Zibo Township Enterprise Investment Fund and Ninbo Township Enterprise Development Fund – were set up in 1992, in which CADTIC was a holding shareholder. Zibo Township Enterprise Investment Fund, with a share capital of 300 million yuan, was floated on the Shanghai Stock Market in 1993. CADTIC should invest at least 60 per cent of its capital in rural enterprises, but in fact it had strong interests in other activities such as real estate and securities trading in the early 1990s. Mis-management resulted in serious liquidity problems, and real estate speculation and securities trading resulted in large losses. Both financial collapse and corruption eventually led to its closure by the government in 1997 (see ‘China shuts debt-ridden investment group’, Financial Times, 15 January 1997). With it went the government’s intention to open up additional channels of financing for rural industrial enterprises. Xu Xiaobo et al. (1994), p. 86. In Mencheng County, Anhui Province, Shangli Rural Co-operative Fund Association lent 70 per cent of its funds to rural industrial enterprises (Wuan 1994: p. 220). In Pengxian County, Chengdu City, Sichuan Province, 61 per cent of funds in Lichun Township Rural Co-operative Fund Association went to rural industrial

Notes

10 11 12 13

14 15 16

17 18

19

20 21 22 23

24 25

131

enterprises (Wei and Guo 1994: pp. 246–7). In Fujian Province, agricultural loans in rural co-operative fund association made up only 9.5 per cent of their loan portfolio, and 71.5 per cent of funds went to industrial and commercial activities Almanac of China’s Finance and Banking 1994, p. 297). Liu (1993), p. 19 and pp. 71–2. The change in the rural financial market is a part of the process of financial deepening in post-Mao China. McKinnon (1994) provides a comprehensive analysis of this. Full-time employees only. There were an additional 266,533 part-time employees working in credit stations of the rural credit co-operatives in 1993. Since information on aggregate banks loans to rural industries is not available, analysis in this section is generally based on published statistics of bank loans to rural enterprises. Rural industries are the largest constituent part of rural enterprises. It is therefore believed that the information on rural enterprises in the analysis can be seen as a very good approximation of the statistics for rural industries. Unpublished report prepared by the Tong County Branch of the Agricultural Bank. See Xu Xiaobo et al. (1994), p. 60. The six regulations or provisions were: ‘Provisions Regarding Collective Industrial Enterprise Lending’ (1985), ‘Approaches to Implementing Loan Contract Regulations’ (1985), ‘Regulations regarding Improvement of Financial Services, Strengthening of Financial Supervision and Support to Sustained Development of Rural Industry’ (1987), ‘Provisions Regarding Evaluation of Credit Ratings and Lending Management of Rural Industry’ (1988), ‘Provisions Regarding Collateral and Guarantees of Loans’ (1988), ‘Provisions Regarding Project Management of Industrial Fixed Investment Loans’ (1989). After 1985, the central bank no longer provided free planned credit funds but extended funds as loans, albeit with a low interest rate. This change has weighed heavily with locally-generated savings. Among others, the following five special funds are the best known: the ‘Spark Plan’ funds; poverty alleviation loans; export promotion funds; rural enterprise loans in national minority areas; and special loans to rural enterprises in central and west China. As of 1993, interest rates were between 1.80 and 3.15 per cent for both individual and institutional current deposit accounts, between 6.11 and 12.24 per cent for individual fixed deposit accounts, and between 7.56 and 10.98 per cent for institutional fixed deposit account (Almanac of China’s Finance and Banking 1994, p. 491). Xu Xiaobo et al. (1994), p. 60. ‘Fed east’, The Economist, 21 November 1998, p. 102. Reforms and Development of Rural Finance in China, p. 21. In the 1990s the financial performance in China’s state banks deteriorated. China’s central bank estimated that problem loans of commercial banks as a whole accounted for 20 per cent of total assets, see report ‘China issues closure order against bank’, Financial Times, 23 June 1998. Unpublished reports prepared by theTong County branch of the Agricultural Bank. Calculated from information in Almanac of China’s Finance and Banking 1994, p. 553. But the rural credit co-operatives balance sheet of 1993 shows that the redeposit rate rose again to 32 per cent of the total deposits.

Chapter 6 1 China Statistical Yearbook 1995, p. 221. For more comprehensive investigation of this important issue, see Watson (1989) and Saith (1993), among others.

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Notes

2 It was estimated that public assets that were distributed to rural households were devalued at about 40 per cent and in the meantime part of the revenues thus generated could not be collected. See Yu Guoyiao (ed.) (1994), p. 72. 3 Two forms of corvée remain in existence: yiwu gong (duty labour) and jilei gong (accumulation labour). The use of labour mobilisation was reduced dramatically after 1978, but the systems are maintained. Various official documents have regulated the levy of this tax in kind. See also E.B. Vermeer (1998), ‘De-collectivisation and Functional Change in Irrigation Management in China’, in Vermeer, E.B. et al. (eds.), Co-operative and Collective in China’s Rural Development – Between State and Private Interests, Armonk and New York: M.E. Sharp. 4 Labour was mobilised on a large-scale for capital construction (irrigation works, soil conservation projects, etc.). See Griffin (1984) in Institutional Reform and Economic Development in the Chinese Countryside, p. 317. 5 At the provincial level, fiscal decentralisation started in 1980 when a revenuesharing system was first introduced. Known as ‘Eat in separate kitchens’, this system was officially named the ‘Contract responsibility system’ and lasted till 1984. Between 1985 and 1988, the fiscal contract system was redesigned to control inter-provincial inequalities in fiscal revenue. Since this change made the rich regions worse off, a further modification was made in 1988 to take into account the interests of the rich provinces. This system was not replaced until the tax assignment system was introduced in 1994. A detailed discussion of three stages of major changes in the fiscal contract system can be seen in Ma (1997), pp. 6–9. 6 The three other types of revenue-sharing arrangements were ‘Sharing total revenues’, the ‘Fixed-term contract’, and ‘All revenues to be remitted and all expenditures to be disbursed’. For a more detailed description, see Wong (1997), pp. 193–4. 7 Taking the taxable wage bill as an example, the accounting rules state that monthly taxable salary per capita in the cost accounts should not be more than 600 yuan, but the restriction was relaxed in that for every 10 per cent increase above 1,000 yuan of the yearly profit per capita, an additional 50 yuan of monthly salary per employee could be validly counted as costs. 8 Collective funds do not include the township and village pooling of funds (xiangzhen tongcou kuan) that are collected for spending on the one-child family award, military training and sanitation. 9 Collected at the ratio of at least one per cent of farmers’ net income of the previous year. 10 See ‘Regulations on Financial Management of Rural Enterprises’, in Almanac of Rural Enterprises in China 1978–87, p. 516. This principle was later reiterated in ‘Regulations on Rural Collective Enterprises in China’ which came into effect on 1 July 1990. see Almanac of Rural Enterprises in China 1991, p. 111. 11 China Township Enterprises, No. 11, 1995, p. 9. 12 According to the World Bank, the economic infrastructure can be subdivided into three services: (a) public utilities: power, telecommunications, piped water supply, sanitation and sewerage, solid waste collection and disposal, and piped gas; (b) public works: roads and major dam and canal works for irrigation and drainage; and (c) other transport sectors: urban and interurban railways, urban transport, ports and waterways, and airports. See World Development Report 1994, p. 2. 13 Interview with officials of Fengxi Township in 5 September 1995. 14 Oi, p. 105. 15 Interview at the Chaoan Taxation Office, 20 August 1995. 16 Estimated from Almanac of China’s Rural Enterprises, various issues. 17 Calculated from China Statistical Yearbook 1992, p. 413. 18 Beijing Review, vol. 32, no. 33, 14–20 August 1989, p. 6.

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19 Odgaard (1992) provides a comprehensive discussion of the tax evasion issue with particular regard to rural private enterprises. In addition, poor accounting in rural private enterprises was an important reason for tax evasion. One investigation of rural private enterprises of Gaomi City, Shandong Province, reported that, of all 153 enterprises concerned, 70 per cent of enterprises did not have accounting records at all, 16 per cent of them had simple accounting records, and only 14 per cent of enterprises had full accounting records in accordance with the state regulations. See China Township Enterprise Daily, 15 August 1995. 20 In Table 6.2, more figures are added in order to provide an interesting reference. These localities can be classified as relatively developed regions in China. Zhongshan City, situated in the Pearl River Delta, has been one of the leading cities in the development of rural industries in China since the 1980s; Chaoan County is in the next tier of development after Zhongshan. Qiuai Township in Ningbo City, Zhejiang Province and Liu Village in Xinxian County, Henan Province were the national stars for their respective administrative levels in the country. 21 For a more detailed analysis of the change in land ownership in rural China after 1978, see Christiansen (1990), pp. 39–51. A discussion on the same issue can also be seen in Putterman (1993), pp. 266–74. 22 The collective land system was also an important policy instrument available to local governments. In China, arable land is an extremely scarce resource. If a land market existed, the price of good arable land for the use of enterprise premises would no doubt constitute a considerable portion of new industrial investment. However, in most of the 1980s period that market was simply absent, and the authority to administer land use for non-agricultural purposes was not clearly defined. Therefore, the collective ownership of land in rural areas gave local governments the privilege of helping new enterprises reduce their investment threshold by offering free enterprise premises. 23 For a detailed discussion of responsibilities of local governments in the commune system, see Ghose (1984), ‘The new development strategy and rural reforms in post-Mao China’. 24 These are the three most commonly-rated objectives in the responses to a township leader questionnaire carried out by the World Bank study, see Wang Xiaolu (1990), p. 227. The other survey using a questionnaire by the Stockholm School of Economics comes to a similar conclusion, see Zhang Gang (1993), p. 4. 25 Zhang Gang (1993), p. 15.

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Index

ABC see Agricultural Bank of China above-quota taxes and profits, 83 accelerating depreciation, 108–9 accounts payable, 63 accounts receivable, 62–3 agency costs, 24–5 information costs, 24 moral hazard costs, 24 transaction costs, 24 Agricultural Bank of China contract responsibility system, 83–4 dual role, 93–4 history before 1978, 130 policy-related lending, 75 profit-retention system, 83 re-established, 74 responsibilities, 75 sub-contracting, 83–4 Agricultural Development Bank, 76 Anpu Township, 9 assessment of loan applications, 84 Aston Business School, 127 Atinic, T.M., 108 Bahl, Roy, 110 Bank of China, 74 Bankruptcy Law, 68 Beijing, 7 ‘big-bang’ approach, 13 ‘bottom-up’ approach, 2 Brigham, E.F., 20, 22 business failure definition, 68 failure rates, 69 reasons for, 69 Byrd, W., 2, 15, 17, 98, 112, 113, 124

Capital–labour ratio, 61 case studies Chaoan County, 7 representativeness of, 7 Tong County, 7 central and western regions, 41 Central Party Committee, 39 CESRRI, 100 Chaoan County, 8, 32, 61, 68, 107, 108 local institutional structure, 115–16 structure of rural finance, 77–8 Chen, C., 90 China Agribusiness Development Trust and Investment Corporation, 130–1 Chinese reform economy, 2 Christiansen, Flemming, 7, 114, 133 Clegg, Jenny, 64 collective funds, 103 Commercial Bank Law, 76 commune and brigade-run enterprises, 38 Company Law, 50 consequences of competitive tax evasion, 109–10 contract land, 113 contract system down payment of collateral for contracting, 51–2 in rural industries, 51 corporate analogy, 18 corporatism, 127 county rural enterprise bureau, 115 credit squeezes, 91 Croll, E., 59, 105 debt capacity, 3, 53–5, 71–2, 120–3, 128 growth rates and profitability, 53–5 internal equity investment, 55–64 tax shields and soft credit, 64–7

Index debt financing, 3 determinants of financing small firms bankruptcy costs, 23–4 financial gearing, 21–3 financial market imperfection, 24–6 soft budget constraint, 26–7 development models South Jiangsu, 7, 36 Wenzhou, 7, 36 Du, He, 16 dualistic development strategy, 100 economic infrastructure, 132 enterprise bonds in China introduction of, 48 regulations, 49–50 rural industries and, 49–50 types of, 48–9 enterprise’s own capital, 129 equity capital in rural industries net accumulation rate, 58–60 start-up capital, 56 retained profits, 56–7 European Commission, 5 Fengxi Township, 9, 105, 111, 112 fieldwork in Chaoan County, 7 in Tong County, 7–8 financial decentralisation, 4 financial default, 80 financial gearing comparative, 1984–94, 45 pecking-order theory, 21–2 performance of sales growth, 22 three advantages, 21 financial market failure, 127 financial market imperfection, 24–6 information asymmetry, 24–5 implications, 25–6 principal–agent relationship, 24 financing pattern current ration, 46 financial gearing, 1984–94, 45 fixed capital investment, 48–52 self-finance, 46–8 short-term debt ratio, 46 financial predation, 17 financial risk measured by, 22 vs. business risk 22–3 financial sector, development of, 129–30 financing of rural industries, a paradox, 12–13, 19–20, 119

145

fiscal decentralisation, 132 fiscal reform, 14, 110 fiscal predation, 113 fluctuations in output, 42–4 in profitability, 44 Gelb, Alan, 16, 17 Gérard, R., 15 Griffin, Keith, 31, 54, 60, 101 grain ration land, 113, 114 Gregory, R.G., 70 growth and cyclical patterns cyclical features, 42 macro- vs. micro-economic factors, 43–4 national industry vs. rural industry, 42–4 Guangdong Province, 8 Guo, F., 66, 67 hard budget constraint approach ‘federalism’ perspective, 15 ‘local government-led growth’ perspective, 14–15 ‘marketisation’ perspective, 14 Hofman, Bert, 108 household responsibility system, 1, 37, 74, 113 Hu, Z., 44, 45, 58, 66, 70–1, 114 Huang, Y., 76 Hutchinson, P., 21 Hutchinson, R.W., 26 Imai, Hiroyuki, 42 Industrial and Commercial Bank of China, 76 industrial restructuring, 61–2 internal and external capital foreign investment, 48 formal vs. informal enterprise bonds, 48–51 fund raising, 48, 50 local government support funds and fiscal funds, 48 share issuance, 63–4 investment threshold, 60–1 Islam, Rizwanul, 31, 128 Jensen, M.C., 24 Jovanovic, B., 25 Knell, Mark, 28 Kornai, János, 26, 99

146

Index

labour management employment management, 70–1 wage setting, 70 labour substitution for capital, 101 lending strategy reasons, 79–80 trade-off between yield and risk, 78–82 Liew, Leong, 90, 106 Lin, Q., 2, 15, 98, 124 local community risk-sharing, 17, 123–6 financial balancing operation, 110 mechanism, 110–16 local governments agricultural investment, 105 competitive tax evasion, 106–9 detrimental to economic efficiency, 19 expansionary drive, 99–100 financial capacity, 4, 100–4 fiscal contracting system, 14, 102, 107, 132 infrastructure investment, 105 intergovernmental transfers, 101–2 labour mobilisation, 101, 132 public accumulation, 101 revenue-sharing, 102 local government–bank relations information advantage, 18, 89 interdependence, 88–90 local competitive credit creation, 90–1 personnel management, 89–90 quasi-fiscal agent, 88 undesirable consequences, 91–3 local government–enterprise relations implications, 58 origin of, 57 local self-reliance, 100 local state capacity, 11, 98 financial responsibilities, 104-6 institutional capacity, 114–16 revenue capacity, 101–4 local state corporatism, 18–19 definition of, 16, 127 overcoming rural financial market imperfections, 18 local surtaxes, 102–3

methodological challenges data, 5 generalisation, 6 Miller, M., 21 Ministry of Agriculture, 33–4, 39, 41 Ministry of Finance, 83 Ministry of Foreign Trade, 41 Modigliani, F., 21 Myers, C., 21–2

Ma, Jun, 89, 132 Macmillan Committee, 20 Majiluf, N.S., 21–2 market boom, 99 McKinnon, R., 86 Meckling, W.H., 24

rate of repayment, 81 Rawski, T.G., 14 Ray, Graham, 21 RCCs see rural credit co-operatives reform dynamics perspective, 3, 27–8 defined, 28

Naughton, Barry, 17, 18, 54, 65 Nee, Victor, 18, 28 ‘neolocalism’, 18 nominal and real interest rates, 65 non-bank financial institutions, 75 non-collective industries, 34, 106 non-financial interests, 26 Odgaard, Ole, 133 Ody, Anthony J., 31, 34, 113 Oi, Jean C., 16, 17, 18, 89, 98, 102, 112, 124 over-collection of after-tax profits, 58–60 over-dependence on debt, 3, 45–52, 55, 120 lack of equity capital, 60 increase in capital intensity, 60–2 net suppliers of trade credit, 62–4 over-distribution of net profits, 63 over-issuance of credit, 91 Pei, X., 113 Peng, Y., 13 People’s Bank of China, 49, 74 role of local centres, 90–1 people’s commune, 75, 86, 101, 116 three-tier commune system, 114 People’s Construction Bank of China, 74 private enterprises, 33 private lending, 76 privatisation, 13 profit equalisation, 128 property rights, 13 Putterman, Louis, 133 Qian, Y., 15

Index regional disparities, 34 Rider, C., 28 rural banking sector see rural financial sector rural collective land system, 113–14, 133 rural co-operative fund associations, 75–6 rural credit co-operatives credit co-operative association, 77–8 redeposit funds, 94 relationship with Agricultural Bank of China, 94–5 restructuring, 75 rural enterprises characteristics, 13, 32–6 composed of, 1 consequences, 1 exports, 1 growth, 1 see also rural industrial growth job creation, 1, 99 objectives, 133 support for agricultural and rural development, 1 see also commune and brigade-run enterprises, town and township enterprises rural financial sector bad loans, 92 before 1978, 74 competition for savings, 86–7 credit rating, 84 decentralisation, 84–5 deposit structure, 86 financial performance, 92–3 incentive structure, 82–4 index-linked deposits, 87 liabilities portfolio, 84–8 loan management, 78–9 see also lending strategy loans portfolio, 82 loans to rural enterprises, 79 local loanable funds, 84 problem loans, 92, 131 restructuring after 1979, 74–6 saving generation, 85–8 under dynamic reform, 93–5 rural industrial cycle see growth and cyclical patterns rural industrial enterprises cyclical patterns of, 42–4 effective income tax rate, 107 firm size, 32–3

147

ownership structure, 33–5 regional patterns, 34–6 rural industrial growth, 36–41 adjustment period: 1978–83, 37–9 fast growth period: 1984–8, 39 period of resurgence: 1991–4, 40–1 period of slowdown: 1989–90, 40 rural industrialisation, 16 rural shareholding co-operatives, 41, 64 rural social output, 1, 127 Saith, A., 131 securities market, 49 Shi, M., 104 short maturity and rapid repayment, 81–2 Singh, Ajit, 14 Sjöberg, Örjan, 67 small and medium-sized enterprises (SMEs) definition by European Committee, 4 definition in China, 5 small firms, financial life-cycle of, 20–1 Smith, C.W., 24 soft budget constraint, 3, 26–7 definition, 26 on rural financial institutions, 93–5 on rural industrial enterprises, 15, 71 types of, 27 soft credit, 4, 66–7, 100 Song, Lina, 16 special funds, 131 Spark Programme, 39, 131 standard deviation, 43 state capacity, 98 State Commission for Economic Planning, 41 State Commission for Science and Technology, 39 State Council, 38, 49 state-owned enterprises, 2, 32, 61 Storey, D., 2, 4 Stiglitz, Joseph E., 25 survey in Zhejian and Sichuan, 67 Svejnar, Jan, 13 Tamari, Meir, 24 tax assignment system, 132 tax evasion by enterprises, 108, 133 tax reduction and exemption, 107 tax shield, 21, 64 taxation system, 102 ‘three guarantees and one linkage’, 83 Tong County, 9, 64, 127

148

Index

Tong County Branch of the Agricultural Bank, 60, 80–1, 92 town and township enterprises, 39 town and township finance budgetary revenues, 102 extra-budgetary revenues, 102–3 self-raised funds, 103 trade credit, 62–3, 129 transaction cost perspective, 18

Wang, Xiaolu, 34, 60, 107 Ward, Keith, 22–3, 44 Watson, A., 131 Weiss, Andrew, 25 Weitzman, M., 6, 13 Weston, Fred J., 20, 22 Williamson, O.E., 25 Wong, C., 19, 99, 100, 103, 104, 125, 132 World Bank, the study, 2, 17

under-capitalisation, 21, 60

Xiu, Meng, 70 Xu, C., 6, 13

Vermeer, E.B., 132 Walder, A.G., 14–15, 17, 110, 112, 125 ‘walking on two legs’ see dualistic development strategy

Zhang, Gang, 58, 59, 64 Zhongshan City, 8 Zhou, Kate Xiao, 13 Zhou, Q., 44, 45, 58, 66, 70–1, 114