It was mid-2005 and Joseph Chan had a problem. As chief financial officer of start-up restaurant chain Chatea, the Taiwanese-born Shanghai resident had a dream, but no way of financing it.
Chan had joined the company a year earlier in his capacity as a fund manager for the Shanghai City Fund Enterprise, a US$100 million fund that used money raised from off-shore Chinese to support start-up ventures in the city.
The backing had helped the company grow from three to 16 outlets, but Chan and the original management team had a bigger ambition: to become the first international Chinese-style casual dining chain.
"We hoped we could be the first, and the best, just like Starbucks, but we needed expansion capital," Chan said.
"For our shareholders' benefit we wanted to get financial leverage from commercial banking but domestic banks are not familiar with project financing."
Despite years of reform, China's banking system is effectively still run by the state and for the state, making it all but impossible for small entrepreneurial players to attract a credit line from commercial lenders. "It was hard, but still we tried," Chan said. "I got a deal, but because we were so small we couldn't finalize it."
Chan and Chatea eventually struck it lucky with a group of venture capitalists. But for millions of other Chinese entrepreneurs, luck belongs to other people when it comes to accessing capital.
China's financial depth – assets such as bank deposits, corporate and government bonds and equities that can be put to use in the financial system – has grown massively in the last decade, from around 100% of GDP to approximately 220% today.
But inefficiency in allocating these funds costs the country up to US$259 billion per year in lost productivity, according to Diana Farrell, director of McKinsey Global Institute (MGI), McKinsey & Company's economic think tank.
A sharper system that allows money to gravitate to where it can generate the best returns would boost GDP by an additional US$62 billion every year, she estimates.
"China does a very good job of mobilizing savings in the financial system, but it does a poor job in allocating those savings to where it will get the highest returns," Farrell said.
The problem is that the financial sector is dominated by banking, which accounted for 72% of China's financial assets in 2004, and the banking sector is dominated by the state, which controls 83% of all bank assets. This has led to the system being co-opted to political rather than commercial use, allocating capital according to the developmental priorities of central and regional governments rather than to the most productive sectors of the economy.
"What you have is less a set of commercially minded institutions seeking out the highest return investments in the economy, but rather a system that promoted investment, and therefore employment, in sectors and areas that the government has traditionally assumed to be strategically important," Farrell said.
MGI research shows wholly state-owned companies receive 35% of bank credit and account for almost all domestic equity and bond issues in China. Shareholding enterprises that are partially state-owned and collective enterprises (owned by the population, run like private enterprises, but generally controlled by local political interests) account for 38%.
Private enterprises, both foreign and domestic, battle over a meager 27% of loan balances. Small- and medium-sized enterprises (SMEs) receive just 16%.
From the perspective of China's banks, it makes sense to lend to the largest state-owned enterprises (SOEs) because it is cheaper to make large loans to fewer borrowers than many loans to smaller private companies. Given the poor quality of information on potential borrowers, banks are also drawn toward lending to SOEs as they are backed up by implicit government guarantees, making them lower-risk.
But that is only half the story.
Joint OECD and National Bureau of Statistics research from 2005 shows that the productivity of privately-owned companies – taking into account company size, location and industry – was twice as high as that of the majority state-owned firms.
By channeling a disproportionate share of credit to SOEs, the financial system is lowering productivity, and increasing the burden of bad debts.
As a result, it costs China US$4.90 in investment to generate US$1 in growth, up from US$3.30 per dollar in 2001.
"If you could mobilize these savings efficiently you could do great things with them," said Farrell. "But instead you are channeling them towards lower productivity enterprises."
Paradoxically, the country's private sector has thrived over the last decade. By 2003, it accounted for 52% of national output, according to MGI estimates, and the bulk of new job creation, with 29.3 million private businesses employing over 200 million people. In contrast, SOEs now contribute barely a quarter of China's GDP. Small and mid-sized companies, both private and state-owned, provide 75% of the nation's employment and 55% of its GDP.
Much of that growth has been driven by foreign capital, but informal sources of finance, known as the "curb market", have also played a significant role.
"China's economic miracle would not have been possible if private entrepreneurs had not found a way around the financial straightjacket applied by central leaders," said Kellee Tsai, a specialist in Chinese informal banking at Johns Hopkins University in Baltimore, US.
"There is no way China's private sector would be as developed as it is without informal finance. It's just inconceivable."
Based on research for her 2002 book Back-Alley Banking, Tsai estimated informal finance accounted for up to three-quarters of private sector credit and at least one-quarter of total financial transactions in the Chinese economy during the first two decades of reform.
More recently, Professor Li Jianjun of the Central University of Finance and Economics in Beijing estimated that the total volume of curb market lending in 2003 was anywhere between US$91.42 billion and US$100.79 billion. This represents about 28% of total lending by formal financial institutions.
A 2004 survey by the People's Bank of China put informal lending at US$118 billion, or 6.96% of the country's GDP.
"If you look at the PBOC estimates, I actually think those are vast underestimates," said Tsai. "Not intentionally – I actually believe that is what they found – but it's very difficult because people aren't prepared to talk."
Even in the coastal city of Wenzhou, Zhejiang province, widely considered to be the spiritual home of back-alley banking, businessmen are unwilling to speak publicly about the informal financing upon which their commercial success is built.
Wenzhou is an exception in China, a product of circumstance.
The central government starved it of state assets due to its proximity to Taiwan and private enterprise filled the void. Helped by protection from local cadres and largely ignored by Beijing, the informal financial sector flourished.
By 2003, 71.8% of all financial transactions in Wenzhou were believed to occur outside of the formal banking system, prompting the People's Bank of China to wave the white flag and designate the province as an official experimental district for financial and banking reforms.
"They tried to clamp down and they haven't been able to successfully," said Tsai. "So in the localities where it is particularly vibrant, like Wenzhou, they said, 'okay, it seems to be working there, it's not a really huge locality in Chinese terms, let's just give it a chance'."
Although Beijing is watching it closely, Wenzhou and other cities in Zhejiang province now have legal, commercial banks that are allowed to accept private investment, extend small loans of less than US$60,975, and float interest rates. Tsai described Wenzhou as an example of the government inspiring "reform from below", through partial formalization of its informal institutions.
Anxious for change
For private entrepreneurs, the reforms can't come quickly enough.
Although the informal economy has played a significant role in the private sector's success, it has come at a high cost to individual borrowers. While the cost of borrowing in China is low by international standards, with the one-year lending rate at 6.12%, mutual assistance societies offer savers annual returns of around 24% on deposits. This can reach as high as 36% at rotating credit associations in the coastal south, Tsai said, sending the borrowing rates even higher.
According to MGI figures, reducing the size of the curb sector by increasing credit for SMEs and private companies from formal banks would boost the economy by US$2 billion every year. Most of this would accrue to borrowers through lower interest charges on loans.
Curb market lending also runs the spectrum from legal through quasi-legal to highly illegal. This depends largely on whether it involves interest rates above the state-mandated ceiling, a matter which is further complicated by regional variations in interpretation and changing patterns in enforcement.
The dark side to informal lending has been in the spotlight in recent weeks after at least a third of Shanghai's US$1.25 billion pension fund found its way into real estate and infrastructure investments. At the center of the corruption scandal is Zhang Rongkun, chairman of Fuxi Investment Holdings, one of Shanghai's largest private investment firms. (See: Gray lending: pension funds find a home)
In response, Beijing announced a nationwide audit of locally managed pension funds. But there are doubts as to how deep auditors will be able to probe, with many China watchers agreeing the sudden focus on Shanghai is more a case of political opportunism than concern with the fund's investment decisions.
"This practice has been going on for a long time and Beijing has condoned it for a long time," said Mark Frazier, a professor of East Asia political economy at Lawrence University in Wisconsin and a specialist in China pension funds.
"I agree with assessments of people who look at this as a move by Hu Jintao to push aside some of the Shanghai people."
Political or otherwise, Beijing has opened up a can of worms by playing its hand. Frazier believes pension fund lending to private enterprise is so widespread it has the potential to reach hundreds of billions of yuan if not pegged back.
It is not just pension funds handing over cash. Equipped with bank loans and retained earnings and with few formal investment channels open, SOEs have much to gain by lending on the gray market.
"The government gives a lot of money to city companies to help them improve their performance but most of these companies cannot guarantee a return on that money," said one Shanghai property insider.
"Naturally, companies that hold a large amount of money try to find worthwhile projects to generate income. A lot of it goes to the property sector."
While it is clear that cleaning up the informal finance system is a prerequisite to altering the formal apparatus, until such time as reforms are completed the economy is still heavily dependent on the curb.
"It's a chicken-or-egg issue," said Tsai. "In order to clamp down on this they need to give better investment opportunities to the SOEs."
Tackling the issue will require a balance between carrot and stick.
Not only does private enterprise need access to China's vast savings, allocated according to market criteria rather than political expediency, the state sector and the government pension funds require higher-yielding investment instruments than bank deposits and government bonds. Legitimate debt and equity channels are necessary to connect those with cash to those who need it.
But rather than taking a hard line with the informal lenders, it should instead be taking a hard look. "The lesson from Wenzhou," said Tsai, "is that you are better off regulating and observing than outright banning. Outright banning just pushes it further underground."
China will have enough trouble with the old skeletons in the closet without creating new ones.
Cash and carry
Government oversight is putting the squeeze on big money deals, but there is still space around the edges in which to do business
As China opens up access to foreign investors, the shopping list for big name deals is filling up fast. But so is the line at the cash register as the government comes under pressure to block foreign investment in certain sectors.
"A lot of major players have been trying to push the envelope there with no success," said Kenneth Read, managing director of business development for Thomson Financial Asia.
Recent deals to have hit regulatory hurdles include Carlyle Group's US$375 million takeover bid for state-owned construction equipment maker Xugong; a proposed US$138 million purchase of state-owned machinery manufacturer Luoyang Bearing by German firm Schaeffler; and Hong Kong-listed Shanghai Industrial Holdings's plan to take a controlling stake in the Lianhua Supermarket chain.
French home appliance group SEB failed to acquire Zhejiang Supor Cookware, and CVC Asia Pacific, which raised a US$2 billion China buyout fund last year, has scrapped plans to pay US$600 million for a 30% stake in leading Chinese papermaker Shandong Chenming Paper Holdings. However, CVC denied that the deal collapsed due to regulatory problems.
The National Development and Reform Commission's research institute of investment has also weighed in, calling for a special government department to be set up to "rigorously examine" foreign takeovers of state-owned companies.
While the government should try to stay out of corporate matters, the institute said, it should step in to "guard against all the kinds of hidden dangers that such investment brings".
But it is a bottleneck, not a blanket ban, with other deals slipping through the net.
Most recently, a US$252 million bid by a Goldman Sachs-led group to acquire China's largest meat processor Shineway Group won the regulatory go-ahead after much debate. And UBS slipped into the brokerage business before the door closed, getting approval for a minority stake with management control in Beijing Securities.
Read contends the Chinese authorities are simply employing oversight to direct investment towards industries and regions where investment dollars and foreign expertise is needed.
"Here you see the Chinese government re-inserting itself only to the degree where it leaves itself options with respect to politically sensitive acquisitions or investments," he said.
But oversight is wrapped around a hefty stick which the government can use to make its presence felt.
New merger and acquisition rules introduced September 8 enable the commerce ministry to void acquisitions of domestic targets engaged in key industrial sectors if it sees the purchase as a threat to national security. Transactions involving well-known trademarks or traditional brands will also be subject to heightened scrutiny.
Nevertheless, China is still a happy hunting ground for the foreign investor.
"You've just got to be careful," said a Shanghai-based venture capitalist who asked not to be named, adding that there were plenty of areas open to growth capital and foreign expertise. "We generally try and stay away from politically sensitive industries. What we have seen so far from the Chinese government is that they have been pretty supportive of foreign investors working for venture companies."
The failure of China's financial sector to allocate savings to its most productive sectors has created a vast pool of capital-thirsty domestic companies. As the government looks to address this problem, it is well aware of the important role foreign money plays in filling the gap.
As such, the heightened regulatory oversight is not so much a crackdown as a slowdown. It is a move to control rapidly escalating foreign investment, much of which is headed for areas that are already mature, unlike the early foreign money that was used to build industry from scratch.
Beijing has always been cautious of selling off state assets.
When China became the world's leading FDI destination in 2003, accounting for 9.6% of global flows, its cross-border mergers and acquisitions (M&A) made up just 1.3% of the global total.
But this is changing fast. Thomson Financial recorded US$13.2 billion in completed acquisitions by foreign companies last year, up from only US$2.7 billion in 2001. M&A accounted for 3.9% of foreign direct investment in China in 2002; last year its share was 21.5%.
Deals big and small
It is not all large-scale deals either. In the first half of 2006, US$757.9 million in venture capital (VC) financing found its way through 85 deals to companies headquartered in mainland China, according to figures released last month by Dow Jones VentureOne and Ernst & Young.
The second quarter saw 54 deals worth a total of US$480.1 million, the highest aggregate capital investment in two and a half years. It was also double the amount invested in the second quarter of 2005, when the industry slumped in response to the release of two sets of regulations affecting the formation of offshore entities.
"With China's emergence over the past several years as a source for new technology and services, investors from around the globe have taken notice and are demonstrating this by providing them with the economic support necessary to compete in the global marketplace," said Bob Partridge, China leader of Ernst & Young's Venture Capital Advisory Group.
Chinese companies were also beneficiaries of US$731.1 million in private equity (PE) investments in the first half of 2006, representing 68 deals from 62 different PE firms. As much as US$600.64 million of this came from offshore investors, almost three times more than the US$208.6 million attracted in the first half of 2005.
Despite the early 2005 investment slowdown, China-dedicated VC funds still raised US$4 billion in committed capital last year, encouraged by high-profile, high return exits like the offshore listings of Baidu and Focus Media and Wuxi-based renewable energy firm Suntech.
The huge oversubscription of a US$668 million Carlyle Group private equity fund targeted for investment in China, India, Japan and South Korea, suggests there is plenty of money waiting for a China play.
Unsurprisingly, the principal challenge faced by PE and VC investors, many of which operate with five-year investment pools, is getting their money out.
"Even if you can find that quality company, make the investment and get past all the hurdles you would encounter, then you've got to figure out how to exit that investment," Read said.
"You still don't really have a NASDAQ-style market so you are constrained on the smaller investment side."
According to Bruce Richardson, managing director of research at Xinhua Finance, the domestic listing process is focused on high volume listings, forcing venture capitalists to list off shore.
"Many of the smaller private companies are good but if you try to list them as an A-share you get sent to the back of the pack," he said, citing China Biodiesel International Holding's listing on London's AIM board in June last year, which raised a relatively modest US$72 million.
"It's tiny so AIM can take it but the A-share regulators wouldn't bother with it."
Offshore exchanges have long been a favored destination of domestic firms looking to break into the big time.
Despite the resumption of domestic listings after a year-long hiatus, this situation is unlikely to change without a prod from the regulators.
Chinese solar panel maker Yingli Solar, is planning to raise about US$400 million in what will be NASDAQ's largest initial public offering by a Chinese firm, while another Chinese solar specialist, CSI, is also heading toward an overseas listing.
The NYSE, which reeled in Suntech Power's US$396 million IPO to break NASDAQ's China tech hegemony, is hunting for fresh Chinese companies to list. Exchange executives came to Zhejiang province in August to meet with the province's top companies and sign an agreement with the provincial government.
But easy offshore exits may be a thing of the past. New M&A regulations affecting the establishment of offshore special purpose vehicles, which are the favored entity for PE and VC investments, mergers and acquisitions, and overseas IPOs of China-based companies, could change the entry and exit investment landscape.
By reinstating China Securities Regulatory Commission (CSRC) oversight of offshore listings, which it virtually relinquished three years ago, and requiring that the commerce ministry is notified of such deals, Beijing is better placed to control deals that once flew under the radar.
Stemming the tide
According to one domestic venture capitalist, the regulator is keen to stop the loss of hi-growth companies to offshore exchanges. It is gambling that the requirement for approval from two or three government agencies will slow the pace with which PEs and VCs can exit their investments in offshore markets, and thus encourage companies to list at home.
"If all the good companies list offshore, who will list in the Chinese market?" the investor said. "I don't really care where I list [companies] I just want to make money and there are good returns to be had here."
In closing off exit channels, the government is putting itself under more pressure to speed up reform of the securities markets in order to provide a viable alternative.
The Shenzhen SME board, which opened in May 2004, was intended as a place for smaller companies to raise capital but so far it has been a disappointment.
Faced with concerns from the Shenzhen and Shanghai exchanges that they would lose business to the SME board, the regulator retained the same listing requirements as companies listing on the main boards had to meet. As a result, despite more than 1,000 companies joining the IPO queue, only 66 small- and medium-sized enterprises have listed there.
According to a source close to the Shanghai Stock Exchange, the government is eager to develop Shenzhen into a NASDAQ style high-growth board. It is quite possible that the Shenzhen main board will be incorporated into the Shanghai stock exchange, leaving Shenzhen to reinvent itself as a specialist board to rival NASDAQ or London's AIM board.
Early signs are promising. Following the resumption of domestic listings in the second quarter, the Shenzhen SME Board grabbed three of the first four IPOs, including the only domestic VC-backed listing, Shenzhen COSHIP Electronics.
Though significant issues still exist, the government is making rapid progress in reforming the financial sector, with more financing avenues open to private companies than ever before.
"The options are the same as you have in the West or in transparent markets in Asia," said Thomson Financial's Read. "It's just the limits that are the issue: the scale and the flexibility to be more creative about how you raise capital are limited, whether you are private or listed."
Despite the obstacles, China is a very attractive risk reward opportunity.
"There are headaches in getting the regulator's approval and oversight, but on a functional basis, although they are still quite finite in many respects, the thresholds of ownership still are going up."