Informal Financing Channels Rev up Private Firms' Performance in China

284 private firms in China investigated in the new study shows that informal financing channels including underground finance and trade credit have contributed to the rapid growth of private firms in China and transitional economies in general.

HONG KONG, CHINA - Media OutReach - August 3, 2015 - Many Chinese private firms are turning to alternative fundraising options to survive and thrive, as it isn't always easy for them to obtain a bank loan. A new research on the role of alternative financing at The Chinese University of Hong Kong (CUHK) Business School reveals its positive impact on the performance of private firms.

The research, led by Daphne Yiu, associate professor at the Department of Management of CUHK Business School, explores the relationship between alternative financing in the forms of underground finance and trade credit and the performance of private firms.1 Using the metrics of return on assets (ROA) and net income reinvestment rate (NI reinvestment rate), the study reveals that underground finance and trade credit are useful informal financing channels for private firms in China and transitional economies in general.

"How firms are financed is one of the fundamental issues raised in the literature of private firms," says Prof. Yiu. "Private firms have flourished in mainland China despite their limited access to formal financing, such as bank loans and fundraising in the capital market. Why is that the case? The reason had never been studied. That's what prompted us to unveil the mystery."

According to Prof. Yiu, private Chinese firms have been undergoing rapid growth and serving as the main driving force of China's economic development in the past decade. For example, the number of private firms increased from 52,920 in 2005 to 102,345 in 2009, accounting for half of the total number of industrial firms in China. In addition, the private sector contributed about 18.7 percent of China's industrial value in 2009.

However, given such a large number of private firms, only 3.52 percent of the total loans issued by state-owned commercial banks went to private firms in 2009. Moreover, the complex procedures and high costs of state bank loans make it more difficult for private firms to obtain loans in a timely manner. As a result, state bank loans can only satisfy 10 percent of private firms' total financing needs, and these firms have to turn to other financial channels.

"In light of this, we would like to explore if there are alternative ways of financing for private firms to sustain their growth in China," says Prof. Yiu.

Beneficial to Private Firm Performance

According to Prof. Yiu's research paper, alternative or informal financing refers to all other financing channels that are based on reputation and relationships rather than on formal contracts, such as underground financing and trade credit. Prof. Yiu points out that alternative financing provides funding access to private firms when formal financing channels are not accessible to them.

In the study, Prof. Yiu and her collaborators, Jun Su, a graduate student at the Department of Finance, and Yuehua Xu, a graduate student at the Department of Management of CUHK Business School, investigated the financial data of a sample of 284 private firms in 19 cities in China. These private firms are neither listed nor state-owned, each with a headcount below 1,000. At the same time, the researchers collected data from a random-sample survey conducted in 2007 by the provincial branches of three listed banks in China.

They found that alternative financing is beneficial to private firms' performance. "The reason may be that alternative financing is better than formal bank financing in terms of flexibility and timing of supplying cash needed in a short period of time," explains Prof. Yiu.

In addition, the researchers found that the value creation of alternative financing varies across different provinces depending on the level of institutional development. For example, underground financing plays a more important role for private firms in provinces where there is less governmental support, less non-state economic development and less credit marketization.

The study's third major finding is that there are industry preferences in the use of underground financing and trade credit. For example, manufacturing firms normally have larger capital expenditure needs than trading companies. The large amounts of capital required can easily be met by underground financing. By contrast, trading companies generally have more frequent transactions and trading partners than manufacturing firms. As such, trade credit is their preferred channel as they can establish trust and social networks with their suppliers and customers through its usage.

Implications for Policymakers

Having deciphered the relationships between alternative financing and private firms, the study offers important implications for policymakers in China and other countries that are undergoing similar economic transitions, according to Prof. Yiu.

First, governments in transitional economies should provide more support on alternative financing to private firms. Careful steps are needed to regulate alternative financing resources to promote their positive effects and to mitigate the risks, such as delayed payments and defaults that are not supported by current legal systems. "A series of carefully designed alternative financing mechanisms by governments would help the development of the private sector in transitional economies," Prof. Yiu points out.

Second, these governments should create a multi-faceted financing system for private firms, such as accelerating private firms' access to capital markets, encouraging them to get loans in small banks and setting up SME credit guarantee systems, which will serve to better meet private firms' financing needs and support their long-term development. "In the long run, under a multi-faceted financing system, private firms may seek bank credits in the first place while using alternative financing as a supplemental means for their immediate cash needs," concludes Prof. Yiu.