Factoring: A n Effective Financing Option to SMEs in China

Factoring: A n Effective Financing Option to SMEs in China FENG Yue Economics and Management Department, Nanjing Institute of Technology, P.R.China, 211167 fengyue@njit.edu.cn Abstract: Factoring is a growing option of external financing for small and medium-size enterprises (SMEs) in China since its entry into WTO in 2001. The reason why there is considerable potential for factoring in China underlies three aspects: large funding gaps and serious difficulties in getting financial supports by SMEs, dramatic trade growth, and tremendous increase of factoring business itself in China as well as around the world. Data analysis also shows there is a good chance for factoring s further growth in China. Therefore, some recommendations are put forward to advance factoring in Chinese market in this paper, such as strengthening credit information infrastructure, enhancing legal and judicial system and training professional personnel. Keywords: Factoring, Financing, Small and Medium-size Enterprises 1 Introduction As accounted for 99% of total enterprises, small and medium size enterprises (SMEs) play an important role in increasing production, providing service, and creating jobs and so on. However,SMEs is facing many problems and market challenges in their efforts to develop and grow, and the funding gaps are vital for the firm s survival and growth. Because of such disadvantages of SMEs as asymmetric information and insufficient collateral which probably resulting in adverse selection and moral hazard, banks and other finance institutions cannot provide adequate credit supports to SMEs (Lin Yifu and Sun Xifang 2005; Xu Xianmei 2008). According to statistics, among the total credit balance RMB Yuan 26169.09 billion, only RMB Yuan 711.26 billion is for township enterprises and RMB Yuan 350.77 billion is for private enterprises, which account for only 2.72% and 1.34% respectively (Jiang Fuxin and Zhou Chunping 2008). Under the recession conditions of world economy due to the Subprime Mortgage Crisis in American, traditional credit at most commercial banks is being tightened significantly, and it is more and more difficult for SMEs to obtain financing. The existence of these problems normally directs many SMEs to seek different alternatives of finance for their operations, and factoring is exactly the right alternative, a flexible and low cost financing vehicle for SMEs. Factoring, an external financing source for corporations and SMEs, is growing around the world, and a lot of financial literatures focus on this issue in recent years. Comparison to conventional financing technology, factoring with its unique advantages may be particularly useful in countries with weak judicial enforcement and imperfect records of upholding seniority claims, and this has been well supported by Leora Klapper (2006) and Marie H.R. Bakker, et al (2004) with discussion of some factoring cases in emerging economies and Eastern Europe. A certain kind of factoring, that is reverse factoring is also discussed by some researchers, and the case of the Nafin reverse factoring program in Mexico is illustrated as a successful example by Leora Klapper. The choice of factoring as a financing source is not only based on firm s demographic characteristics, but also on some additional factors, such as the availability of credit to firms, the collateral requirements by banks and its value, the value of the firm s debt, and also whether the business is experiencing financing difficulties (Khaled Soufani 2005). There is only a little literature focusing on factoring in China, but China is a rising star in factoring among developing and transition countries. The purpose of this paper is to give a small contribution to factoring field in China. In the next section, we present a theoretical analysis on the reasons why there is considerable potential factoring market in China. And subsequently we make a time-series data analysis and a comparison of factoring turnovers among China and some developed countries, and we find there exists large room to develop factoring in China in the third section. And then we put forward some 318

recommendations on how to effectively advance factoring business in China, such as strengthening credit information infrastructure, enhancing law system and training professional personnel in the fourth section. In the last section, we provide conclusions and some suggestions for future research. 2 Potential Factoring Market for SMEs in China 2.1 On the aspect of SMEs: large demand and huge difficulty in financing SMEs face significant funding gaps and thus have a large demand for external financing due to its poor capability of making accumulations and profits. But the imperfection of Chinese security market makes it very difficult for SMEs with small scale and low credit score to obtain capital support by issuing stocks and bonds, and also the imperfection of Chinese security market makes bank loan to be the primary funding source for SMEs. Taking SMEs in Shanghai as an example, the ratio of bank loans to their all external financing is even higher than 70%. Nevertheless, even heavily depending on bank loan comparison to large size enterprises, SMEs can get less bank loan at more strict terms, because commercial banks usually put more constraint on SMEs. According to a fresh statistics, the fraction of bank loan to SMEs to overall bank loan is only 8%, which is obviously unbalanced with SMEs contribution of 1/3 GDP, 2/3 industry increased value, 38% export and 1/4 fiscal revenue. As for export firms which factoring mainly serving for, funding demand is largely increasing under the situation that their trade partners, mainly EU, American and Japanese enterprises, are in a downward economic condition. On the one hand, the importers in EU, American and Japanese ask for a deferred payment terms which causes a further lack of working capital for Chinese exporters, thus the exporters are dragged into a worse finance situation and they have to rely more on bank financing. On the other hand, banks put more strict conditions on lending contracts with SMEs in order to limit their risks of defaults because some Chinese SMEs have already gone bankrupt as the result of being affected by this financial crisis, thus, there occurs a vicious circle being difficult to obtain bank loan, then going bankrupt, then getting more difficult to obtain loan. In a word, financial crisis makes it more and more difficult for SMEs to looking for external funding opportunity. 2.2 On the aspect of export growth: factoring is especially suitable for international trade A factoring case is called international factoring when it involves four parties of clients: exporter, importer, exporter factor and importer factor. In recent years, international factoring developed rapidly and benefited a lot of foreign trade companies, especially small and medium size trade companies, with the advantages to be derived from an international factoring arrangement: working capital, credit risk protection and collection service for the exporter, while the importer benefits from buying on open account terms without the need to open letters of credit or to accept other payment conditions with a similar restrictive character. Due to the benefits of factoring to exporters and importers, it is more popular that the exporters and importers are outsourcing their credit and collection functions to international factors. Since China s entry into WTO in 2001, the export and import volume continuously increased four times at a more than 20% annual rate. The volume of export and import reached US Dollars 2, 562 billion, ranking the third in the world (only next to the U.S.A. and Germany), and the amount of export increased to US Dollars 1, 429 billion and only US Dollars 36.5 billion less than the top Germany in 2008. Although affected by financial crisis, both export and import turnover decreased in the first half of 2009, the increasing tendency of foreign trade in China is absolutely not changed. So, there is big room for factoring, especially international factoring in China. 2.3 On the aspect of factoring itself: developing popularly around the world In 2008 world total factoring turnover stands at Euro 1,325,111 million with an increasing of 190% compared to that in 1998, also in 2008 world total international factoring volume to be seen with the biggest growth of 20% compared to that in 2007. The Asian countries continued to gain in market share, 319

both in domestic factoring and in international factoring with each 35% growth rate. Meanwhile FCI itself grew to a membership of 245 members, located in 65 countries. Most of those members in developed countries have existed for many years and have abundant experience to let them the leaders in their respective markets. In most developing and transition countries, factoring is normally initially introduced and at its beginning stage, but factors in these countries can gain in Know-how by working closely with factors in developed countries. 3 Current Situation of Factoring in China At present there are 16 FCI members in china following the first FCI membership got by Bank of China in 1993, but factoring didn t attract much attention until the Ericsson case happened in March 2002, and from then on factoring industry experienced a rapid expansion from a very low base. In 2008, factoring volume reached Euro 55,000 million, which is more than 26 times compared to that in 2002. But compared with some biggest factoring business countries, such as the U.S.A., the U.K. and Japan, China is only a small factoring country. Table 1 shows the vertical and horizontal comparison and indicates large room for factoring industry development in China. Table 1 Factoring Turnover in China and Some Countries China U.S.A. U.K. Japan World (1)1(2)2 1 (1) (2) (1) (2) (1) (2) Total 1998 11 0.00 70,059 15.35 84,255 18.46 38,980 8.54 456,410 2 1999 31 0.00 88,069 15.82 103,200 18.53 55,347 9.94 556,815 2000 212 0.03 102,268 16.39 123,770 19.84 58,473 9.37 623,839 2001 1,234 0.18 101,744 14.84 136,080 19.85 61,566 8.98 685,680 2002 2,077 0.29 91,143 12.59 156,706 21.64 50,380 6.96 724,196 2003 2,640 0.35 80,696 10.61 160,770 21.14 60,550 7.96 760,391 2004 4,315 0.50 81,860 9.52 184,520 21.45 72,535 8.43 860,215 2005 5,830 0.57 94,160 9.26 237,205 23.33 77,220 7.60 1,016,546 2006 14,300 1.26 96,000 8.46 248,769 21.93 74,530 6.57 1,134,238 2007 32,976 2.53 97,000 7.45 286,496 22.01 77,721 5.97 1,301,590 2008 55,000 4.15 100,000 7.55 188,000 14.19 106,500 8.04 1,325,111 Percent Change 499900% 42.74% 123.13% 173.22% 190.33% 1998-2008 Annul Growth 134.37% 3.62% 8.36% 10.57% 11.25% Source: Factors Chain International and calculation. Note: (1) represents factoring turnover (million euro) (2) represents percentage to world total (%) As an important branch of factoring, international factoring is normally the introductory and principal type of factoring in most developing and transition countries, Table 2 shows that China has become the biggest generator of international factoring business, with superior continued growth potential compared to other countries in the world. Table 2 Domestic and International Factoring Turnover in China and Some Countries Domestic International Percent Domestic International Volume1 Volume International Volume Volume Percent International (2008) (2003) (2003) (2003) (2008) (2008) China 2400 240 9.09% 30,000 25,000 45.45% U.S.A 77496 3200 3.97% 90,000 10,000 10.00% 1.56% 158270 2500 175,000 13,000 6.91% Japan 60000 550 0.91% 105,000 1,500 1.41% 320

Total World 712657 47735 6.28% 1,148,943 176,168 13.29% Source: Factors Chain International and calculation. Note: 1Volume (million euro) Although there is a decrease in factoring business in the first half of 2009 in China, the potential for the longer term is confident. With the recovery of world economy and world trade in the second half of 2009, many SMEs, who are still facing the difficult time of limited access to working capital and limited availability of credit insurance for debtor risks, will be eager to use factoring as the first choice of financing. 4 Recommendations to Advance Factoring in China 4.1 Credit information infrastructures should be strengthened Factors provide working capital to sellers through purchasing the sellers accounts receivable at a discount. Whether the factors can successfully collect the accounts receivable depends on the creditworthiness of the buyers. The information about a firm s payment performance is vital to factors because the firm s record of paying its past obligations may be the best indicator of its ability to pay its future ones. A survey found that credit risk is negatively correlated with measures of formal information sharing (Jappelli and Pagano 2001). At present, there exists a big lack of financial system s information infrastructure in China. The missing is not only the financial information records, but also, even more, the awareness of credit records. To strengthen the credit information infrastructures by setting up both public credit registries and private credit bureaus should be a solution. 4.2 Legal and judicial environment should be enhanced A country s legal and judicial environment may play a critical role in driving factoring business. It involves many law rules to conduct a factoring, such as contract law, bankruptcy law, guaranty law, and private international law, etc. The lack of an effective legal and judicial system and relative supervisory measures may be the main obstacle to factoring in developing countries. In fact, there are countries with a strong rule of law that have significant amounts of factoring, examples include the United Kingdom, the United States of American, Japan, Austria, Denmark and Netherlands. The law system is getting more and more complete and healthy after the introduction of market mechanism to China, but there is still a big gap to meet the market need, especially to meet the requirement of factoring business. So, it is essential to enhance the legal and judicial environment in China. 4.3 Professional personnel should be trained Because factoring is usually a bundle of services: financing, the credit risk assumption service, and the collection service, employees who work in this area might be needed with a high level of comprehensive knowledge in the line of factoring. However, there exists a large shortage of financial talents due to the short history and small scale of factoring in China. Professional personnel should be trained in various ways. Learning from fellow traders in factoring developed countries by both inviting experts in and sending financial personnel abroad can be viewed as a useful method. For example, the case of the Nafin reverse factoring program in Mexico is regarded as a successful case and it is worth to be popularized in developing countries, so to learn from this mode in Mexico might be one of the feasible learning affairs. And another available way is to introduce talents in factoring special area directly from Wall Street and other factoring developed countries, particularly that a lot of employees lost their jobs in banks and other financial institutions during this financial crisis might be a good chance for attracting senior talents. 321

5 Conclusion On demand side, SMEs are popularly facing financing difficulties. While SMEs playing a more and more important role in economic growth and social stability, and also with their big growth in foreign trade, the funding gaps become the main hindrances for SMEs survival in the drastic competition. On supply side, factoring is a popular and growing source of external financing for business firms, particularly for SMEs because of its flexible and welcoming virtues in serving clients needs around the world. Therefore, there is considerable room for factoring in China. By means of strengthening credit information infrastructure, enhancing legal and judicial environment, and training professional personnel, factoring would become a kind of really effective financing technology for SMEs. Data limitations prevent a complete analysis to reveal what are important determinants for SMEs to their decision on financing by factoring, therefore, empirical tests should be one of the further research works. References [1]. LIN Yifu, SUN Xifang. Information, Informal Finance and SME Financing. Economic Research Journal, 2005 (7):35~44(in Chinese) [2]. XU Xianmei. Discussion on Small and Medium-sized Enterprises Financing. Journal of Nanjing University of Finance and Economics, 2008 (1):39~41,64(in Chinese) [3]. JIANG Fuxin, ZHOU Chunping. Transaction costs, Informal Finance and SME Financing. Forum of World Economics & Politics, 2009 (2):22~26(in Chinese) [4]. Leora Klapper. The role of factoring for financing small and medium enterprises. Journal of Banking & Finance, 2006,30(11): 3111~3130 [5]. Bakker, M., L. Klapper, G.F. Udell. Financing Small and Medium-Size Enterprises with Factoring: Global Growth in Factoring--and Its Potential in Eastern Europe. Working Paper No. 3342. World Bank, Washington D.C. [6]. Khaled Soufani. On the Determinants of Factoring as a Financing Choice: Evidence from the UK. Journal of Economics and Business, 2002, 54(2): 239~252 [7]. Jappelli, T., M. Pagano. Information Sharing, Lending and Defaults: Cross-Country Evidence. Journal of Banking and Finance, 2001, 26: 2023-2054 [8]. LU Fangfang, DUAN Yuanping. Research on China s Factoring Development under Sub-prime Mortgage Crisis. International Economics and Trade Research, 2009, 25 (7):50~54(in Chinese) [9]. ZHANG Tianqiao. On the Application of International Factoring in Small and Medium-sized import and Export Enterprises. Reformation and Strategy, 2008,24 (6):103~106(in Chinese) [10]. Tadeo A. Satta. Exploring the value of factoring as a finance option for small enterprises in emerging economies. Entrepreneurship and Innovation, 2006, 7(4):243~249 322