Financing private investment in China: the role of alternative finance and banking reforms

Noëmie Lisack

Small, young private firms in China have long been struggling to obtain formal bank loans. To bypass financial constraints, these firms have resorted to alternative, less formal financing sources. In this context, Chinese authorities are aiming to develop a more formal, market-based, and better regulated credit sector. In a Staff Working Paper, I argue that carefully designed credit sector reforms are crucial to avoid throwing out the baby with the bath water. Despite the interest rate liberalisation progressively implemented by Chinese authorities, a general crackdown on alternative finance would remain detrimental to the dynamism of small enterprises. Selectively tightening the limits around informal financing could better balance financial stability on the one hand, and welfare and efficiency on the other.

Constrained financing conditions…

Since the start of the 20th century, business lending in China has been controlled by four state-owned banks and mostly directed to large, state-owned enterprises. While credit has been readily available for state-owned enterprises, private, small and medium enterprises (SMEs) have been struggling to obtain formal bank loans, thereby hindering these firms’ abilities to invest, grow and spur economic growth. Access to informal, alternative funding – mainly social networks and personal connections –  is key for SMEs’ development. A well-known example is Wenzhou, a prosperous Chinese city, where a clan-like social organization and strong mercantile traditions facilitated the flow of credit to SMEs

… alleviated by alternative finance

Survey data from the World Bank show that in 2003, before the start of banking sector liberalisation, large, private enterprises were financing the majority of their investments through formal bank loans. Enterprises with more than 1,000 employees, for instance, financed 58% of their total investment through bank loans (See Chart 1). This reflects the incentives given to banks by Chinese authorities in favour of loans to larger enterprises. Conversely, smaller enterprises faced strict collateral requirements and were often unable to secure bank loans – problems that persist to this day. In addition, SMEs could not access capital by raising equity (listing shares) because Chinese capital markets were not well developed. To bypass these financial constraints, SMEs could turn to self-financing (reinvesting their profits). However, this is only possible for enterprises that are active long enough to accumulate sufficient profits. Instead, small, young firms rely on informal financing sources through social connections; obtaining funding through family, friends, non-listed equity or moneylenders (referred to as “alternative” in Chart 1 and for the remainder of this post)

Chart 1: Average shares of funding sources for new investment, by enterprise size (number of employees)

Note: Enterprise survey data, 2003, private firms only. Small firms: below 50 employees, medium firms: between 50 and 250, large firms: between 250 and 1000, very large firms: above 1000 employees.

To better understand the importance and implications of alternative finance and credit sector reforms, I built a theoretical model where heterogeneous enterprises choose how much to invest and how to finance it between bank loans, retained earnings and alternative finance. This model is able to reproduce enterprise decisions observed in the data in a general equilibrium framework, and allows me to simulate the Chinese aggregate economy and individual firms’ behaviour under various scenarios.

First, without introducing any credit sector reforms, and assuming alternative finance did not exist, I find that aggregate output would be 6% lower and aggregate capital 7% lower. The presence of alternative sources of funding has a strong positive impact on the main economic aggregates –  increasing aggregate consumption by 6% and aggregate welfare by 4% – and decreasing resource misallocations by 13%. Indeed, alternative finance provides enterprises facing credit constraints with additional resources to finance investment and produce more efficiently.

Credit sector reforms

Keeping in mind the impact of alternative finance in a pre-reform scenario, let us now evaluate the impact of credit sector reforms in China on national aggregates.

What are these reforms?  They concern three main areas:

  1. A progressive liberalisation of retail interest rates. Before 2004, the retail deposit and lending rates were fixed by the government. From then on, the interest rates have been allowed to fluctuate within progressively widening bands, until banks were authorised to freely set their rates in 2015.
  2. Window guidance, which in the Chinese context corresponds to oral or written directives from the authorities to direct credit towards various sectors of the economy. The People’s Bank of China (PBoC, Chinese central bank) started monitoring credit to small and medium-sized enterprises in 2004 and incentivising banks to direct more funds towards these enterprises.
  3. Financial regulation. From 2004 onwards, the PBoC has stated its intention to “curb usury” by tightening rules regarding banks’ off-balance sheet assets and their role as intermediaries between households and non-bank financial institutions.

The impact of the reforms: banking sector liberalisation…         

Using the same theoretical model as above, I simulate the impact of the first two reforms mentioned above; allowing more credit to be directed to SMEs by relaxing the collateral constraint, and letting the interest rate vary accordingly. I consider two cases: (a) when alternative finance is not accounted for in the model both before and after the reforms; (b) when alternative finance is taken into account in the model, both before and after the reforms. While case (a) gives us an idea of how off the results would be if completely ignoring alternative finance, case (b) reflects the market’s reality. Two facts are striking. First, irrespective of whether alternative finance is accounted for, the impact of these liberalisation reforms is overly positive; all economic aggregates go up: GDP, capital and consumption increase by up to 10% (Chart 2). Resource allocation and welfare significantly improve too. Second, it is important to account for alternative finance when evaluating the impact of the reforms.  At first glance, the increase in capital and production is similar in both cases. Yet, the reforms’ effect on consumption and welfare is about a quarter smaller when alternative finance is included in the model (Chart 2, blue bars). Following the liberalisation, welfare increases by 2.6% without alternative finance as opposed to 1.9% with, a non-negligible difference from both a household’s and from a policy-maker’s perspective.

Chart 2: Impact of liberalisation reforms (1. and 2.), including or not alternative finance in the model

… with a tighter regulation

Despite its overall positive impact, liberalisation reforms increase the borrowing capacity of all firms, which pushes up the share of non-performing loans by 11%. A reasonable policy reaction to this change may be to tighten financial regulation.

The last, and most realistic, reform scenario I examine is to combine the liberalisation (points 1 and 2 above) with a tighter regulation (point 3). Since alternative finance is a broad term, my model separates it into two types: (i) “cheap” alternative finance, corresponding to funds obtained from close social circles, requiring very low interest rates, and generally easier to obtain than bank loans; (ii) “expensive” alternative finance, for which cash-starved enterprises have to search beyond their close social circle, and which requires much higher interest rates – an extreme example being moneylenders, charging very high interest rates to enterprises that have no access to cheaper financing sources.

In the simulations, tightening financial regulation means either shutting down all alternative finance, both cheap and expensive, or shutting down only the expensive kind. Despite being combined with the liberalisation of the banking sector, shutting down all alternative finance (Chart 3) has a strong detrimental impact on the economy. This reform scenario lowers both production and consumption, despite an aggregate capital increase. Producing less with more capital means that resources are used in a less efficient way, which is corroborated by the 10% increase in resource misallocation. Logically, aggregate welfare decreases by 0.7%. The easier access to formal credit and the interest rate liberalisation cannot compensate for the disappearance of all alternative funding sources.

Chart 3: Impact of liberalisation and regulation reforms, when alternative finance is successively maintained, partially shut down or fully shut down

The red bars in Chart 3 show the effects if only expensive alternative finance is shut down. Although efficiency gains are not as high as without regulatory tightening, both capital and production increases are more pronounced. As a result, consumption and welfare gains from liberalisation are almost entirely preserved.  This combination of reforms – banking sector liberalisation and selective regulatory tightening – seems the most desirable answer to the trade-off between efficient resource allocation and financial stability. While limiting the power of moneylenders, it preserves the role of social networks in the provision of finance for SMEs.


Alternative finance allows Chinese firms to partially bypass credit constraints, thus facilitating a better resource allocation and a higher production level, and should be accounted for when examining ongoing liberalisation and regulatory reforms. Even if conducted in parallel to a reform of the Chinese banking system, tightening the regulation of alternative finance should be careful and selective, so as to avoid undermining the dynamism of smaller, younger enterprises unable to obtain formal loans. The PBOC has recently proposed a plan to facilitate bank loan access for micro- and small enterprises. While the crackdown on the informal financing sector has been ongoing for several years, this plan could partially compensate for the increased financing constraints faced by SMEs, and help strike a balance between liberalisation, regulation and financial stability.

This post was written whilst Noëmie Lisack was working in the Bank’s Global Analysis Division.

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Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

This post is published jointly on Bank Underground and Duke University’s FinReg Blog.

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