The Internal Environment and Input Conditions

Defining SMEs

The statistical definition of SMEs varies by country, and is usually based on the number of employees, capital, or the value of assets and sales volume. The PRC adopts a rather complicated classification system, with at least two kinds of classification methods. The first method is based on output capacity and is applied to industries with a limited number of products. For example, in the electricity sector, small is defined as an annual production capability of fewer than 50,000 kilowatts, medium is between 50,000 and 300,000 kilowatts, and large is over 300,000 kilowatts. The second method is based on the original value of fixed capital and is applied to firms with diversified products. However, the definition of what constitutes an SME differs in different sectors. This is summarized in Table 1 [ PDF 67.9KB | 1 pages ].

According to the PRC Government, SMEs are roughly characterized as having less than 200 employees (with the exception of 3000 employee for the construction industry), with sales value lower than 300 million yuan or capital value lower than 400 million yuan. ⁹ For the purposes of the present paper, we will adopt this relatively inclusive definition, although more specifically the term SME is used in the context of small and medium-sized firms in the technology sector, producing tradable (technological) goods and services.

The early development of SMEs

Historically, the PRC's industrial organization has not been a product of market forces. Industrial enterprises in the PRC were a creation of the pre-1979 Soviet style command economy. Enterprises were not really business organizations, but factory units under the active direct supervision of central and provincial government industrial bureaus. The SME sector in the PRC was first allowed on the fringes of the economy, and was initially regarded as a supplement to the state and collective sectors. Faced with restrictions and biases, SMEs, at an early stage, had to establish close links with the local bureaucracy and operate under a high degree of informality. However, because of the decentralization and strong bureaucratic incentives to promote local development, the system was both flexible enough and suffciently responsive such that it allowed for the cumulative development of SMEs. Yet, this has only been possible since the late 1970s (in agriculture) and the 1980s (in various manufacturing industries). According to Wang & Yao (2004), several factors have been identified as having contributed to the dynamic development of SMEs.

First, the fast growth of the SMEs in the PRC was made possible by the reforms carried out in both rural and urban areas. The rural reforms have re-established the family farming system and raised the prices of agricultural products. The enhanced productivity provided critical initial capital for the establishment of numerous small firms in the rural areas. The urban and industrial reforms have gradually released resources to the market, so SMEs that were not covered by plans could get access to needed materials. Second, a large market for consumer goods was left unaddressed prior to the 1980s as a result of the heavy industry-oriented development strategy pursued by the PRC under the centrally planned economies. This gave SMEs a perfect opportunity to fill the gap. Third, the PRC is a country with abundant labor, especially in its rural areas. Further opening up to foreign trade also allowed SMEs to expand further by taking advantage of the relatively abundant labor force.

Earlier industrial policies and challenges for the innovation system

It is well known that, in general, centrally-planned economies lack an incentive structure for promoting innovation as well as the organizational mechanisms to translate science and technology (S&T) resources into either industrial or commercial products, or innovation. Prior to the period of market-oriented reform, many problems appeared. First, most of the talented scientists involved in S&T were located in military research labs and research universities, thereby creating self-contained ivory towers that were inaccessible for the most part to industrial enterprises. Second, even though the industrial research institutes-under various industrial ministries and bureaus-were assigned to serve industrial needs, they were usually trapped within the vertical authority of their respective ministries or bureaus. There existed almost no direct horizontal channels among research institutions and enterprises across the authoritative boundaries of the various ministries or bureaus. Third, within the same administrative authority, communication between research labs and enterprises was more or less along vertical channels via administrative organs at the top. Direct horizontal links between labs and enterprises were often secondary.

Economic reform in the PRC has been accompanied by a shift in technological and industrial policies away from the nationalistic strategy of self-reliance which prevailed until the 1980s. The government has moved toward a more pragmatic strategy of importing advanced technology and directing domestic technology development toward commercial purposes. This has included several "five-year plans" since 1952, as well as key technology programs, such as the 863 program and the Torch Program. Economic necessity has led to further changes, as the PRC realizes the importance of upgrading its technology rapidly in order to further enhance productivity growth. In 1998, the State Science and Technology Commission changed its name to the Ministry of Science and Technology (MOST); its name change coincided with a functional shift toward serving enterprises, especially SMEs. This has occurred mainly through encouraging innovation, upgrading management practices, promoting science parks and incubators, and overseeing the development of human resources needed in S&T field. The PRC's expenditures on scientific and technical activities is summarized in Table 2 [ PDF 66.7KB | 1 pages ]

By and large, economic and enterprise reforms over the last 20 years have dramatically altered the structure and dynamics of the PRC's innovation system. As a result, the system is no longer characterized by a strict division of labor among functionally specialized organizations. New policies and institutional reforms have fundamentally changed the way decisions over activities-such as resource creation and allocation in the innovation process-are made. Moreover, operational and strategic decision making has also been decentralized. This has been accompanied by an initiative that forces organizations to compete with each other, based increasingly on their ability to perform functional activities more effectively and efficiently.

Nonetheless, evidence of improved diffusion and implementation of technological innovation is, in some cases, indirect or ambiguous. On one hand, the explosion in product choices that have become available to industrial and individual consumers suggests real improvements. On the other, researchers attempting to track changes in productivity that would reflect improved production methods, implicitly based on better production technology, have found mixed results. Some authors claim that SME productivity has risen throughout the 1980s and early 1990s (McMillan & Naughton 1992; Rawski 1994), while others argue that there has been little improvement after a one-time increase in the early 1980s (Woo 1997).

Other researchers have argued that there have been dramatic improvements in the development, diffusion, and implementation of technological innovations. Gu (1999), for example, has carefully documented the emergence of new technology enterprises. She describes this as an "unlocking" of R&D assets from research institutes, since over 80% of these new technology enterprises are spinoffs, or are primarily supported by research institute and universities. This phenomenon is largely the result of cuts in central government funding to these research organizations, coupled with changes in the legal and regulatory environment that allows them to establish such new ventures. These new technology enterprises are leading the commercialization of advanced technology in the most science-intensive industries, such as computers and information technology, biotechnology, and new materials. Not only have the new technology enterprises generated their own profits, but they have also made new technology embodied in production equipment and inputs available to other manufacturers, thereby supporting quality and productivity improvements in these organizations.

Current status of SMEs and clusters

There are currently 39.8 million SMEs in the PRC, accounting for 50% of the country's aasset value, 60% in turnover, and 60% in exports. It is commonly acknowledged that the PRC's trade performance has been remarkable over the last decade. Particularly impressive has been its ability to gain significant global market shares in the labor-intensive as well as medium- and high-technology sectors. Between 1996 and 2000, the share of high-technology products in exports increased from 14.2% to 22.4%. the PRC's exports of computers, mobile phones, and electronic circuits also more than tripled during this five-year period.

An abundant and skilled labor force, combined with economies of scale, has naturally played a key role in the PRC's trade success. The PRC is no longer-as traditionally perceived-solely an exporter of supply capacities, specializing in pure assembly activities. It is now also involved in R&D activities. According to Secretariat (1998), high-technology transnational corporations have set up over 100 R&D centers, mostly in Shanghai and Beijing. These R&D centers have played a crucial role in enhancing the innovative capability of foreign affliates and upgrading their activities. The breakdown in R&D expenditures for 2002 is summarized in Table 3 [ PDF 66.3KB | 1 pages ], while Table 4 [ PDF 63.8KB | 1 pages ] provides an overview of R&D expenditure as a share of sales income.

As of early 1990, the PRC has approved the establishment of 53 STIPs (Science and Technology Industrial Parks), including the renowned Zhongguancun Science Park in Beijing (the so-called Silicon Valley of the PRC), as well as other regional development zones. This initiative is part of the wider Torch Program, which was drawn up in 1988 with the aim of developing new hightechnology industries in the PRC. The program has also seen the expansion of Technology Business Incubators (TBIs)-which are based on the idea of business incubators in industrialized countries-as well as an innovation fund for small technology-based firms.

The Torch Program has also been bolstered by the Decision on the Reform of the Science and Technology Management System, made in 1985 by the Central Committee of the Communist Party of the PRC. The program seeks to promote commercialization through venture investment by universities, the transfer of research results from universities and the Chinese Academy of Sciences, and the dual employment of professors and researchers, all of which has led to many ventures being launched from universities. In addition, industrial clusters-mainly STIPs-have formed that boast strong university affiliations, such as TsingHua and Beijing University in Zhongguancun. Finally, the commercialization of technology has also been matched with measures that include the simplification and unification of procedures for launching new businesses, as well as increased support for encouraging the return of students that have studied abroad.

The existing clusters in the PRC are primarily located in export processing zones-usually in the coastal areas-and are mostly limited to the production of standardized consumer or low-technology goods made for mass markets (such as furniture, consumer electronics, and textiles and garments). There is usually little innovation, ¹⁰ and R&D activity, if present at all, tends to be negligible. A subset of these firms may be integrated into global supply chains, but such integration is minimal, and the relatively homogeneous nature of their products makes them highly vulnerable to changes in demand from abroad. To the extent that firms seek to improve their competitive position, the strategy is often through cost-cutting measures. Overall, there is complacency in the conduct of business, which is usually based on the copying or licensing of products, using machinery imported from abroad.

Constraints on SMEs in the PRC

Problems facing SMEs in the PRC are many and varied. Such SMEs are constrained from achieving economies of scale in the purchase of such inputs as equipment, raw materials, finance, and consulting services; are often unable to access global markets; and are also limited in their performance in increasingly open, competitive domestic markets. Because of their size, it is difficult for SMEs in the PRC to access such functions as training, market intelligence, logistics and technology. As such, they are unable to take advantage of market opportunities that require large volumes, homogeneous standards, and regular supply. Furthermore, firms compete more and more not only on the basis of prices, but on the basis of their abilities to innovate, or upgrade. Improvements in product, process, technology, and organizational functions such as design, logistics, and marketing have become the critical success factors in firm competitiveness in a globalizing economy. SMEs in the PRC are thus under pressure to innovate, to upgrade their operations in order to participate in international markets. However, they often lack the resources to do so.

Late-industrializing economies, such as the PRC, tend to be restricted by the technology gap. This technology gap can be decomposed into three aspects: Innovation lag, process lag, and customer lag.

Innovational ability involves the levels of creation and developmental capability in science and technology. Examples in this context are R&D capability and re-engineering skills. It has also been argued that the late-industrializing economies suffer from an innovation lag in the form of a steeper learning curve and a later start in the patent race, as compared to the advanced economies. Process capability refers to the infrastructure and infostructure that supports human capital and the firm's ability to make multiple copies of a product or to deliver repeatedly a service once the product or service performance specification is given. The relative shortage of physical systems used to transmit and store intellectual material and the inadequate public R&D infrastructure in the PRC poses a threat. Finally, the PRC may suffer from the disadvantage of being a latecomer to the industry-a phenomenon that leads to customer lag. For example, advanced industrialized economies may enjoy the benefits of first-mover advantage and capture a larger share of consumers and subsequent switching costs (as embodied in brand recognition, user sunk costs, and so on) may act as a barrier to entry for the PRC. ¹¹

Perhaps the greatest internal challenge that the PRC faces, going forward, is the issue of a relatively underdeveloped and structurally shaken domestic financial system. This has a direct impact on SME business activity, since small firms-unable to bypass bank intermediation in order to raise funds directly from capital markets-are more likely to find that financial constraints are binding in the absence of bank loans. ¹²

Financial constraints arise in the SME sector for different reasons. The literature highlights distinctive differences in terms of SME access to as well as form of financing, as compared to large firms. For example, smaller companies may choose to limit their issuance of outside equity so that ownership control of their firms is not diluted (Hamilton & Fox 1998). Similarly, it is more diffcult for the smaller (and younger) SMEs to access debt financing, since they generally have shorter banking relationships and face greater asymmetries of information. As a result, they face higher interest rates and are more likely to be required to pledge collateral (Berger & Udell 1995; Saito & Villanueva 1981).

SMEs in transition economies, such as the PRC, face additional constraints unique to their environment. Characteristics common to transition economies in the initial stages of reform-such as a high concentration of firms in the industrial/ manufacturing sector, the underdevelopment of financial systems, and low legal and governance standards (Gros & Suhrcke 2001)-exacerbate the challenges faced by SMEs. These constraints may be classified along the lines of internal and external constraints. In the context of SMEs in the PRC, several constraints appear to be more relevant than others. ¹³ Internal constraints stem mainly from informational asymmetries, leading to credit rationing on the part of bank lenders. These include: Differential financial treatment due to ownership, region, size, and industry; the relatively low levels of accountability of credit, compounded by false accounting and bookkeeping records; the absence of credible collaterals; a lack of transparency; weak corporate governance and management skills in the SME sector; and risks that arise due to the specific markets that SMEs operate in. External constraints derive from the failure of bank competition; cost-effectiveness of loans to SMEs; underdeveloped and incomplete capital and commodity markets; and the perception-a remnant of socialist mindsets-that SMEs are second-tier firms. The implication of these constraints is that the proportion of SMEs receiving bank loans is very low: Only 30 percent of the total number of enterprises that need loans fulfill the requirements and submit formal applications.

The role that VCs play in filling the financing gap faced by the PRC's SMEs, therefore, is critical. The increased marketization and privatization of the PRC's economy has brought with it an ownership transformation and, with it, greater synergies between the respective sectors. It is likely that future growth opportunities in the SME sector will rely heavily on the development of this VC-SME nexus.

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