Appendix

A.1 Defining SMEs

The PRC adopts a rather complicated classification system for SMEs, 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 summarized in Table A.1 [ PDF 91KB | 1 page ].

According to the definition released by the State Economic and Trade Commission, State Developing Planning Commission, Ministry of Finance, and National Bureau of Statistics of China (Feb 2003), SMEs are roughly characterized as having less than 200 employees (with the exception of 3,000 employees for the construction industry), with sales value lower than 300 million yuan or capital value lower than 400 million yuan.

A.2 The Venture Capital Industry in the PRC

This appendix discusses in detail the venture capital (VC) industry in the PRC.

SMEs often face diffculties in gaining access to standard forms of credit due to their lack of collateral and the tenuous nature of their business establishment. In more mature financial markets, bank credit and regular trade credit comprise only part of the financial landscape, and financial innovations may offer other forms of credit that help ease financing obstacles faced by SMEs. This appendix looks into venture capital as one alternative form of financing that is developing in the PRC.

The institutionalization of the PRC's venture capital is simultaneously an extension of transition-era policy trajectories and an attempt to answer problems that could not be solved within the framework of other institutional systems. Early initiatives for the development of the VC industry in the PRC were largely theoretical, and usually resulted in little actual action. High-level policymakers failed to pay much attention to this industry, hence resulting in the establishment of only 23 VC firms in its earlier development phase. In 1998, the People's Political Consultative Conference changed its stance and sought to rapidly engage itself in the process of the PRC's risk investment industry development. This concomitantly set the stage for the subsequent upsurge in VC firms; within three years the number of VC firms established skyrocketed from 59 to 246. Among these registered venture capital firms, four distinct categories of VC firms can be identified, each with different ownership structures, objectives, and operational features (see Table A.2 [ PDF 60KB | 1 page ]).

The main sources of VC funding in the PRC are government and state-owned enterprises, with private and foreign institutions and individuals comprising only a small percentage. The founding of domestic VC firms began with the establishment of local government-financed venture capital firms (GVCFs) in 1991{1993 in selected provinces, before expanding to other provinces by the late 1990s and early 21st century. University-backed VC firms (UVCFs) rapidly followed GVCFs, and generally followed a relatively similar mode of operation. Corporatebacked VC firms (CVCFs) were offcially sanctioned following Announcement No. 1 at the Ninth Conference of the National People's Congress in 1998, and|in contrast to GVCFs and UVCFs|tend to invest directly in newly listed shares or to make mid- to long-term investments instead of high-risk investments. Finally, there are a fair number of joint venture and foreign VC firms operating in the PRC, although these generally choose to invest in the offshore holding companies of the PRC's enterprises due to numerous foreign exchange controls and limited exit options.

The PRC's venture capital system has developed rapidly, but this development is far from even across activities, and the system remains immature in terms of regulatory (and related) institutions. There are no national-level regulations that govern the VC industry, although various departments act to assist in regulating the industry at the provincial level. However, local guidelines are only effective locally, and this occasionally leads to confusion and ineffciencies. Harmonizing these laws at the national level will help take the PRC's VC market to the next stage.

Beyond regulatory issues, the VC industry in the PRC faces several challenges. First, the immaturity of financial markets in general leads to limited channels for VC exit. Existing mechanisms are ineffcient and cumbersome, and VC firms taking their portfolio companies public face greater realization risk than otherwise. There is no easy fix to this, and only time will tell whether greater domestic financial market integration is forthcoming. Second, the market for investment professionals remains very thin. Most venture capitalists remain inadequately trained and lack suffcient experience as well as exposure to international best practices. This suggests a role for government to relax immigration restrictions in order to bring in foreign professionals with the relevant VC management experience and expertise.

A.3 Constraints in Financing SMEs in the PRC

This appendix outlines the consensus in the literature on financing constraints generally faced by SMEs in the PRC.

1. Poor management and supervision, ill-defined property rights, and local government interference have all contributed to the PRC's long-term financial losses. According to offcial estimates, at 2002 year-end, non-performing loans were 514.7 billion yuan or 37% of total loans.
2. The absence of an effective fiscal system at sub-national level leads to local governments running chronic budget deficits (International Finance Corporation 2002), which in turn leads to administrative interference in local financial institutions as these governments seek out tax revenue.
3. The predatory practice of local offcials in extracting various taxes from peasants may be a systemic, as opposed to behavioral, problem (Bernstein & Lu 2003), perhaps due to the wider problem of a partially reformed political economy.
4. Regional variations in terms of peasant burdens and the availability of basic necessities suggests a vicious circle that perpetuates the existing gap between the richer coastal provinces and poorer interior (Wong 1999). This is further exacerbated by a nondiscriminatory federal tax policy (Byrd & Qingsong 1990).
5. The banking system is a highly centralized one|loan provision is dominated by the Big Four: the Industrial and Commercial Bank of China, Bank of China, Construction Bank of China, and Agricultural Bank of China|which believe that the cost and risk of providing loans to SMEs is still high vis-a-vis SOEs.
6. Incomplete capital markets due to informational asymmetries and imbalances in the control and supervision mechanism lead to diffculties for SMEs in bidding on projects requiring large financial resources. Resources available for SME investment in 2001 showed that 2.3% came from the national budget, 1.9% from foreign countries, and the rest was self-financing (82%) (Asian Development Bank 2002).
7. Incomplete commodity markets due to the repeated entry of SMEs into the same lowentry- threshold markets, which results in the further degradation of these markets in terms of excess supply.
8. SMEs in the PRC have low accountability of credit, with widespread incidences of false accounting and bookkeeping, which hinders further development of their businesses due to discriminatory credit rationing. This lack of access may be the biggest barrier for the development of private SMEs (All-China Federation of Industry and Commerce 2002).
9. SMEs in the PRC, especially the small and private ones, have no or little credible collateral, since most of them are set up as family-oriented or small-sized businesses (International Finance Corporation 2006).
10. SMEs in the PRC still lack transparency in terms of their business performance. As much as 96% of private enterprises are owner-operated, and such firms usually dislike disclosing information about their business performance (All-China Federation of Industry and Commerce 2002).
11. SMEs in the PRC have weak corporate governance and management skills. In many cases, they have fatal shortfalls in their corporate governance structure, primarily due to their dependence on the model of family-oriented management (International Finance Corporation 2006).
12. SMEs in the PRC are still relatively small in size and their production capability and product structure are usually unilateral, resulting in the production of counterfeit, lowquality goods (International Finance Corporation 2006).

A.4 Japan's SME Sector and Industry Clusters

This appendix provides a case study of Japan as a country that has demonstrated the evolution of SMEs toward internationally competitive global firms.

A.4.1 The Evolution of Japanese SMEs

The historical development of Japan's SME policy can be summarized in four stages. The first stage (1945{1954) was a period of reconstruction after World War II. The period laid the foundations for future SME policy. The SME Agency was established, and its main goal was mainly focused on providing financial and organizational support to SMEs. Government institutions that provided financing to SMEs were also established. In the second stage (1955{1972), Japan experienced a period of rapid economic growth, and against this background, sectoral measures to modernize SMEs were introduced. Furthermore, preferential tax treatments were introduced. The years 1973{1984 marked a period of stable economic growth where the Basic Law of SMEs, as well as the Act on the Promotion of Modernization of SMEs, were enacted. The focus for SME policy shifted toward human resource training and technology enhancement, as well as sectoral revitalization programs. The government also provided guidance to SMEs on how to prepare for the liberalization and opening up of their respective markets. In the fourth stage, which began in 1985 and extends to the present, there has been a greater focus on supporting SMEs and in launching new businesses, together with changing existing, low-performing businesses. In order to promote R&D, SME policy has sought to streamline and consolidate SMEs. This period has also been accompanied by a shift toward a more market-based policy approach.

There are generally two underlying philosophies concerning SMEs. The first is that SMEs are one of many market participants, and it is more important for policymakers to ensure a fair and competitive market environment in order to promote the development of SMEs. The second philosophy is more consistent with Japan's SME policy after World War II through the 1970s. This philosophy explicitly recognizes the various disadvantages that SMEs face vis-a-vis large enterprises, and hence the primary objective of SME policy is to provide a protective environment where these SMEs can be nurtured and grow. Accordingly, SME policy in Japan has traditionally been embedded within larger-scale industrial policies. Various market-distortionary measures|such as preferential tax treatments, favorable government subsidies, and favorable lending by government-affliated financial institutions specialized in SME financing|were also introduced to support and protect SMEs.

This, however, has since evolved to recognize SMEs as market participants|and, critically, as contributors to the national economy|possessing diverse skills and innovational capacity. SME policy has also gradually shifted from protectionism toward a more market-oriented approach. Measures to this effect include developing strategies on working out a fair and competitive market environment and providing support to SMEs in order to enhance their competitiveness; as a result, start-up businesses and ventures have strengthened since the mid-1990s. In this limited sense, one can argue that the philosophy underlying Japan's SME policy has moved closer to that of the United States (Kanamori & Zhao 2005).

Recently, it has become more and more important for Japan's SMEs to strengthen R&D activities and introduce higher value-added products with lower costs in order to survive in the market where competition with other countries (in particular with East Asia) is being intensified under the globalized economy. Surveys of Japan's SMEs have also concluded that SMEs do not necessarily lag behind large enterprises in R&D (Small and Medium Scale Enterprise Agency various years). Nevertheless, there are concerns that SMEs face a relative shortfall of managerial resources, and need to engage in collaborative efforts with others so that they can complement each other and pursue innovation in a more effective way. Likewise, with a focus on R&D that directly relates to new products, SMEs tend to rely on academics and research institutions as far as basic theoretical research is concerned. From this viewpoint, SMEs may find it potentially beneficial to pursue partnerships with research organizations. This is, in fact, what Japan's SME policy currently promotes, with a growing interest in academia-industry partnerships and joint practical research projects.

Partnerships with other enterprises that have different technical skills, or different markets, would also be helpful for many SMEs if they are to enhance their complementarity with one another. Possible elements of such a partnership arrangement would include the importance of the combination of different knowledge and skills|possibly through partnership with a variety of entities such as local universities, the government, private research institutions, large enterprises, and other SMEs|and a core entity and hence the creation of a clear division of responsibility, thus maintaining good governance among partners.

As in the PRC, financial issues are major bottleneck for SMEs in Japan. Japan has addressed SMEs' financial diffculties primarily by utilizing policy-lending financial institutions specializing in SMEs. However, in this regard, a few new trends have emerged recently.

First, there has been a change in the attitude of commercial banks toward SME financing. The main reason seems to be that the real estate bubble has led to a re-evaluation of the requirement that immobile property be used as a safe collateral for loans. Banks have begun to try to monitor SME performance in various ways, and by developing relationship banking with SMEs, banks are starting to see SMEs as concerns from a long-term and qualitative perspective. Second, there have been new innovations in transaction banking instruments, where commercial banks now decide to provide loans based on various financial statements and accounting information. The typical example is the credit scoring model, which scores the credibility of each SME based on its past credit history and debt outstanding. However, short loan term lengths and the absence of past credit histories limit the applicability of the model. Third, SMEs are increasingly beginning to tap capital markets, although this remains relatively small, at about 4%.

A.4.2 Japan's experience with industry clusters

The approach to addressing industrial clusters in Japan is best summarized in terms of five main strategies: network development within the cluster; sales network expansion; financing issues; human resource development; and government policy.

• As the size of a cluster expands, some strong network facility becomes more important. For this to strengthen the linkage between participating SMEs, regional industry-supporting organizations and associations, large enterprises, and trading houses (the so-called shosha) would be useful, as would coordination with the industrial policy initiated by the local governments.
• The expansion of the sales promotion network is an issue, and one idea is to create local trading houses (local shosha), or to recruit and make use of human resources who have experience with trading houses.
• To address the financing issues requires the promotion of relationship banking in cooperation with the Financial Service Agency. In addition, there is a need to strengthen the capability of commercial banks so that they can properly assess the level of technology and intellectual property (IP) of SMEs; SMEs likewise should also recruit and develop staff that are familiar with commercial banking operations, and IP rights, and are capable of attracting venture money.
• It is important for SMEs not only to develop technical engineers but also to develop human resources that are familiar with IP rights, business coordination and market research.
• The most important objective in government is to acknowledge the cluster strategy as a viable and valid policy to pursue. This would involve identifying issues and challenges and carefully working out government policies and ensuring budget appropriation for such policies. Currently, the policy scheme worked out has main three pillars: to support and strengthen networks within the cluster, to support businesses, and to support and strengthen the ties with related organizations. The core ministries for these are the Ministry of Economy and Industry (METI) and Ministry of Education, Science and Technology (MEST). In particular, METI local bureaus play a coordinating role for regional clusters.

The views expressed in this paper are the views of the authors and do not necessarily reflect the views or policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms..

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