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Entrepreneurship in China
Entrepreneurs often rely on a support framework to get started and grow their business. But China’s institutions seem to lack the support they need. What lies ahead for entrepreneurship in China?
By Louisa Wah Hansen
In a mature economy, institutions play an important role in setting the rules and providing support for entrepreneurial activities. However, in emerging economies such as China, a sound legal structure, credit markets and professional standards are often lacking.
To what extent is the institutional context in China impeding or encouraging entrepreneurship today?
According to Prof. David Ahlstrom from the Department of Management at The Chinese University of Hong Kong (CUHK) Business School, who has been closely following entrepreneurship research in the context of institutional theory for nearly two decades, the degree and sheer number of ‘institutional voids’ in mainland China is daunting. In his view, the gaps in institutional support could seriously impede the sustainable development of entrepreneurship in China.
Not Enough Money Flows Downstream
One of the biggest problems faced by entrepreneurs in China today is inadequate financing and financing options.
“The state of entrepreneurship is not good in China today,” comments Prof. Ahlstrom. “Private and entrepreneurial firms are not growing much. They have actually gotten smaller since the 1990s. The numbers are pretty flat. There is just not enough financing for them.”
The lack of financing for entrepreneurs is not a new phenomenon, but the condition has exacerbated in recent years as a result of the slowdown in the overall economy and export demand.
The National Bureau of Statistics in China reported that only 8.6 percent of the small- and medium-sized enterprises (SMEs) requiring bank loans got the money they applied for in the first quarter of 2012. And according to the All-China Federation of Industry and Commerce, SMEs accounted for merely 50 percent of the country’s total lending since the start of the global economic downturn. This despite the fact that SMEs accounted for 99 percent of China’s registered enterprises and their output in the first nine months of 2012 amounted to about 60 percent of the country’s gross domestic product (GDP).
Much of the quagmire that entrepreneurs in China find themselves in has to do with the government’s preferential policies favoring large state-owned enterprises (SOEs). Banks are often reluctant to lend to SMEs out of risk concerns. Private firms also have few options in terms of equity financing and strategic sales and purchases (mergers and acquisitions).
It is no surprise, then, that entrepreneurial activities are losing steam. Many private firms face the prospect of shutdowns. Prof. Ahlstrom observes that the Chinese state’s commitment to private enterprises has drifted substantially in the past 10-15 years. “We had the dot-com thing, and that was a little crazy. But people pulled back a little too much. And they started to talk about financing and merging the state firms. Then you got a number of big IPOs in the early 2000s, especially in the banking sector. But apart from a few successes in improving the state sector, in general, if you remove the free land and cheap financing the state firms get, research has shown that many state firms in China have actually been losing money for several years.”
Property Rights: a Sticky Issue
Besides financing, intellectual property rights is one big institutional issue in China that continuously ties the hands of innovative entrepreneurs.
“If I develop something new, I have to know that somebody else is not going to copy it in the provinces next door,” contends Prof. Ahlstrom. “It’s happening a lot in the life sciences because it is easy to copy those formulas. People are stealing them and local governments wouldn’t do anything about it. This has to improve a lot, because it’s going to hurt.”
Prof. Ahlstrom believes that the Chinese government not only needs to strengthen the law enforcement, especially on the local level, but should also encourage entrepreneurs to patent their products or trademark them. He believes that filing patents overseas, such as in Japan and the EU, will help increase the legitimacy of these private enterprises.
Where Institutions Become Superfluous
When it comes to the laws in China, a lot depends on the bureaucrats who implement them.
Prof. Hugh Thomas, a finance professor at the CUHK Business School and director of the school’s Center of Entrepreneurship until recently, says the Chinese government has to avoid the problem of becoming too rigid lest it impairs innovation in enterprises. “You develop an economy where you can start something new and develop it, but there is a bureaucratic mentality that is against that. It takes a lot of regulatory approvals, and the licensing system is not clear. Even if it is clear, the interpretation of regulation is in the hands of individual bureaucrats, who may abuse that. And so, when you are running your company, you have to cater to that bureaucrat. Those are sand in the mechanism of a well-functioning economy, and the sand has to be cleaned out.”
Some entrepreneurs we have talked to believe the existence of layers upon layers of bureaucracy in China is counterproductive to the growth of entrepreneurship. One of them, Richard Ho, Managing Director of Zhen Hua Group of Companies, the largest manufacturer of charcoal briquettes in China, who has done business all over the country for more than three decades, says the Chinese government has hired a large number of “superfluous cadres” who have nothing to do on a day-to-day basis. So they constantly have to think up something. “Officials from a flood-prevention department, for example, would go and visit some factories near the river and tell the management what to do to avoid flooding,” he says. “To save their face, the factory’s management has to send someone to treat the officials a dinner or at least buy a few water pipes as a goodwill gesture of compliance.”
Ho adds that due to the constantly changing nature of the laws and of their execution, legal compliance has become more of a nuisance and obstacle than protection for private enterprises in China.
Institutions Do Matter
In China, where institutions are not strong enough to support systematic entrepreneurial growth, cultural elements such as guanxi — the informal relationship networks — can help individual entrepreneurs a great deal. Prof. Ahlstrom points out that most studies of entrepreneurship in emerging economies thus far have been focusing on cultural factors such as this, neglecting the influence of institutions. He believes culture does play a role in the case of the Chinese branch of entrepreneurship, but not too much — “It probably explains no more than 5 to 10 percent of firm behavior and performance, maybe less,” he says.
To him, the survival and growth of private enterprises in China still depend largely on a sound institutional regime, especially since China can no longer turn inward from the globalization tide and disregard the formal rules and standards that govern international business and commerce.
So what is happening on the institutional front in China? Despite the slow pace, initiatives have been taken by the central and local governments as well as universities to promote entrepreneurship. “It’s interesting to hear the entrepreneurial vocabulary coming from the official pronouncements right from the center in China. It’s a real change in mindset,” says Prof. Thomas.
Prof. Thomas is referring to the new top-down approach as opposed to the grassroots, bottom-up approach in the early days of entrepreneurship in China, which was largely a ‘rural phenomenon’.
He observes that from 2008 up to now, significant initiatives have been taken by local governments to support entrepreneurship. They have expanded their funding and infrastructural support for specific industries in their own cities or municipalities to benefit entrepreneurs from all over the nation. “This is the kind of thing that the government should be involved in. It’s only very recent that the government is having that kind of attitude.”
Venture Capitalists: Setting New Rules for the Game
Besides formal institutions, informal institutions such as venture capitalists, angel investors and successful entrepreneurs themselves are also chipping in and perhaps playing a more active role in promoting entrepreneurship than the formal institutions.
Prof. Ahlstrom remarks that venture capitalists act as ‘institutional entrepreneurs’ in shaping the business culture and regulatory environment through such actions as improving accounting standards, introducing Western contractual laws and corporate governance standards, to name just a few.
“I think to some extent, venture capitalists have helped improve the legal, accounting and corporate governance standards in mainland China,” he says. “It’s quite common to sign a venture capitalist contract using California law and the Mainland government accepts it. There are a lot of bottom-up changes happening. Going overseas to bring institutional standards back to your country—that’s very unusual but that’s what’s happening.”
He believes venture capitalists can have a big effect on the sectors they are working on, like life sciences and information technology. “There are just certain standards you have to follow, especially in life sciences. The hospital and clinical trial people help to bring in testing organizations and international standards. That’s a good thing.”
Besides venture capitalists, there is also a small number of angel investors who are working very hard to build entrepreneurship in China, one person at a time.
Dr. Gregg Li, a Hong Kong-based angel capitalist, who is a guest professor at the CUHK Business School, is currently financing and grooming two entrepreneurs—one in Guangzhou and one in Hong Kong. Both are involved in innovative businesses — one in LED and the other, insurance brokerage. His goal is to help them build highly profitable companies.
He believes that institutional support is irrelevant when it comes to the birth and growth of enterprises. “Without customers, there is no business,” he says. “Institution is something you’d like to have. You’d like to have the law and the legal system in place. That’s a problem in China. But in the end it’s about what the customers want. If you can do that you can make money. My role is to create something new and to help the business sustain itself.”
Regardless of whether institution is relevant or not, from a macro point of view, a healthy economy requires a healthy growth of entrepreneurial activities. Prof. Ahlstrom points out that, for an economy to be sustainable, innovation and new venture creation should account for at least two-thirds of a nation’s economic growth, with additional growth coming from productivity improvements and improved human capital and macroeconomic management. The current figure in China in terms of innovation and new venture creation is likely far from that.
“Chinese governments at all levels know they should build an institutional framework to support entrepreneurial activities,” says Prof. Ahlstrom. “They do care about this. But there are well-positioned opponents of that point of view in China. Some of the traditional guys are afraid that entrepreneurs would become too powerful. It’s a political issue, but it’s also ideological. They sincerely believe in the state enterprise model and want to promote it.”
The impasse is not totally insurmountable, however. Institutional challenges are there, but a good number of private companies have succeeded in spite of these. “Entrepreneurs like Jack Ma of Alibaba just follow good entrepreneurship principles,” Prof. Ahlstrom notes. Nonetheless, “good entrepreneurs can find a way to succeed, but problem institutions keep people out of the market and hinder those already in the market from growing.”
“Could we have more successful entrepreneurs if the policies were different? I think the evidence is quite clear—we could!” says Prof. Ahlstrom.