http://www.wsj.com/articles/small-business-wont-save-china-1410281985

Small Business Won’t Save China
To succeed, private Chinese companies of all sizes must be able to compete with state-owned enterprises.

By ANDREW BATSON
Sept. 9, 2014 12:59 p.m. ET

These are good times for China’s small businesses. Despite a steady slowdown in economic growth, new companies are being founded at the fastest pace in a decade. Small businesses have long complained of difficulty getting loans from the state, but roughly 30% of corporate loans now go to small firms, up from 20% a few years ago. A government notorious for favoring state-owned enterprises now regularly praises small firms and offers them help.

“The government has the responsibility, and the obligation, to create better conditions for your businesses,” Premier Li Keqiang told small business owners in July. Beijing has told state banks to expand their loans to small businesses faster than the rest of their loan books. Mr. Li has also eased regulatory burdens to starting new companies, for example eliminating onerous requirements that anyone registering a company deposit large sums in a bank account to show they can pay the bills. Judging by the 21% increase in registered private companies this year, entrepreneurs are taking advantage of the change.

But this friendliness to small business isn’t enough to solve China’s economic problems. China does need stronger private firms as it tries to move away from its excessive reliance on public investment to support growth, yet the government’s trumpeting of good news for small businesses betrays a misunderstanding of their real role in the economy.

The core issue for private Chinese companies of all sizes is their ability to compete with state-owned enterprises. For the government to hand out favors to small businesses—rather than ensuring a level playing field for all companies—risks confining entrepreneurs to a ghetto of small shops and service companies where they can’t challenge state firms’ hold on strategic sectors. The Communist Party’s “glass ceiling,” which keeps private firms from becoming dominant players in industries other than the Internet, hasn’t been shattered.

Nor did small businesses have it so bad before the reforms of the past two years. The population of private companies has been growing by double-digit rates since the 1990s. In 2012, 40% of all firms were three years old or younger. China’s registered-capital requirements were indeed high by global standards before the latest change, which took effect in March, but most other startup costs were relatively modest.

Small businesses everywhere find it hard to borrow from banks, and there is little evidence that this phenomenon is more severe in China. According to the Organization for Economic Cooperation and Development, loans to small- and medium-sized enterprises accounted for 24% of U.S. corporate lending in 2012—a rate below China’s.

So why all the official and public attention on China’s small businesses? The conventional justification, repeated in Beijing as often as elsewhere, is that small businesses create most jobs. Premier Li has credited his deregulatory measures with helping keep job creation humming this year even as growth slowed. Yet this is only a partial view: Small businesses create a lot of jobs but also destroy a lot of jobs, as most new companies fail. Permanent job gains come from those few small firms that become successful large firms.

The founding of many new small businesses doesn’t guarantee increased national productivity. Small companies are often less efficient than large ones because they don’t have the same economies of scale. Small businesses deliver their biggest boost to the economy when they successfully compete with existing businesses—forcing incumbents to raise their game or displacing competitors with a superior product or service. That process requires not just lowering barriers to entry for new competitors, but also lowering barriers to exit for old ones. Creating more private businesses will therefore do China little good if those firms can never successfully compete against entrenched state-owned enterprises.

If Beijing really wants to help the private sector and small business, it should slash the ranks of inefficient SOEs. There have been steps in this direction: 19 provinces have put together plans for overhauling local SOEs, and Beijing is now pushing even the biggest firms to shape up.

But the government seems more interested in using antitrust legislation to make examples of foreign multinationals than in breaking up state-backed oligopolies. Tolerance for real corporate failure remains low: This year friendly officials have organized informal bailouts for many companies near bankruptcy or default.

Thus while Beijing has embraced the “creation” part of the creative destruction that drives market capitalism, it still needs to get more comfortable with destruction.

Andrew Batson is the China research director for Gavekal Dragonomics.