When China released its 12th Five-Year Plan in March 2011, one sentence raised more than a few eyebrows: “Government at all levels should create a sound policy, system and legal environment, break down market segmentation and industry monopoly, stimulate initiative and creativity of market players, steer the behavior of market players towards national strategic objectives.”

China’s “industry monopolies,” lest we forget, are state-owned enterprises. Why on earth would the government want to break them up?

The answer lies in some of the plan’s broader goals, like boosting consumption and enabling the service sector to be a larger driver of economic growth. Success on that front likely requires a robust private sector, abounding with competitive small businesses — something China’s struggled to foster.

Small firms can’t thrive without cheap, easy access to credit, but the large state-run banks — which dominate China’s banking system –aren’t keen to lend to them. They prefer transacting with state-run companies, which are a far less risky investment, thanks to their implicit government guarantee.

Untapped Economic Potential

Hence, many small-business owners and entrepreneurs are forced to seek financing in the shadow banking system, where high borrowing costs and unscrupulous tactics reign. Some companies do all right, securing expensive loans and running a productive operation, albeit with slimmer margins and lower growth potential than they’d otherwise have — and the constant threat of loan sharks. But many firms aren’t so lucky, and many more likely don’t even try. Thus, there’s a ton of untapped economic potential.

Policymakers have tried to fix this. Last October, Premier Wen Jiabao directed banks to increase and broaden small businesses’ credit access, scrap unreasonable charges and waive stamp taxes on small-business loans, and — for good measure — eased small firms’ value-added tax burden. But none of these measures were concrete, and banks largely continued shutting out small firms.

A longer-term solution took shape in March, when officials approved a plan to deregulate the financial industry in the coastal city of Wenzhou. Citizens can set up banks, invest abroad, trade unlisted equities and develop different types of bonds. Officials’ goal is to fully legitimize the shadow banking system and wipe out the darker practices in its underbelly.

If it works as intended, the market’s invisible hand would bless the lenders who run an ethical, useful institution and wipe out the loan sharks: If lending is free and easy, miscreants become redundant.

The Wenzhou reforms are a blueprint for nationwide financial deregulation, but it could take years for officials to gauge their viability, so this isn’t a near-term solution for credit-starved small enterprises. Thus, officials are taking unprecedented steps to revolutionize banking in the here and now.

More Lending to Small Business

China’s National Development and Reform Commission — the agency commanding China’s command economy — is reportedly doubling last year’s corporate bond issuance quota in 2012. Collectively, firms can secure at least 500 billion yuan on primary debt markets this year, and small firms can now issue debt akin to junk bonds — speculators can invest directly in small outfits.

And thanks to new rules allowing foreign pension funds to invest directly in Chinese securities, there will likely be ample private demand; state-run banks, historically the largest purchasers of Chinese corporate debt, likely won’t play as large a role.

In theory, if 500 billion yuan in corporate financing comes from bond markets in 2012, about that much should be freed for banks to lend to firms they might not otherwise deal with: small and medium businesses. That potentially gives small enterprises 500 billion yuan to spend on new equipment, software, facilities, innovation, employees and the like. Best of all, this capital is in private hands, historically far more efficient stewards than the average government.

And that dichotomy is likely amplified in China, where corruption reigns. Capital spent productively, rather than used to grease crony-communist palms, would only add to Chinese economic growth.

Let Failing Firms Fail

While higher small-business lending is likely a near-term economic positive, the regulatory changes enabling it are an important step in China’s ongoing financial liberalization. Private investors have an ever-greater market stake, and the government is slowly surrendering control over everyday business activity. The introduction of junk bonds suggests the government is finally open to letting failing firms fail: Bailouts are no longer a given.

That gives markets more room to accurately price risk and investors the chance to capitalize on that risk through higher yields. And where higher risk exists, derivatives — still rare in China — likely follow. And greater ability to hedge risk likely attracts ever more foreign investors, which means more foreign capital to support Chinese firms.

Of course, none of this will happen overnight. Markets take time to mature, and there will no doubt be growing pains in the interim. But that China’s starting this process is more evidence officials remain committed to boosting economic growth, rendering the likelihood of a Chinese hard landing ever more unlikely.

— Elisabeth Dellinger, Fisher Investments

This article constitutes the views, opinions, analyses and commentary of the author as of June 2012 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. In addition, no assurances are made regarding the accuracy of any forecast made herein. Past performance is no guarantee of future results. A risk of loss is involved with investments in stock markets.