Shaky underground banking system raises fears in China

These are humbling times for a city that flaunts its entrepreneurial success with exotic cars and luxury apartments.

Wenzhou, a city in southern Zhejiang province famed for its savvy, risk-taking merchants, is considered a bellwether for the health of small and medium-size private businesses in China.

But an engine of that remarkable success, a thriving underground banking system, has begun to fracture, exposing new fault lines in China’s economy. Two heavily indebted Wenzhou entrepreneurs recently jumped to their deaths and nearly 100 business owners have fled their factories, leaving piles of unpaid loans behind, according to state media.

One of them, a manufacturer of pneumatic valves who was worried about reprisals when he couldn’t pay back his creditors, reportedly sent his 300 employees on a mountain retreat and then fled the country.

“This whole situation is very serious right now,” said businessman Huang Fajing, owner of a cigarette lighter factory who has had to scale back his business for lack of credit. “I think the crisis is just starting.”


The troubles stem from inequities in China’s banking system, where most loans go to big state-run companies. Small fry depend largely on informal lending pools charging annual interest rates as high as 60%.

Although some of those funds are provided by loan sharks with criminal ties, much of it comes from households and businesspeople looking for better returns than those paid on savings accounts in China’s government-controlled banks. An estimated 90% of all households in Wenzhou and 60% of its firms participate in lending pools, according to the country’s central bank.

This unregulated lending amounts to as much as $78 billion annually in Wenzhou alone; nationally it could be as high as $627 billion or 10% of gross domestic product, according to financial services firm UBS. The business is so profitable that some entrepreneurs obtain cheap bank loans to re-lend the funds in the underground market.

But pressure started to build late last year when the central government decided to hike interest rates and restrict bank lending over worries about inflation and a growing real estate bubble. That credit squeeze soon rippled through the informal market. Thousands of small Wenzhou companies have closed their doors for lack of funding, according to state media.

“If you are anyone in business in Wenzhou, you are being impacted by this,” said Guan Hongsheng, an importer of French wine and scrap metal who has both unresolved credits and debts. “I think everyone needs help right now.”

The problem was compounded, analysts say, because businesses that made eyeglasses, clothing and disposable lighters had been speculating on stocks and real estate. But Beijing’s cooling measures have hurt. Home prices, for example, declined for the first time in a year from August to September.

The scope of the crisis remains to be seen. Wenzhou, a city of 9 million, is the largest source of private capital in China by some estimates. A wave of defaults could destabilize markets across the country.

If that happens, the “local crisis could evolve into a national problem,” Ren Xianfeng, a senior analyst for IHS Global Insight in Beijing, wrote in a research note.

But experts expect the central government to do what it always does in such times: throw money at the problem.

Premier Wen Jiabao paid a special visit to the coastal city Oct. 4 and called for small firms to receive tax breaks and more loans from state-owned banks. He gave local authorities a month to stabilize the situation.

“Small businesses play an irreplaceable role in creating jobs and boosting economic growth,” Wen said, according to the official New China News Agency.

Wenzhou reportedly asked the central bank for a $9.3-billion loan, a request that has been met with criticism reminiscent of the U.S. financial bailout.

“Saving Wenzhou is like saving a gambler,” Han Zhiguo, an economist at a private securities firm, wrote on his blog. “Using the taxpayers’ money to save Wenzhou has a huge moral risk.”

Part of the backlash is fueled by a distaste for Wenzhou’s freewheeling ways. Many Chinese blame the city’s speculators for worsening the country’s property bubble, and despise their outlandish displays of conspicuous consumption. This year, a video of a Wenzhou wedding motorcade — a parade of Rolls-Royces, Bentleys, Ferraris and Lamborghinis — went viral.

Guan, the importer of wine and scrape metal, said outsiders don’t understand.

“Those people against a bailout probably don’t work hard and just hate rich people,” said Guan, who said he owns property in every city in which he does business. “Wenzhou people take initiative. But sometimes, like in a family, children make mistakes. So the government should come in and help their kids to resolve this difficult situation.”

Tommy Yang in The Times’ Beijing bureau contributed to this report.