Illustration by Antler.
Credit: Frederic J. Brown

Editor's note: "Cracks in the Wall" is an ongoing series about the challenges facing China's economy.

WENZHOU, China — For years, this city’s web of underground loans, cash and credit traded on trust and the promise of profits, fueled factories and made many people rich.

From the outside, Wenzhou’s system of informal and private lending to small businesses that had trouble getting credit was admired in China. It was seen as a thriving example of Chinese entrepreneurialism.

But with the global financial meltdown in 2008, cracks emerged in Wenzhou’s grey loan market.

In recent months, tighter credit, rising inflation and disappearing profit margins finally started to crash the system. Dozens of people and companies have gone bankrupt. Debt-ridden factory bosses have slipped into hiding.

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As Chinese officials look for ways to shore up weak spots in the national economy, Wenzhou’s private credit system has gone from role model to cautionary tale.

Following a high-profile visit and promise of help from Premier Wen Jiabao this fall, Wenzhou’s very public credit collapse has raised new questions about the potential for nationwide problems.

And while the government is promising help for small businesses across China, Wenzhou’s crash illustrates the dangers of relying on a private, unregulated credit market to finance growth.

What happened in Wenzhou

Smaller private companies don’t have access to big bank loans. They have long depended on underground lending and the private credit network for cash to run their business.

They’ve also been key drivers of the local and national economies, with an estimated 40 percent of China’s businesses now classified as small- and medium-sized enterprises.

Faced with inflation, higher costs and diminishing ability to get bank loans, those same companies are trapped.

What remains unknown is how far the bug could spread, as well as what potential impact the crash might have on the rest of the Chinese economy. The latest numbers show China’s economy is growing by 9.1 percent — the lowest level in two years, though still robust — and inflation has slowed.

But speculation, bad loans and the lack of cash for smaller enterprises remain critical concerns.

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Shanghai-based economist Andy Xie, writing of a recent research trip along the Yangtze River and in Wenzhou, said loan-sharking seems common, and interest rates in private lending far exceed what business people can actually repay.

“The size of the market is impossible to estimate,” said Xie. “If the slowdown in bank-deposit growth partly reflects this phenomenon, it could be several trillion yuan in size. When it bursts, it may lead to significant social instability.”

Wenzhou workers say they were duped

On the outskirts of Wenzhou in a shuttered steel factory, a group of middle-aged men who got caught in the system explained how it worked.

Over several years, they both cashed in foreign currency notes and lent money to Zheng Zhujhu, a woman who used an extensive network of private finance to build a chain of home appliance stores. When the banks tightened controls on credit, Zheng stopped repaying her lenders, refused to take their calls and went into hiding.

Zheng became the first person arrested in the credit collapse, apparently not running as far or fast as the rumored other 80 bosses who fled to escape their debts. Authorities have confirmed one loan boss committed suicide, and the city swirls with rumors of more. Whispers of mafia violence are also common, though there’s been no confirmation.

For the steelmakers, both lenders and borrowers in the private credit market, the situation is grim.

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One of the men lost nearly $800,000 to Zheng’s scheme. In all, her victims claim Zheng took more than $45 million that was never repaid. They’re looking for a lawyer to take their case, but see little hope of getting their money back.

Their factories have orders, but they can’t produce anything because they have no cash or credit on hand to pay for workers or raw materials. So workshops sit idle, while the factory bosses wait for a legal solution.

“It’s a very difficult thing,” said Zhu Fang, one of the men who lost a fortune to the lending scheme. “Small and medium-sized companies are not able to operate now. Some of the big factories can still produce, but the smaller ones are stuck.”

How the state played a role

Zhou Dewen, head of Wenzhou’s small business association, explained that while in the United States banks raise interests rates to control lending, in China the central bank increases reserve-rate ratios. That means the bank has repeatedly, throughout the past few years, increased the percentage of money borrowers must keep on hand.

That cuts small businesses working on credit out of the mix, argues Zhou, and gives power to large and state-owned companies.

While China’s central government has pledged to help small businesses, Zhou said, Wenzhou business people already are picking up the pieces on their own. They’ve started a collective emergency fund for companies in trouble and are proposing that the provincial government legalize and regulate private lending, so large banks aren’t in total control of the local economy.

“Most companies are operating and recovering from panic mode, but the general environment cannot be changed overnight,” said Zhou. “The companies themselves need to huddle together and get through winter.”

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