City left in dark by shadow banking

Buildings Brics: The economic problems in boom cities such as Wenzhou highlight the dangers facing China

A factory worker stitches leather shoe uppers on a production line at the Kangnai shoe factory in the Chinese city of Wenzhou 30 March 2006. Kangnai is one of about 20,000 Chinese shoemakers at the cShow more

Wenzhou was until recently a shining example of success in China and was home to many self-made millionaires. But the story has taken an unhappy turn lately as an unofficial credit system puts pressure on commercial borrowers, writesDaniel Bardsley, foreign correspondent

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The city of Wenzhou in south-east China used to be synonymous with freewheeling capitalism, a "wild east" where anything was possible.

Such was the city's reputation that books were written about the no-holds-barred approach of entrepreneurs who set up businesses there and made fortunes.

But after building their foundations on cheap consumer goods for local and then foreign markets, and investing heavily in property, Wenzhou's millionaires have suffered a blow to their fortunes this year.

Now the city is more likely to be associated with lending bubbles than success.

In the past six months, according to media reports, more than 90 debtors have fled the city after finding themselves unable to meet payments on debt said to total 20 billion yuan (Dh11.55bn). At least two have committed suicide.

By the start of this year, the appreciation of the yuan and rising wages were making life harder for Wenzhou's manufacturers, and the subsequent tightening of bank credit, ordered by the Chinese authorities amid concern over economic overheating and rampant inflation, pushed many over the edge.

The problems partly resulted from high rates of interest being charged on loans, because entrepreneurs had been forced to turn to private lenders after the official banking sector, which has traditionally favoured state-owned enterprises in any case, curtailed its lending.

Some business people were reportedly being charged 70 per cent interest, considerably more than the maximum permitted amount.

As many as 90 per cent of households in the city were said to be involved in the grey lending market, with savers pushed into it because bank savings rates were too low to keep up with inflation.

"The incentives for [unofficial lending] are clearly there: deposit rates are controlled; and the real return from the strong economy is high. So people like to lend outside the banking system," says Cui Li, the chief China economist for the Royal Bank of Scotlandin Hong Kong.

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The question is whether Wenzhou's problems are isolated or highlight issues that could affect the wider Chinese economy.

"I think the significance of the event is that it's uncovered a lot of irregularities in the system," says Ren Xianfang, an analyst at IHS Global Insight in Beijing.

If the government does not take "proper measures", she says, there could be problems, with interest rate liberalisation a key reform. Analysts have highlighted the risk that government control over the economy will be compromised if grey lending is allowed to grow.

China has tried to downplay the wider significance of events in Wenzhou. Figures from the China Bank Regulatory Commission indicate that the total amount of loans provided by the unofficial banking sector was 20 times smaller than that of state banks.

"It's not a major risk yet because the magnitude is very small," says Ms Cui.

In response to the Wenzhou crisis, the State Council, China's cabinet, has tried to ensure that smaller companies can obtain credit through official channels by continuing preferential reserve requirements for the modestly sized banks that do lend to them.

Various tax breaks have also been introduced to give smaller companies breathing space.

It was necessary for the authorities to inject liquidity into Wenzhou "to alleviate panic" in the short term, says Ms Ren.

More significant nationwide could be problems from excessive lending faced not by private lenders but by the formal banking sector.

Banks are "saddled" with non-performing loans as a result of the vast stimulus package implemented after the onset of the global economic crisis, she says.

The state-owned banks were key to the 4 trillion yuan stimulus that helped China sustain its economic growth through the crisis.

Ms Cui believes some observers have taken an "extremely bearish" view of the potential problems China's banking system faces. She says the high savings rates in China will support the banking sector, meaning the risks it faces are "relatively low".

Last week, Bloomberg News reported that local government financing vehicles would be given extensions on repayments due by the end of next year on debt totalling 4.5tn yuan.

This would ease financial pressures, Bloomberg noted, after the clampdown on lending ordered by the central authorities to prevent overheating.

Renewing the debt would, some analysts say, temporarily solve the liquidity problems, although others have noted this would not alleviate concerns over the long-term repayment of these debts.

There will be a "fiscal solution to this debt", says Ms Cui, who adds that she does not see that as a major threat to economic stability, given the strength of government finances.

"Because of the strong public balance sheet, they can deal with it," she says.

Overall, she does not expect stimulus package debts will come back to haunt the country, a stark contrast to the situation in Wenzhou.

In addition, with domestic demand having picked up considerably in the past couple of years, the country is more insulated from shocks elsewhere in the global economy.

"I see a soft landing," Ms Cui says. "In a relatively benign scenario - a slow [global] recovery - China's growth is still protected.

"Even in the worst [global] scenario, there are plenty of policy instruments the government can use to support the economy."