In recent weeks, at least 80 business owners have fled Wenzhou in eastern China and gone into hiding because they can't pay crushing debts to the city's empire of underground lending firms and loan sharks.
Chinese Premier Wen Jiabao became so concerned that he flew to Wenzhou earlier in October to try to keep the problem from spreading.
The city's credit crisis highlights some of the flaws — and potential risks — of the banking system in the world's second-largest economy....
The premier called for state banks to lend more to small firms and accept higher debt levels. He also called for a crackdown on high-interest loans.
Need To Break State Banking Monopoly
China's state media says the problem has been contained, but some worry that credit crises could emerge elsewhere.
Ye Tan, an economist based in Shanghai, notes that underground banking isn't unique to Wenzhou.
"It exists in many other parts of China, including Inner Mongolia and Guangdong province. This is definitely not just a Wenzhou phenomenon," she says.
[Private firms] know underground lending is very risky because of the high interest rates, but they have no choice.- Gary Liu, China-Europe International Business School
The monopoly on China's banking system should be broken, says Gary Liu, who runs the financial research center at the China-Europe International Business School campus in Shanghai.
He says the problem is that China's banks are state-run and prefer to lend to state companies.
Consequently, many private firms — which produce most of the jobs in China — must hunt for loans elsewhere.
"They know underground lending is very risky because of the high interest rates, but they have no choice," he says.
Underground lending isn't just risky for borrowers. Liu says much of the money actually comes from state banks.
"For instance, you are bank staff, you have a friend. The friend can use his house to borrow a bank loan. And then you can lend money to underground borrowers," he explains.
And then they can lend the money to someone else. So, it can be hard for banks to keep track of where the money actually goes.
The rest of funding for underground lending comes from ordinary families, which can put entire communities at risk.
Underground Lending Out Of Control
Liu says despite these problems, the Chinese government has refused to reform the system.
"Many top leaders don't really understand the market economy. And actually, they don't want to give up their power. When there is a problem, the first thing that comes into their mind is to control," he says.
In China, shadow financing has grown dramatically in recent years. This summer, it stood at $2.6 trillion — nearly one-third of all lending in China, according to GaveKal, a global financial research firm based in Hong Kong.
Underground lending solves a huge problem for private companies. But no one knows exactly where all that credit is really going — and nobody seems able to control it.
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