Shadow Financing Boom Exacts High Toll In China In Wenzhou, China's entrepreneurial capital, scores of business owners have fled, with at least one committing suicide, after they could not repay loans from the city's underground banks and loan sharks. The rise of this $19 billion empire highlights flaws in China's banking system.

Boom In Shadow Financing Exacts High Toll In China

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Wenzhou in China is a city of entrepreneurs, but in recent weeks, dozens of business owners have fled. They've gone into hiding because they can't pay off crushing debts they owe to the city's empire of underground lenders. The situation has caused national concern. Chinese Premier Wen Jiabao even flew to Wenzhou earlier this month to try to keep the problem from spreading.

As NPR's Frank Langfitt reports, the city's credit crisis highlights flaws in the banking system of the world's second largest economy.

FRANK LANGFITT, BYLINE: This is Wenzhou's Zhengdeli shoe factory, or at least it used to be. Now, it's all abandoned and there are chains around the doors. The only person who's here is a security guard from the government, which is taking the place over. Now, late last month, the owner of the factory jumped from his 22 story apartment because he was facing more than $60 million in debts.


LANGFITT: To find out what happened, I met up with Xu Jianpian at a tea house.


LANGFITT: That's a bubbling teapot. Xu runs a business here and he knew the factory boss, Shen Kuizheng, who took his own life.

XU JIANPIAN: (Through Translator). He expanded his business and wanted to be number one in the shoemaking industry. He took out underground loans and the interest was more than $15,000 a day.

LANGFITT: Shen's timing was terrible. The Chinese government is deeply worried about inflation, which is over six percent, so earlier this year it tightened already paltry lending by state banks to private firms. More factories turned to underground banks which, in turn, jacked up their annual interest rates to 25 percent or more. Shen became a marked man.

JIANPIAN: (Through Translator) He owed money to many people. The number was probably in the thousands. He used the properties of more than 20 relatives as collateral to get loans. Wherever he went, the creditors would follow him. He was cornered. There was so much pressure, he lost all hope of living.

LANGFITT: Wenzhou is the capital of Chinese entrepreneurialism. Underground lending here - valued at a staggering $19 billion - has been a part of commercial life in this coastal city for decades. But Xu had never seen so many factory bosses run away. He says China's Premier had no choice but to come to the city.

JIANPIAN: (Through Translator) Wen Jiaobao saw Wenzhou's economy was in the process of collapsing.

LANGFITT: 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. China's state media says the problem has been contained, but some worry that credit crises could emerge elsewhere.

Ye Tan is an economist based in Shanghai.

YE TAN: (Through Translator) Underground banking is not 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.

GARY LIU: China's banking system - you know, we should break the monopoly.

LANGFITT: Gary Liu runs the financial research center at the China-Europe International Business School campus in Shanghai. He says the problem is 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.

LIU: They know that underground lending is very risky because the interest rate is so high, but he have no choice.

LANGFITT: Underground lending isn't just risky for borrowers. Liu says much of the money actually comes from state banks.

LIU: For instance, if you are a bank staff, you have a friend. The friend can, you know, use his house to borrow bank loan and then you can you can lend the money to underground, you know, borrowers.

LANGFITT: And then they can lend the money to someone else, so it can be hard for banks to keep track of where all that money goes. The rest of funding for underground lending comes from ordinary families, which can put entire communities at risk. Liu says, despite all these problems, the Chinese government has refused to reform the system.

LIU: Many top leaders, they don't really understand the market economy, and actually, they also don't want to give up their power. When there is a problem, the first thing that comes into their mind is to control.

LANGFITT: In China, shadow financing has grown dramatically in recent years. This summer, it stood at $2.6 trillion, according to GaveKal, a global research firm based in Hong Kong. That's nearly a third of all lending in China. Underground lending solves a huge problem for private companies, but no one knows exactly where all that credit is really going and no one seems able to control it.

Frank Langfitt, NPR News, Shanghai.

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