When Wenzhou Sneezes

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Photograph by Patrick Zachmann

Cobbled together At a shoe factory in Wenzhou. Declining margins have brought economic uncertainty to the city

Wenzhou is known for making shoes, buttons, eyeglasses, electric switches, water valves and 70% of the world's cigarette lighters. But its most famous product is entrepreneurs. Hemmed in by mountains and with little arable land, this city on China's southeastern coast has relied on trade for centuries. Even in the Maoist era, when capitalism came under sustained and violent attack, private enterprise was never entirely extinguished there. So after China began market reforms in the late 1970s, Wenzhou flourished. "The Wenzhou Model" of small, low-cost manufacturing operations was widely copied in China. Wenzhou now has some 140,000 companies, and its businessfolk have invested across the country in everything from real estate to mining. The city is the locus and symbol of private enterprise in China.

But in recent weeks, the reputation of Wenzhou's entrepreneurs has taken a serious hit. Dozens of factory bosses have fled bad debts, and at least two have committed suicide. Part of the cause is the challenging operating environment for manufacturers. Demand from export markets like the U.S. and Europe is weak, wage and materials costs at home are rising, and China's currency, the renminbi, has been steadily appreciating, making Chinese goods more expensive abroad. "Orders have been down this year and last — that causes a lot of pressure," says Cai Jianguo. He started his Wenzhou eyeglass company, Zhengshi Optical, with just $1,200 and eight employees in 1997. Today he has more than 100 employees churning out some 30,000 pairs of plastic frames a month, mostly for export. But he's feeling the pinch. "For small businesses like ourselves, survival itself is a big challenge."

The main cause of Wenzhou's ills is far more explosive, however, and lies in the local tradition of private lending. Because Chinese banks prefer to lend to larger, state-owned enterprises that are ultimately backed by the central government, Wenzhou's entrepreneurs have long turned to one another for financing. "Private lending and private enterprises are a natural couple," says Hu Zhenhua, a professor of economics at Wenzhou University. "One cannot exist without the other."

That relationship has come under extreme strain. The central government's efforts to control inflation over the past year have restricted bank credit, driving up the demand for underground loans even more. In Wenzhou, local investors, including a significant share of the town's businesses, have been chasing hefty earnings through making private loans that have interest rates as high as 60%. But such levels of return are unsustainable, and over the past month the credit market has collapsed. In a town where almost everyone has lent or borrowed through the informal networks, the pain has been severe. Wenzhou entrepreneurs' ability to access nonbank credit may have been one of the sources of the city's success, but it now threatens to bring the local economy down. And given the extent to which local entrepreneurs have invested throughout China, the shocks will likely be felt nationwide. Shanghai Daily calls the Wenzhou meltdown "China's subprime crisis."

Not Just Kids' Stuff
Cai's anxieties about slim margins in the eyeglass business are almost mundane compared with those of another Wenzhou entrepreneur known as the Kid. (For his safety, he asked that his real name and some identifying details not be divulged.) The Kid is a private moneylender. Some would call him a loan shark. He pools money from local investors and loans it out to businesses that need cash. He started lending in 2007 with about $1 million of his own, bank loans against family property and money from hundreds of investors. A year later, when the global financial crisis hit, the Chinese government initiated a $586 billion economic-stimulus package and ordered banks to flood the market with credit, all in an effort — ultimately successful — to keep the domestic economy humming. But even amid that sea of credit, SMEs in places like Wenzhou still found it difficult to get bank loans because state enterprises were soaking up most of the money. For private firms, the stimulus was "like the rain that never reached the land — it was intercepted in midair," the Kid says. "So the land had to draw water from underground."

That underground supply did not come cheap. The Kid made loans at 2.5% monthly interest, or about 34.5% annualized, far higher than the 7% to 8% charged to those getting bank loans. Things really took off for him over the past year as the central government tightened credit, raising benchmark interest rates and upping banks' reserve requirements. "You've got an environment where growth for the past few years has been driven by almost limitless easy credit," says Patrick Chovanec, an associate professor at Tsinghua University's School of Economics and Management in Beijing. "When the People's Bank of China began to impose limits on credit in order to rein in inflation, that demand for limitless credit as a driver of GDP growth didn't go away." Rather than squelching the demand for credit, those actions shifted it to the informal market.

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