Quotes of the Day

Mao Jiatai's disposable cups ought to runneth over. In 2002, says the entrepreneur from western China's Sichuan province, his private company made and sold $2.5 million worth of paper containers for food and beverages. He has four production lines making paper cups in hangar-like buildings, and 20 young women from the countryside toil in the yard beside them, pasting labels for White Family Potato Noodles onto single-serving bowls. Business has never been better. Yet Mao, like so many other owners of private companies in China, can't get funding to take his firm to a higher level.

Last year Mao wanted to boost production to ride a trend of restaurants' serving tea in paper cups with colorful plastic holders. Although he had plenty of collateral in the form of sales contracts, machinery and inventory, lenders wouldn't grant him even a small line of credit. So potential customers, he fears, have gone to state-owned companies with better access to capital. "The government sees state enterprises as its sons, so it helps them," Mao says. "Someone else will drink up my market."

The dry well of funding for entrepreneurs like Mao poses a danger for the entire country. As China shifts from a state-controlled economy to a free market, success will depend largely on the work of gritty local companies producing pedestrian goods and services. Small- and medium-size enterprises generate most of China's employment growth. By the government's reckoning, companies with annual revenue of less than $30 million account for more than 8 of every 10 jobs in urban China and three-quarters of the country's industrial output.

Yet entrepreneurs like Mao have been cut off from vital resources by the country's antiquated and deeply indebted banking system, which still lends mainly to lumbering state-owned enterprises. The government has allowed the failure of thousands of these uncompetitive vestiges of the revolution — in the past eight years, 56 million factory workers have lost their jobs. But the government's fear of mass unrest keeps thousands more state firms on life support, consuming government-directed "policy loans" that will probably never be repaid. China's four biggest banks are technically insolvent because they are owed an estimated $500 billion in nonperforming state-enterprise loans, but 70% of their new loans still go to state companies.

The SARS outbreak is making matters worse for private companies, many of which are face-to-face service businesses: restaurants, retailers, guesthouses. One hopeful sign is China's appointment of Liu Mingkang, the reform-minded former head of the Bank of China, to the chairmanship of the new China Banking Regulatory Commission. Liu wants to raise money on stock markets to recapitalize the country's commercial banks. For now, however, China's spurned entrepreneurial class must rely on unconventional lenders, including pawnbrokers and loan sharks. Liu Qingrong borrowed money from friends and family to set up a factory making traditional Chinese medicines in Sichuan in 1992. Within two years, her remedies far outsold those produced by her biggest state-owned competitor. Did that land her some bank credit? Hardly. In 2000 she had to borrow from a real estate developer she knows to finance her purchase of some ailing state-run factories — and later, she was obligated to guarantee a loan made to him. "If we'd had to repay," she says, "we would have had to stop production."

Then again, a quid pro quo with an associate is safer than borrowing from the pawnbrokers who have become China's de facto commercial lenders. The booming city of Chengdu, Sichuan's capital, is home to some 200 of them. Don't think of them as small-time purveyors of rusty bikes and busted TVs. The tiled floors and tawny sofas of the Building China Pawnshop suggest a bank lobby, and rightly so. Loans from owner Liu Jianjun, which can run up to $1 million, mostly go to private businesses. Parked in front of the pawnshop one day recently was a new Volkswagen. The owner of a construction company had hocked it in exchange for a quick $10,000 to meet expenses. He was well advised to repay fast — Liu charges interest rates of up to 5.7% a month. It's all legal; without the pawnshops, the government knows, small-business owners would have almost nowhere to turn. "Banks make it difficult and confusing to get a loan," Liu says with a smile. "Our business is booming."

China's bankers shouldn't take all the blame. The government caps the annual interest rate they can charge at 6.6%, which barely compensates them for their risk. It also prevents them from accepting things like sales contracts or inventory as collateral, even though small companies usually lack hard assets like land or machinery. Liu Binbin has seen it all as a lending supervisor at the Chengdu City Commercial Bank, one of a hundred or so banks set up across China specifically to make loans to small companies. A recent applicant, the owner of a factory that pickles vegetables, showed Liu his ledger: a single piece of paper with handwritten entries kept folded in his breast pocket. Liu chuckled, but he knows: there lies the future of China's economy.

• Matthew Forney/Chengdu