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Private Finance

When Wenzhou Sneezes

Chinese Premier Wen Jiabao’s recent crisis-aversion mission to Wenzhou was a clear sign that the city’s economy was in deep trouble. With China’s most legendary private finance market faltering, could it spell the end for Chinese entrepreneurship?

December 2011 Issue | by Li Jia

“The banks and the Chamber of Commerce have expressed their support for my return”, said Hu Fulin, owner of Zhejiang Center Group, China’s largest manufacturer of eyeglasses, in an interview with the Wenzhou Daily on October 10. Twenty days earlier, Hu had ab­sconded to the US, causing fears of an im­minent collapse of his business. Like many other Wenzhou companies, Zhejiang Center Group has recently come under massive fi­nancial pressure, causing many to question the core value of the city’s progressive eco­nomic model. Hu may now have returned to the helm, but he still faces a complete over­haul of his business, and for many, the case has confirmed suspicions that China’s private credit crunch has spread to large enterprises.

Recent headlines in Chinese and foreign media concerning Wenzhou, a mountainous city in China’s rich coastal Zhejiang Province, have echoed this sense of doom. Hailed for decades as the cradle of private Chinese en­trepreneurship, Wenzhou’s influence on the domestic market has made it a barometer of economic reform. But since September, reports of heavily indebted local business­people fleeing the country or even commit­ting suicide have triggered panic over a feared meltdown in the city’s intricate system of pri­vate financing.

Debt-related legal disputes and even criminal cases have erupted. The local court warned that a host of cases involving private lending had been filed between March and May this year. In Lucheng district, where private lending is particularly active, 158 verdicts could not be implemented because debtors had either disappeared or were insol­vent. Local media reported a case where the daughter of Gao Zhisheng, a local manu­facturer of engine springs, had been taken hostage by his largest creditor. She was saved only after her father offered to be taken hos­tage in her place. At the end of September, the local government announced a campaign to “crack down on the criminal use of force in demanding debt repayment.”

The danger has been noted by China’s top decision makers. On October 4, Premier Wen Jiabao made a trip to Wenzhou to in­vestigate the seriousness of the situation. He ordered the local government to restore pub­lic confidence “by any means necessary.” On October 12, in a bid to prevent the spread of the crisis, the State Council announced a package of policies including tax breaks and easier access to loans from State banks for small enterprises nationwide. Border checks have been stepped up in Zhejiang to prevent any more businesspeople from fleeing abroad to escape their bad debts.

Ye Tan, a well-known finance commenta­tor, even warned recently that “the decline of the Wenzhou economy, if it happens, could be a harbinger of the decline of China’s mar­ket economy.”

Private Problems

Private financing, which has been blamed for the current crisis, has underwritten Wen­zhou’s economic take-off and boom since the country commenced economic reforms in 1978. Without the natural endowment of fertile land or other resources, Wenzhou was a poor, rural area. Yearly savings per capita were less than US$1. It was private lending that made grassroots entrepreneurship and expansion possible.

Although most Wenzhou enterprises are small-scale producers of light goods such as clothing, they exercise influence not only lo­cally, but nationally and even globally. 99.5 percent of Wenzhou companies are privately owned, and they account for 86 percent of local tax revenue and 94 percent of local jobs. While the majority of international trade in China is carried out by foreign companies, in Wenzhou, it is private companies that have formed the backbone of the imports and ex­ports with other countries of the world. Near­ly 20 percent of Wenzhou’s total population, more than 1.7 million people, have founded companies. Since the mid 1980s, this has been hailed as the “Wenzhou model”.

The role of banks in this success story has been minimal. Incapable of providing the requisite collateral or guarantees required by banks, small and medium-sized enterprises in China have traditionally had little or no access to bank loans. As a result, Wenzhou’s rise has been concurrent with a proliferation of local private financing institutions such as guarantee companies, pawnshops and loan sharks.

Given these circumstances, the central government’s tightening monetary policy that targeted bank loans starting in late 2010 should not have hit small enterprises. In practice, however, the tight supply of money restricted access to bank loans for large enter­prises, driving them toward the private credit market. As a result, the interest rates of private finance companies have been pushed higher by the increasing demand. A report by the Wenzhou branch of China’s central bank shows that the current interest rate of the private lending market stands at a historical high, fueling the risk of default.

Speculative Efforts

However, Wenzhou’s problems do not begin and end with credit woes. Wenzhou has also proven to be vulnerable to the wider eco­nomic downturn. As Zhou Dewen, chair­man of the Wenzhou Small and Medium-sized Enterprise Development Association said, the credit crunch was the “last straw that has pushed small and medium-sized en­terprises (SMEs) to collapse.” The top three problems, according to a joint survey by Pe­king University and Chinese Internet giant Alibaba Group, are increases in the costs of labor and raw materials, and the appreciation of the yuan. Increases in these three elements are an “irreversible trend,” warned Zhou. In addition, some company managers found themselves in debt due to poor management or gambling.

Of course, none of these problems is unique to Wenzhou; all three have plagued China’s small and medium sized enterprises since the global financial crisis sent the world economy into a tailspin three years ago. However, they have served to highlight a lack of effective financing in the city, with the cur­rent crisis seemingly exposing hidden weak­nesses in the Wenzhou model itself.

The chaos on Wall Street since 2008 has proven that any clever game of finance can most certainly backfire. While Wenzhou companies have become increasingly aggres­sive on the asset market, their positive effect on the real economy has been lackluster. Cash-rich from the success of their SMEs, Wenzhou businesspeople have pursued quick, speculative returns with forays into real estate in 2001, coal in 2002, cotton in 2003, mineral resources in 2006 and oil in 2007, before turning their attention to pri­vate equity investment.

With the money supply tightened, these avid prospectors are keen to turn a profit from a capital-thirsty market. While bank lending decreased sharply, the central bank’s Wenzhou branch recorded 110 billion yuan (US$17bn) of private lending in the first half of 2011, compared with 80 billion yuan (US$12.5bn) in the first half of 2010. Lo­cal enterprises in the industrial sector are the largest providers of credit.

This sudden eagerness to lend has not only caused today’s chaos, but also discouraged entrepreneurship in the real economy; only a small part of the total borrowed money was spent on industrial operation. For some listed companies, loan sharking can often generate more cash flow than their main business. But as has been shown, the asset market is risky. Due to the central government’s current poli­cies aimed at cooling the housing market, investment in property is no longer such an attractive prospect. According to Wenzhou media, Mr Gao, the spring maker, got into trouble partly because his investment in mines went sour.

In the mean time, many enterprises are se­rious about improving their growth model. At the end of 2008 when the promotion of alternative energy became national strat­egy and the monetary policy was relaxed, Hu Fulin’s eyeglasses company made huge investments in the renewable energy tech market. But before the investment had made sufficient returns, monetary policy changed and his financing costs soared, showing that abrupt changes in monetary policy have also played a part in enterprise’s failure to adapt.

Survival Strategy

Voices calling for more support, rather than restriction, of the private lending market have never been so loud. Mao Yushi, a well-known economist, has argued that private enterprises are very good borrowers as they put their own money, businesses and even family at risk if they default. He stressed that only the private credit market can help small enterprises when they need money immedi­ately to survive. He even questioned the law which defines the practice of lending at a cer­tain interest rate as illegal usury: “This regula­tion… is groundless and should be annulled immediately,” he said in a recent article in NewsChina’s Chinese edition.

Zhou Dewen has long been calling for incentives to drive private investment in a direction that will benefit the real economy, rather than towards speculative financial games. Last May, the central government announced a 36-article package of policies to encourage private investment in markets monopolized by State companies, such as in­frastructure, utilities, finance and even arms technology. However, implementation has been disappointingly poor. On his trip to Wenzhou, Premier Wen recognized that pri­vate companies still encounter glass ceilings in these key sectors.

In a market with such insurmountable barriers, private companies remain incredibly vulnerable. A week after the State Council’s October 12 policy to support small enter­prise, the media carried reports about pri­vately-owned gas stations around the country facing fuel shortages. But Sinopec, one of the three State-owned oil monopolies, declared that it was not their responsibility to guaran­tee fuel supply for private gas stations. The central government is rushing to review the implementation guidelines of the 36-article policy, but there is little reason to suggest that any real change will result.

What happened in Wenzhou has not only already had repercussions beyond the area, but encapsulates China’s current dilemma. Over the last three years, China has been ap­plauded for its resolute efficiency in the face of the global financial crisis, with policies of assertive State intervention appearing to carry the country through the storm unscathed. However, with its private economy under­mined, it faces a backlash. Now, as always, how it treats its private economy will have far-reaching effects on its core competitive­ness and future reform trajectory.

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