Small and medium-sized companies in Wenzhou are getting hit hard by the credit crunch, which the central authorities have imposed on companies to stem speculative investments and slow inflation. Middling-sized firms in exporting provinces such as Guangdong in southern China and the towns of the Yangtze River Delta are struggling, too. Many have already felt the pinch of higher wages, rising raw material costs, and the appreciating currency.

“The situation is getting worse and worse,” says Zhou Dewen, head of Wenzhou’s trade association for small and medium-sized enterprise in the province of Zhejiang. “There are widespread accounts of smaller businesses struggling to gain access to credit,” wrote Jing Ulrich, head of global markets, China, at J.P. Morgan on Aug. 9.

Wenzhou’s Zhou estimates that about one-fifth of China’s more than 10 million small and medium-sized enterprises, most with fewer than 300 employees, are producing at half capacity and risk bankruptcy. “If the government doesn’t come up with new policies to support them and loosen credit, then the number facing possible bankruptcy will double to 40 percent” by the next Chinese New Year, he predicts.

The central bank has raised interest rates five times and hiked bank reserve rates nine times since October of last year. “Banks are still lending to the big SOEs [state-owned enterprises],” says Dong Tao, chief regional economist at Credit Suisse Group (CS). “But the smaller guys, marginal guys—they get cut off completely. They don’t have adequate liquidity at all.” China’s state enterprises can use their connections to local governments and banks to assure financing.

Tighter lending by Chinese banks has helped encourage the growth of a gray market in lending by local business associations, pawn shops, and underground banks without official licenses, says Jianjun Li, professor of finance at the Central University of Finance and Economics in Beijing. The size of the informal lending sector has grown from a loan portfolio worth 6.6 trillion rmb ($1.025 trillion) in 2009 to an estimated 10 trillion rmb by June of this year. That’s equal to about one-fifth of outstanding official bank loans, points out Li.

Today, short-term loan rates in the informal banking sector go as high as 6 percent a month, while just nine months ago they were 1.8 percent, estimates Credit Suisse’s Tao. Annual rates can reach as high as 300 percent in places like Wenzhou, says Central University’s Li. (That compares to a one-year official lending rate of just 6.56 percent.) “So they are being squeezed on two fronts,” says Michael Pettis, professor of finance at one of Peking University’s two business schools. “Labor costs are going up, and capital costs are going up.”

Small and medium-sized enterprises generate two-thirds of industrial output, pay half of tax revenues, and employ 80 percent of China’s workers, according to the Ministry of Industry and Information Technology’s SME Dept. Because they are generally more efficient than the cosseted state-owned companies, smaller companies are key to China’s goal of achieving a more sustainable, less investment-driven economy. “The survival and development of small companies are directly linked to employment growth, economic transition, and social stability,” said Vice-Premier Wang Qishan in early July.

Wang’s comments show the degree to which the central government is now worried about the fate of the small business sector. In June, China’s banking regulator announced it would ease lending terms to encourage more loans to small and mid-sized companies. “We believe China’s policymakers will selectively loosen credit over the next several months,” wrote J.P. Morgan’s Ulrich. Beijing also needs to strengthen rural credit cooperatives and village banks, says Minggao Shen, head of China research for Citigroup (C).

All that will take time, not something smaller enterprises have much of. Topsun’s Wang feels the pressure. “It really doesn’t make sense for entrepreneurs to do business anymore,” he says, “because the more they produce, the more they lose.”

The bottom line: An informal bank sector worth $1.5 trillion is charging usurious rates to China’s small businesses that have been turned down by banks.

(CNN Money)