Danger signals from China

Debt panic in China's Wenzhou may predict wider woes

USA Today,

19 October, 2011

WENZHOU, China – Wenzhou's private entrepreneurs, scrappy survivors in an economy ruled by state industries, once thrived on a formula of cheap backstreet loans and low-cost manufacturing.

Now, they're at the center of what some have dubbed China's own subprime debt crisis, a festering mess of borrowings gone sour that has become one of the weakest links in the economy — at a time when strength here is most needed to offset weakness in the U.S. and Europe.

"Do anything, but not manufacturing in China!" exclaimed Yang Guanghua, boss of a Wenzhou electroplating factory. Unable to collect from customers who themselves have no money, Yang said he stopped paying salaries two months ago.

"I can't get raw materials because suppliers are afraid I will run away," Yang said. "It's just impossible to get loans from the bank unless you have connections," he said.

Wenzhou's factory bosses are caught in a dire credit crunch. Pyramids of high-interest private lending are collapsing as companies whose profits are dwindling due to rising costs and weakening demand default on their debts. Dozens of tycoons have skipped town. The government has intervened, but many worry the stopgap measures will not prevent the problems from getting worse.

The true scale of informal lending nationwide, much of it derived from bank loans originally intended for other purposes, is unknown. But such lending has ballooned because the reluctance of China's state-run banks to lend to small and medium-sized businesses has been compounded by government curbs on credit to cool inflation. Interest charged by private lenders can be as high as 90%, inviting comparisons with dodgy investment schemes.

"I have to conclude that this business is now a Ponzi game, relying on new money to pay off the old money," said Andy Xie, a Shanghai-based economist who traveled the Wenzhou region over the past two months researching the situation. "If not checked, this could lead to a national calamity."

UBS economist Tao Wang puts informal lending at between 2 trillion yuan to 4 trillion yuan ($314 billion-$628 billion), or up to 10% of China's GDP. There is little immediate impact on China's massive state-run banks from some of these loans turning bad. A bigger risk is Wenzhou's credit squeeze spreading to other parts of the world's No. 2 economy.

Though Wenzhou, a city of about 9 million on China's southeastern coast, accounts for less than 1% of the country's economic output, it has an outsized impact on China's manufacturing and its financial markets.

Almost all Wenzhou's business is privately owned, much of it by the city's more than 400,000 small and medium-size enterprises. The city's tycoons hold an estimated 800 billion yuan ($126 billion) in private capital and are renowned for driving speculation in property, coal mining and other commodities.

Mercedes, Cadillac and Toyota dealerships line the roads — attesting to the personal wealth that has left the city's nighttime sidewalks chockablock with parked cars and its streets choking with smog.

Vast chunks of the city are walled off for construction of luxury apartment complexes such as Noble Peninsula and Platinum Garden, while modern amenities such as a subway line are lacking.

Much of the estimated 500 billion yuan ($79 billion) in private borrowing in Wenzhou went not to manufacturing, but instead to potentially higher return investments in property or commodities — or to still more lending by the borrowers themselves.

"When banks cut off lending, businessmen went to the high-interest informal lenders, figuring that a month or two later they'd get loans again to repay their other debts. But the banks are not lending so they ran out of cash," said Yu Jingliang, owner of Zhejiang Pacific Paper Co., which deals in disposable moist towelettes and toilet seat covers.

What might in normal times have been a brief liquidity squeeze became a death grip, as banks ordered to keep record levels of funds in reserves to fight inflation withheld even routine loans.

Some of the tycoons that skipped town, including Hu Fulin, owner of major eyeglass maker Zhejiang Center Group, were convinced or coerced into coming back. A few committed suicide.

Despite the domination of state banking and enterprise elsewhere in China, private businesses account for roughly 80% of new job creation and are vital to the country's exports.

With the problems spreading to other regions, including the Gobi desert boomtown of Ordos, China's leaders stepped in, ordering banks to lend more and to relax repayment terms for small and medium-sized enterprises. Loan sharks and other informal lenders were reminded not to use violence or other drastic measures to collect debts.

Meanwhile, the government is slashing taxes and promising faster processing for export tax rebates.

The emergency measures, and a morale boosting visit by Premier Wen Jiabao and other top economic leaders, appear to have eased the recent panic.

But more needs to be done, said Chen Shishang, founder of Senken Group, a maker of police vehicles, warning lights, sirens and riot gear.

"From the surface, it looks like the situation is somewhat under control. The government policies are coming and the banks are beginning to adjust, but many companies are still in crisis," Chen said in an interview in his office, an elegant haven of beige marble, oil paintings and ceramics at the company's headquarters in a grimy industrial zone in southern Wenzhou.

"We really need for the government to carry through with its help. We need more support measures," Chen said. "It's like a natural disaster. If everyone comes to help it won't be so dangerous."

Zhou Dewen, head of Wenzhou's association for small businesses, estimates up to 40% of the country's small and medium-sized manufacturers may have to close or at least cut back production in coming months due to a lack of working capital.

Yang, the electroplating factory owner, said he is holding back on some orders for customers who are three months in arrears. He paid his workers a 200 yuan ($30) bonus for a recent national holiday, but is letting those who want to leave go.

"The workers know it's not a problem with our factory itself, it's just hard to get our money back," he said.

Lighter factory owner He Zhanjun, who said he is paying 70% more this year for plastic than last year, is persevering. But he expects about a third of the city's lighter manufacturers to fold.

"Manufacturing is just getting harder and harder," he said.

Though Wenzhou's streets rumble round-the-clock with heavy truck traffic and its skyline is studded with cranes, many workshops and smaller factories stand idle and padlocked. Big office buildings and apartment complexes sit half-finished.

"Up to now most of what we have done is cheap cost, cheap priced production," said Zhou, who trained as an economist. "Our industries need to upgrade. They need new technology and innovation. They need to create their own brands."

Such is true for many Chinese manufacturers, who are ceding low-cost competitiveness to other developing countries such as Vietnam and Bangladesh.

But it's a tall order for a city specializing in contract production for other brands, where billboards advertise tongue-twisting non-household names like Lonsid and Zhotr.

For one thing, upgrading depends on persuading customers to accept higher prices, said Chen, whose 21-year-old company employs about 1,000 people.

"We have to use our heads. There is a lot of pressure," he said.

China's ascent up the value chain to more sophisticated, costlier products also will require automation.

Facing wage increases of 25% this year, Qiu Jinguo, 45-year-old owner of Ruian Yutong Vehicle Fittings Co., an auto accessories factory, said he is replacing some of his 70-plus employees with machines.

"The cost is the same, while management is much easier," said Qiu, who reckons his profit will still fall by a third this year from last year due to soaring costs.

But behind Wenzhou's woes lie a wider problem in China: many with capital to invest are no longer looking to manufacturing, when real estate, speculating in commodities such as Pu Er tea and high interest lending can offer much better returns.

Yu, a former bureaucrat who spent seven years in China's rugged northeast as a youth, said he wants to expand his paper products empire, but can't do it without automation. Problem is, there's not much interest in his line of business.

"I need a machine to make those toilet seat covers and I've been looking for one for a long time but I can't find one anywhere," Yu said.