Out of the shadows
Wenzhou is known as a place of the fast buck and the even faster fortune. For 30 years, illegal underground banks have helped grease the wheels of commerce and built the city's reputation as the country's entrepreneurial capital.
But Wenzhou's free-wheeling reputation may soon get the official seal of approval. Beijing's declaration last month that it is legalising the shadow-banking system spurred elation, relief, and even some confusion in the city of 9 million people.
Fang Peilin, a shadow-banking trailblazer in the early 1980s, says the State Council's announcement on March 28 was akin to a birth permit given to formerly 'illegal babies'.
In the past three decades, the underground banks have been instrumental in bolstering Wenzhou's private business sector.
'The babies are now in their 30s, and the birth permits were granted just now. It is hilarious, isn't it?' Fang said.
'But it was definitely a positive step and was in the right direction.'
On the mainland, expectant women will not be accepted for deliveries by hospitals without a birth permit that proves the birth is compliant with the nation's family planning policy.
Wenzhou businessmen, who are seen as among the mainland's boldest and most enterprising, were instrumental in creating the 'private lending' businesses. They have helped thousands of small businesses to flourish amid the mainland's economic liberalisation policy.
The city's shadow-banking system, dubbed the spiritual capital of the mainland's private business sector, has been compared with loan sharking, but local entrepreneurs are more comfortable with the term 'private lending'.
To be sure, businesses in Wenzhou - which produce everything from cigarette lighters to glassware - have flourished, thanks to the use of such private loans.
Here is how an underground bank works: a powerful individual, who runs an underground bank, raises funds from several wealthy people before making high-interest loans to companies or individuals. The interest yields will then be shared with the 'depositors'.
This business practice was illegal until recently because only banks and licensed financial institutions on the mainland were allowed to take deposits and issue loans.
Nevertheless, local government officials have gained from the practice, as they had advanced in their political careers partly due to the private-loans-driven growth of the export businesses in their areas of supervision.
At the start of the private loans business, the participating depositors and borrowers were either family relatives or fellow villagers.
Fang Peilin was one such entrepreneur who set up one of the mainland's earliest underground banks under a 'pilot project'. The central bank initially endorsed Fang's bank in 1984, praising its innovative lending model, as it better served private businesses that were unable to borrow from state-owned banks.
But two years later, Fang was forced to close shop when the central bank tightened controls on non-banking institutions by barring them from taking deposits or making loans.
Fang then applied for a licence for his lending business without success.
'The lending model should have been legalised from the very beginning. Its positive role should have been acknowledged long ago.'
Despite Beijing's obstruction, however, underground banks spread like wildfire across Wenzhou and other cities in eastern Zhejiang .
By the early years of the 21st century, amid the economic boom, it seemed as though everyone in Wenzhou was participating in the private lending business.
The underground banks provided tremendous amounts of loans to businesses that produce goods for export to the West, and received high interest yields to reward their wealthy financiers.
At one point, an estimated 600 billion yuan was flowing through Wenzhou's shadow banking system.
But Wenzhou's underground banks began to reel amid the global financial crisis in 2008.
The economic storm blindsided thousands of Wenzhou business people and a large number of borrowers were unable to repay their loans amid dwindling orders from overseas. Some underground bank operators fled when their businesses collapsed.
Bai Lin, a financier of an underground bank, remains nostalgic about those days when she made easy money by servicing the seemingly insatiable demand for loans from businesses. 'Risk was an unheard-of term at that time because tonnes of money were sloshing around and nobody could have imagined the cash would evaporate,' she said.
'When the day eventually came last year, people were stunned.'
Initially, the worsening business climate and shrinking profit margins ushered in fresh capital to the underground banks as entrepreneurs shifted focus from their manufacturing businesses to the financing sector, chasing higher returns.
Black-market lending rates surged to about 10 per cent a month in the middle of last year from about 2 per cent normally.
Anecdotal evidence suggested that a large portion of borrowers during the economic downturn were using the money to gamble at casinos, and some of them were later found to be swindlers rather than business owners.
Declining to disclose how much she lost, Bai did say that one of her friends, a depositor at one of the underground banks, failed to retrieve a single cent.
Bai is now confident that underground banks will soon enjoy a resurgence. 'The State Council's new policy is reinvigorating it. Wenzhou people's spirit for making money can never be underestimated,' she said.
Several Wenzhou businessmen say they are encouraged by the State Council's decision to legalise the shadow banking system.
Although they remain haunted by the raft of scandals involving loan-sharking schemes that incurred losses of billions of yuan for ignorant depositors last year, wealthy Wenzhou entrepreneurs are actively pursuing new opportunities to make big bucks.
Beijing has made Wenzhou a pilot city to execute the financial reforms, with the State Council saying it would establish rules to help Wenzhou better oversee the private lending businesses.
Towards that end, the city's government is actively seeking advice from the business community, researchers and professionals - including himself - to draft a legal framework for private lending, says Yan Yipan, head of law firm Zhejiang Panyuan.
'A clear-cut legal framework governing private lending has to tell people what they can do and what they can't do,' Yan said.
'It's a lot of work, and there are still quite a few stumbling blocks.'
Under the proposed legal framework, Wenzhou will encourage individuals to set up microcredit firms.
Shareholders of such firms can use their own money to offer credit to clients, charging a maximum interest rate of four times the central bank's guided rates.
Wenzhou plans to create an additional 120 microcredit firms in the next three years - from about 30 currently - which would have 80 billion yuan in total assets.
However, existing licensed microcredit firms have yet to prove successful and loan demand remains weak.
During a visit to microcredit firm Heben Small-Sum Loan by the South China Morning Post, there was not a single client in sight.
The firm extends loans with monthly interest rates of about 2 per cent, translating into an annualised rate of 24 per cent - or about three times the central bank's guided interest rates.
'We are still unable to check out exactly how the loans are being used,' said Wang Xiaoyong, a credit-issuance director at Heben.
'To be honest, we make a call based on our own judgment because there's a lack of a credit assessment system.'
There's also another challenge. People close to the Wenzhou government say the city has lobbied Beijing to further liberalise the interest rate system by using a market-based mechanism to set rates.
Currently, microcredit firms cannot levy interest rates higher than four times that of Beijing's guided rates. But Beijing has rejected the proposal due to fears that loan sharking would resurface.
'Reforming the interest-rate-setting mechanism is necessary,' said entrepreneur Fang.
'At this moment, it's needless to worry about loan sharks. The priority should be given to helping cash-hungry businesses.'
Beijing has a tight grip on deposit and lending rates, and despite growing calls from commercial banks to enact a market-based interest rate setting system, top policymakers remain reluctant to relinquish their power to set rates.
'The theme of legalising the underground banking system is no longer about money,' said Huang Weijian, chairman of Wenzhou Private Capital Research.
'It's about the wisdom. The government has to be smart enough to encourage private lending that can effectively support the local economy,' Huang said.
The [underground] lending model should have been legalised from the very beginning Fang Peilin, private credit financier
The estimated value, in US dollars, of the mainland's underground and investing networks, according to research firm IHS Global Insight