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Wenzhou’s impressive but spookily empty real estate projects make the city feel far larger than its population of three million. But part of that wealth now appears to be illusory.

Carlos Barria/Reuters/Carlos Barria/Reuters

No one believed more fervently in China's economic miracle than the residents of this pretty coastal city, which produces shoes, eyeglasses and cigarette lighters sold around the world. The good times of the past decade made many in Wenzhou rich, and residents repeatedly doubled their bets, pouring their earnings and more into stock markets and real estate.

This city's captains of commerce kept borrowing and investing even as China's government, worried about the rising pace of inflation, began gently trying to apply the brakes to the country's overheating economy. As loans from state-owned banks dried up, many in Wenzhou turned to shadier sources of money, eventually falling into a trap familiar to many on Wall Street and elsewhere – borrowing from one lender to pay off another, at higher and higher interest rates, sometimes 15 times the official standard.

Recently ranked the fourth-richest city in China per capita (trailing only the far larger centres of Shanghai, Shenzhen and Guangzhou), Wenzhou's impressive but spookily empty real estate projects make the city feel far larger than its population of three million. Its streets are lined with multiple BMW, Porsche, Mercedes, Jaguar and Maserati dealerships. But part of that wealth now appears to be illusory, having been funded by some $300-million in high-risk loans from what locals call "shadow banks."

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The reckoning began in June, when three factory bosses, confronted with debts they couldn't pay, disappeared without a trace. Spooked, the "shadow banks" that had become the lenders of last resort – pawn shops, credit companies, in some cases loan sharks who pooled the wealth of individual investors – started calling in more debts. More than more 100 other laoban, as bosses are known in Chinese, fled or went into hiding. Some say the number on the run is twice that, and at least two Wenzhou laoban have jumped off tall buildings to their deaths.

"I believe the first three laoban [who disappeared]are somewhere outside China. Some of the others, who had even greater debts, didn't run. They're just lying on their beds, staring at the ceiling, surrounded by their creditors," said Huang Fajing, the director of a local company that manufactures cigarette lighters and barbecue starters for export to Europe, Japan and North America.

"It was very similar to the collapse of Lehman Brothers in the U.S., it spread so quickly," said Mr. Huang, who is more than $2-million in hock himself.

As a result, while Chinese President Hu Jintao was being wooed in Europe this week to contribute to a fund to save that continent's failing economies, his government was quietly setting up its own $160-million bailout fund to try to halt a domestic credit crisis that many say has already spread beyond Wenzhou to other parts of China. It threatens millions of small and medium-sized businesses, though larger state-backed firms thus far seem immune.

An estimated $580-billion in private loans were handed out in the first 10 months of this year, a number almost 10 per cent the size of the Chinese economy. While cautioning that it did not believe China to be on the verge of a subprime crisis the scale of which the United States recently experienced, the troubles in Wenzhou were one reason Bank of America this week lowered its growth forecast for China next year to 8.6 per cent, which would be the country's slowest pace of growth in a decade. Wenzhou's credit crunch, while perhaps an extreme example, reflects one of biggest fears of investors: that China – rather than being the country that can lead the world out of its debt woes – may be the next one headed for a hard fall. The city has long been unique in China for its experimentation with free enterprise and private credit, but that doesn't mean the crisis can't spread.

"Almost every business in Wenzhou has been affected, to one degree or another," said Zhou Dewen, director of the Wenzhou Small and Medium Enterprises Association. He said one-fifth of the city's businesses had either cut production in half or shut down completely since the crisis began, in some cases leading to streets protests by laid-off workers who never received their last paycheques. The total amount owed by fleeing laoban is estimated at more than 10 billion yuan ($1.6-billion).

It's a situation that has its roots in the global financial meltdown of 2008. As demand for Chinese exports dried up in North America and Europe, Beijing introduced a massive stimulus package worth trillions of dollars in order to keep its economy rolling. In practice, much of that money was distributed in the form of loans through state-owned banks.

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In Wenzhou, at least, only a fraction of that money went where it was supposed to, namely upgrading businesses and developing domestic demand for their products. Much more went into speculative real estate investments – Wenzhou residents famously played leading roles in driving up property prices in Beijing, Shanghai, even Hong Kong and Singapore – and living the high life.

By late 2009, however, the Chinese government dramatically tightened monetary supply, worried that rising prices for food and other basic goods could fuel popular discontent. As anger swelled over skyrocketing housing prices, the government also moved against speculators, restricting the number of properties any individual could buy.

As real estate prices started to reverse direction and money from the official banks dried up, Wenzhou's laoban turned to the "shadow banks." Mr. Zhou said loan sharks doled out some $300-million in high-interest loans in 2010 and 2011. Some of that money was used to pay back older loans, the rest to keep speculating (bank interest rates are lower than the pace of inflation in China, so many look for other places to put their money).

But the cooling of China's economy, almost imperceptible to the outside world, began to pinch hard in Wenzhou. The carefully balanced finances of many laoban depended on the country maintaining its usual double-digit pace of expansion. So the slowdown from 10.3-per-cent growth last year to 9.1 per cent in the third quarter of 2011 meant the math no longer worked. The good times were over – in Wenzhou and maybe beyond.

"This isn't just about Wenzhou; they're just the ones who came down with the fever first," said Patrick Chovanec, a professor of economics at Beijing University. "What is the fever? You borrow based on growth continuing, not decelerating. So if [growth]goes down to even 9 per cent, people go bust."

The problem was unlikely to infect the wider Chinese economy, Prof. Chovanec said; the state has more than enough cash to prop up the official banking system by swallowing non-performing loans, essentially pretending they don't exist. "The magic of the Chinese financial system is it's all supported by untabulated, undisclosed, contingent liabilities. The government is the ultimate backstop for everything."

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But among smaller, independent businesses, the twin symptoms of Wenzhou's fever – a growing number of bankruptcies and disappearing laoban – have already struck Yiwu, a nearby city famous for producing many of the toys that end up under Christmas trees in the West. Small business owners here say their colleagues in other parts of the country are just as reliant on shadow banks as they are. The loans just haven't come due yet. "This is not just happening in Wenzhou. Wenzhou is in fact a microcosm of what's happening all over China," said Mr. Zhou of the small business association.

One reason the problems came to light here were a series of anonymous postings on a local Wikileaks-style website, (in local Wenzhou dialect it sounds like "chit-chat"). Back in April, one laoban "lost over 300 million [yuan]gambling," according to a post on the site that started an avalanche of similar tales. "Now he ran away [from his debts]and his company has stopped production. Workers didn't get their salaries and the company owes a lot of debts to suppliers."

Ye Zhe, the website's 35-year-old founder, rejects the suggestion that he's the Julian Assange of Wenzhou (he sees himself as helping the government fight speculation and fraud, rather than trying to expose official secrets), but he believes his website helped the city avert a worse fall. "My website gave an early signal of the crisis, and warned us that we should stop the horse at the edge of the cliff," he said.

The Chinese government is certainly pulling hard at the reins. In addition to the bailout money, it is considering a proposal from the local government to turn Wenzhou into a special test region where private lending forbidden in other parts of the country would be allowed – in other words, making the shadow bankers legal in order to try to regulate them.

But some of those teetering on the edge believe the help may come too late. In the city's manufacturing core, the 170 employees of Sinoman Clothing were still working the sewing machines on Friday, producing cheap men's wear for sale within China. But the company's owners say they're only days away from having to repay a bank loan of 2 million yuan. It's money they just don't have.

"It's very hard now. There's no way to borrow from the banks, and no way to raise money on the private markets," said Jin Yanzi, a vice-president and founding partner of Sinoman. Ms. Jin said many of her friends and competitors have already been forced to flee their creditors. Though her company's debts are comparatively small, she and her partners admit to musing about leaving Wenzhou too. "I've been thinking about leaving for a long time," Ms. Jin said.

"In the past, it was just one phone call to borrow 1 million yuan from a friend. They wouldn't even write it down; they'd just send the money to my account. Now, it's impossible to borrow even 50,000 or 100,000 yuan," said the company's managing director, Liu Feng. "I think the money's still there in the private markets, but the trust is gone. It's a crisis of trust."

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