Even during the best of times, it has been difficult for China's small and medium-sized enterprises (SMEs) to get bank loans. But with the current regimen of credit austerity, imposed to contain economic overheating and inflationary pressure, making conditions for SMEs worse, the financial sector is now affecting the country's economic dynamism.

In normal times, the informal financial market has helped SMEs to get by; but the recent woes of Wenzhou, a city in southern Zhejiang province renowned for its freewheeling private economy, have shown that the informal financial market can be very volatile and undependable. Several major lenders absconded with large amounts of deposits, and company defaults have now become a serious concern.

China's official foreign reserves are increasing at a rate of about $1 billion per business day, almost all of which is used to buy US Treasury bonds and other international assets that carry a minimal rate of return. At the same time, about 40 percent of China's bank savings are not lent out. One might thus think that returns to capital are low in China. But one would be wrong: studies have consistently shown that the rate of return to capital has been more than 10 percent since the late 1990s.

Why then, can't China's SMEs rely on the formal financial sector to finance their daily operations? While it is not easy for SMEs in other countries to get formal financing, few countries are experiencing the same level of difficulties; surveys consistently show that only about 10 percent of Chinese SMEs' finance comes from banks, while the global average is double that. Moreover, none of these countries has a capital surplus of China's magnitude.

The main impediment in China is local governments, which compete with SMEs for bank loans and inevitably crowd them out from the formal banking sector. Local governments rely on bank credit to invest in infrastructure and real estate development. A report released early this year by the People's Bank of China showed that close to one-third of the country's total outstanding loans, 14 trillion yuan ($2.2 trillion), was owed by local governments. In the last few years, 30-40 percent of bank credit went to government infrastructure projects.

Another impediment is the dominance of large banks. The four largest banks in China account for 60 percent of the country's total bank lending. While the US banking sector is similarly concentrated, it has far more financial institutions - roughly 18,000 commercial banks, savings and local associations, mutual savings banks, and credit unions, compared to around 400 commercial banks and 3,000 rural credit unions and township banks in China. This means that banks in China on average are larger than in the US, especially in view of the difference in the size of the two countries' GDP.

Large banks tend to lend to large companies in order to save costs. This bias is mitigated in advanced economies by the various flexible financing tools offered by large banks. For example, a small business with a decent credit history can borrow large amounts with a major credit card. This is absent in China.

In the end, it is the crippled financial sector that is driving the wedge between China's large surplus of capital and formal financing for the country's SMEs. Indeed, in some parts of southern China, the informal financial sector is growing to match the size of the formal financial sector.

From the point of view of depositors, participating in the informal sector is a rational choice. Bank interest rates on savings are lower than the inflation rate - and many multiples lower than the rates promised by the informal sector. Default rates in the informal sector are high, and lenders may disappear with depositors' money, as happened in Wenzhou, but, despite these risks, investing in the informal market can still be a better choice than keeping one's money in the bank.

The record of the last 20 years shows that the Chinese monetary and banking authorities have a habit of ignoring the informal financial sector until serious problems emerge. This approach cannot last forever, and changing it means acknowledging the problems of the formal financial sector and taking remedial action.

An immediate step that the authorities should take, as many economists have argued for years, is to allow the saving rate to reflect the cost of investment. That way, ordinary depositors would put their savings back into banks, because the formal financial sector would offer them a way to tap into the benefits offered by China's phenomenal growth. With more deposits at their disposal and a more flexible interest rate policy, banks would be able to price risks more easily and thus lend more to SMEs.

The author is director of the China Center for Economic Research at Peking University. Project Syndicate.