Wenzhou's entrepreneurs are paying for their wrong decisions but government should help them defuse speculation bubble

Wenzhou has been in focus in the Chinese media after some entrepreneurs in the city committed suicide or shut down their factories and fled because they could not pay their debts.

Many of the factories in Wenzhou, Zhejiang province, have a profit margin of about 5 percent and, hence, cannot afford to pay 30 percent (or higher) interest rates on the money they have borrowed from loan sharks. More than 80 entrepreneurs have fled without paying billions of yuan in loan. The amount, however, is just a part of the informal debts in the city, which amounts to hundreds of billions of yuan.

So instead of facing a financial crisis, Wenzhou is caught in a speculation bubble. It is surprising, though, that Wenzhou's entrepreneurs agreed to pay such high interest rates when a new government rule says an interest rate more than four times 6.56 percent is illegal and a debtor can refuse to pay the extra amount.

The most critical time of the bubble has passed. But since small and medium sized enterprises (SMEs) generate 60 percent of the exports and provide 75 percent of the employment in China and many SMEs are concentrated in Wenzhou, it is worth taking a deeper look into the matter.

Wenzhou is famous for being one of the first Chinese cities to produce private enterprises. As a result, its entrepreneurs were among the first in China to get rich. Apart from being reinvested in factories, the extra money they generated needed to find ways to multiply. That's why they began speculating in real estate and other fields across China. They even invested abroad with exemplary results.

The same Wenzhou's entrepreneurs now face serious problems. In fact, private enterprises in almost all Chinese coastal cities are facing difficulties and their problem is likely to continue.

For Wenzhou's private companies, the rise in cost and competition, and the decrease in demand from Europe and the United States are a long-term trend. They have to compete with not only countries such as Indonesia, Vietnam and India, but also China's central and western provinces such as Jiangxi, Henan and Qinghai, and Chongqing municipality.

Since most of Wenzhou's private companies have no famous Chinese brand, high technology, customer loyalty or their own sales channels, they had to choose between moving their factories to places where the cost of production is lower or facing bankruptcy. Unfortunately, many chose to turn to financial speculation.

Also, because private investment has fewer choices, some people chose to indulge in high-risk informal loans.

Wenzhou's entrepreneurs turned to speculation in the early 2000s. They did not have or use much capital in the beginning. But when they found that speculating in housing or or other commodities generated more profit than the manufacturing sector, many of them loaned out more money.

But the additional capital they generated found even fewer investment channels thanks to the real estate bubble, the bearish stock market and the monopoly of State-owned enterprises (SOEs) in many fields.

In other words, the prospects for private enterprises and private investment were getting worse, leading to the debt panic in Wenzhou. There were reasons for that. The accumulated effect of the rise in the costs of land, labor and raw materials, accompanied by a sharp decrease in demand abroad and a big increase in the exchange rate of the yuan made matters worse for Wenzhou's entrepreneurs.

The last straw that broke the camel's back was the government policy on real estate, in which many Wenzhou's entrepreneurs had invested. The policy not only decreased the liquidity in the real estate market, but also hampered their cash flow.

To solve Wenzhou's problems, the government has to take some swift measures to deal with the loan bubble. The government has to put a stop to the illegal loan market, though it is justified in fixing the upper limit for interest on loans at four times the standard rate.

The government can deal with the existing debt disputes through legal procedures, too, and along with big State-owned banks it can offer specific types of help to Wenzhou's companies and their employees.

But in the long run, the government should improve the market environment for private enterprises and private investment. First, it should put the "shadow" banks to scrutiny. This is needed because the cost of monitoring small loans for State-owned banks is high, whereas small local loan companies could do the same job at a much lower cost.

Second, the central bank should make more efforts to control inflation and raise the interest on deposits before inflation is controlled. The government has kept the deposit rate so low that people seek other ways to make their money grow. Since there are few other choices, we can say many people will join the illegal loan market.

Third, the government should improve the playing field for SMEs by defusing the real estate bubble, preventing people from making huge profits unfairly in the short term, improving the income of households and increasing their welfare so that they consume more and save less, limiting the monopoly of SOEs and State-owned banks, and allowing efficient private enterprises to participate in the market, issue bonds or go public.

And last, the government should reduce tax to ease the tax burden on private enterprises, so that they are left with enough money for research and development.

The author is a lecturer at the Management School of the Shanghai University and a research fellow at the China Europe International Business School Lujiazui International Finance Research Center.