China's Shadow Banks

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he most common source of funding in Zhejiang comes from investment pools, called hui, run by people like Xu Shoucong. This past March, Xu's family organized 17 people to create a fund that rotates credit to all participants, who use the cash for anything from weddings to starting small businesses. Huis loosely resemble microfinance schemes of the kind made famous by the Grameen Bank in Bangladesh, and millions of people participate in Zhejiang and neighboring Fujian province. Because the pressure to repay derives from social networks that are as strong as rebar in Confucian China, borrowers rarely default. In the past, Xu has used his hui money to invest in a relative's clothing store and to redecorate his $12-per-night inn.

Informal finance isn't just for mom-and-pop shops. Wenzhou's biggest restaurant, the 200-table Golden Fields Village, opened in May and specializes in shark-fin soup, giant snails and stingrays. Owner Wu Jianguan started the business by borrowing $100,000 from banks by mortgaging his home. But that wasn't enough to pay for the floor-to-ceiling fish tanks and staff of 150 hostesses in purple evening gowns, so he borrowed five times more from friends at higher rates. The cornerstones of such informal lending are relationships far stronger than Wu's connections to the bank. "If the bank repossesses my home, I'll have nowhere to live but I can still do business," he says. "But if I fail to repay my friends, I'll never do business in this town again."

Of course, the government must guard against Ponzi schemes and pyramid scams. On occasion, several huis will pool their money, and one failure will lead to a series of them. In September last year, just such a structure collapsed in Zhejiang's Fenghua city, according to Oriental Outlook magazine, and the hui leaders were forced to flee.

Yet on the whole, the government has turned a benevolent eye toward illicit finance. Cracking down would be "like taking seed grain away from farmers," says Beijing University's Shen. Gray-market lending is even providing inspiration for a new generation of would-be private bankers. A group of scholars at Zhejiang's Communist Party School, a training ground for cadres, are proposing to "establish legal private banks" along the lines of underground institutions, according to one of the professors who helped draft the proposal.

The trick for China now is "to regulate private capital without cutting off funding sources for healthy private companies," says Karin Finkelston, China representative of the International Finance Corporation, the World Bank's private-finance arm. And increasingly, Beijing has been welcoming private capital that it barred in the past. In June, regulators approved the country's first two private-investment funds. Both plan to invest several hundred million dollars raised from private firms in Wenzhou. Such funds are still barred from lending, but managers expect approval in the future.

Beijing has even made Zhejiang's healthy government-run banking system, which lends heavily to private companies, into a national model. Wenzhou was the first city to allow banks to ignore government caps and lend at whatever rate the market would bear. Higher rates meant the banks were better rewarded for the risks of lending to small job-creating firms. On Oct. 28, Beijing finally granted the same right to all of the country's banks. The city of Taizhou even has China's first fully private bank, the Taizhou City Commercial Bank. Regulators have refused to approve it but, significantly, haven't shut it down either. "These small banks don't issue loans based on government directives, so their investment is much healthier," explains Shi Jinchuan, an expert on underground finance at Zhejiang University.

As China's socialist-era financial system continues to make the transition to capitalism, shadow bankers may prove to be less of a threat to the system and more of an ally. The CBRC "at first treated us like ugly babies," says Wang Zhentao, vice chairman of the new investment company Zhong Rui. "Now we're growing up." The sooner the rest of the country's beleaguered banking system follows suit, the better.