Yiwu, a noted wholesale market in Zhejiang province, China, is now a household name in India, due to the diplomatic and media furore surrounding the treatment of two Indian traders in the city recently. Until the financial crisis (2009), Yiwu was one of the stars of the China success story due to thriving private enterprises. In 2011, the net profits of Yiwu?s enterprises alone decreased by R13,900 crore, symptomatic of the larger problem hitting non-state enterprises in coastal boomtowns of the Pearl and Yangtze Delta Regions.

The bulk of China?s non-state sector is made up of SMEs; 43 million SMEs form the backbone of its economy and create 80% of the employment in urban areas. In 2009, they accounted for 58.5% of the country?s GDP, half of its tax revenues and 68% of its exports. In comparison, state-owned enterprises (SOEs) are larger (with average assets 13 times of SMEs), and control 50% of the total industrial assets.

SMEs have been a significant employment generator?mopping up China?s floating population (one in five Chinese is on the move) and keeping spiralling social tensions at bay. But, according to China?s industry and information ministry (MIIT), almost a fourth of China?s SMEs are running operating losses. They have been hit by problems ranging from labour shortages to suicides ? recently aggravated by global financial crisis, flagging export market, liquidity crunch, bankruptcies and runaway bosses exemplified in the Wenzhou case. Wenzhou is widely known for its entrepreneurship. It is said that when Wenzhou sneezes, the rest of China feels the tremors.

Since April 2011, Wenzhou businessmen mired in debt have been jumping off sky-rises or absconding, leaving their employees in the doldrums. One-fifth of Wenzhou?s 360,000 SMEs have stopped operating. A survey by Wenzhou?s Economic and Information Commission recently found that 76% companies are struggling to stay afloat. This has fuelled rumours of a wave of ?manufacturing bankruptcies? or ?SME bankruptcies? sweeping through coastal China.

Despite state laws and regulations promoting them, China?s SMEs are faltering because of a combination of external and internal reasons. They are disadvantaged vis-?-vis SOEs in securing loans, subsidies and concessions or in bidding for state tenders. SMEs depend largely on rural credit cooperatives and informal/underground banking?who could become loan sharks in bad times.

China?s measures to control inflation and property bubbles have only made it more difficult for SMEs to obtain loans. The People?s Bank of China increased the required deposit reserve ratio for SMEs from 13.5% to 18% in 2010. And from October 2010 to July 2011, the benchmark interest rates for one-year deposits and loans were increased from 2.25% to 3.5% and from 5.31% to 6.56%, respectively.

It is telling that in 2010, 60% of total loans went to SOEs while only 14% went to SMEs. SOEs were also the ones to gain most from the stimulus package following the 2009 economic crisis. In the Wenzhou case, it has surfaced that most of the entrepreneurs depended on the underground banking system. They had little or no access to loans from state financial institutions.

In the past, SMEs depended on a robust external market for exports, which has now dramatically shrunk. Plus, the informal banking system charges very high rates of interest (going up to 200%), which matters now as it didn?t when the going was good. As goods sat in the warehouses, a spate of lay-offs began, even as China has been battling increasing labour shortages and costs. Earlier, plentiful cheap labour contributed to China?s cost and comparative advantage. Not any more.

Wages in China have been significantly rising following the infamous Foxconn suicides in Shenzhen and the spate of labour strikes witnessed in the Honda factories in Foshan.

In 2010-11, minimum monthly wage rates were raised from from R6,350 to R9,500 in the Pearl Delta Region, and from R6,000-7,150 to R8,700-10,300 in the Yangtze Delta Region.

Further, a sharp increase in producer price index (PPI) and increasing power shortages added to the economic gloom. China?s power crisis led to a suspension of diesel exports in May 2011 as factories switched to diesel-dependent power generators.

The Chinese government has denied that the SMEs are facing a collapse. It is reluctant to admit that there is a bankruptcy wave, which is obvious for all to see. It is also trying to address the situation with new policy initiatives. Prime Minister Wen Jiabao publicly called for amnesty for a prominent absconding Wenzhou entrepreneur. A Nasdaq-style board has been launched in Shenzhen to help SMEs with funding. Tax cuts for VCs investing in SMEs have also been announced. Further, China has reclassified SMEs into 3 categories?small, medium and micro-enterprises. Covering 84 industry categories, the new classification is intended (and the new category of micro-enterprises) to provide support to smaller companies. Businesses with fewer than 1,000 employees and an annual income of less than R320 crore qualify as SMEs. Those with fewer than 20 employees and income less than R2.3 crore are considered micro-enterprises.

Besides, China?s finance ministry has announced that government departments are required to allocate 30% of their purchasing quota to SMEs, of which 60% will be reserved for small- and micro-sized businesses, and up to 22 items of administrative fees previously levied on SMEs will be scrapped for January 2012-December 2014. It is also seeking to optimise the loan structure in favour of SMEs, and trying to get SMEs to move up the value chain from ?made in China? to ?created in China?.

China?s policymakers have been quick to act, and all for good reason: This year of the Dragon is ushering in a much-awaited leadership transition at the top, which despite being on cards for a long time is causing apprehensions in political circles?lest it go awry. As Xi Jinping and Li Keqiang are poised on the political threshold, the old leadership is wiping away some of the cobwebs?many more, however, lie in wait. The Chinese leadership cannot afford for the SME problem to be one of these cobwebs?as it has huge implications for employment, managing internal migration and therefore maintaining social harmony, a top priority for China.

The author is a Singapore-based sinologist, currently a visiting fellow at the Institute of Chinese Studies, Delhi. Views are personal