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.