The State Council has earmarked Wenzhou in Zhejiang province as a pilot zone for financial reform, which will allow local residents to invest overseas and set up loan companies.

The proposed reform, which will standardize and regulate private fund-raising and loans, is of importance not only for Wenzhou but also the rest of the country.

Wenzhou was chosen because it is a prosperous center for small and medium-sized enterprises. But these smaller businesses have frequently complained about the difficulties they encounter trying to get loans from the banks following the credit tightening measures introduced by the central bank. The inability to access formal finance led to a proliferation of underground lending companies keen to fill the gap and lend money with exorbitant rates of interest.

These usurious rates led to many defaults when the economy started to slow down and government measures took the heat out of the property market. But there are still many practical problems that need to be solved to ensure the reform meets its objectives. For example, what role should the local authority play and how to design a mechanism that can give full play to the flexibility of private capital?

This flexibility is the advantage private finance companies have over their State-run counterparts. Private loan organizations can take various forms, such as equity funds, village banks, loan companies and capital management companies.

However, the government needs to establish strict entry requirements and transparency. All qualified private capitals should be registered and supervised, as the stability and order of a well-performing private finance market actually benefits both lenders and borrowers in the long run.

The government should also construct a credit investigation system for all small enterprises, so that only the credible enterprises can obtain loans.

It would be advisable for the government to link the interest rate control of private loans with market changes. A market-oriented interest rate mechanism will be more efficient in allocating resources and prevent over-expansion of lending.

Another challenge will be balancing the private finance companies with State-owned institutions.

Only after answering all the relevant questions can we really call the pilot reform in Wenzhou a milestone in financial reform.