Wenzhou is known for making shoes, buttons, eyeglasses, electric switches, water valves and 70% of the world's cigarette lighters. But its most famous product is entrepreneurs. Hemmed in by mountains and with little arable land, this city on China's southeastern coast has relied on trade for centuries. Even in the Maoist era, when capitalism came under sustained and violent attack, private enterprise was never entirely extinguished there. So after China began market reforms in the late 1970s, Wenzhou flourished. "The Wenzhou Model" of small, low-cost manufacturing operations was widely copied in China. Wenzhou now has some 140,000 companies, and its businessfolk have invested across the country in everything from real estate to mining. The city is the locus and symbol of private enterprise in China.

      But in recent weeks, the reputation of Wenzhou's entrepreneurs has taken a serious hit. Dozens of factory bosses have fled bad debts, and at least two have committed suicide. Part of the cause is the challenging operating environment for manufacturers. Demand from export markets like the U.S. and Europe is weak, wage and materials costs at home are rising, and China's currency, the renminbi, has been steadily appreciating, making Chinese goods more expensive abroad. "Orders have been down this year and last — that causes a lot of pressure," says Cai Jianguo. He started his Wenzhou eyeglass company, Zhengshi Optical, with just $1,200 and eight employees in 1997. Today he has more than 100 employees churning out some 30,000 pairs of plastic frames a month, mostly for export. But he's feeling the pinch. "For small businesses like ourselves, survival itself is a big challenge."

      The main cause of Wenzhou's ills is far more explosive, however, and lies in the local tradition of private lending. Because Chinese banks prefer to lend to larger, state-owned enterprises that are ultimately backed by the central government, Wenzhou's entrepreneurs have long turned to one another for financing. "Private lending and private enterprises are a natural couple," says Hu Zhenhua, a professor of economics at Wenzhou University. "One cannot exist without the other."

      That relationship has come under extreme strain. The central government's efforts to control inflation over the past year have restricted bank credit, driving up the demand for underground loans even more. In Wenzhou, local investors, including a significant share of the town's businesses, have been chasing hefty earnings through making private loans that have interest rates as high as 60%. But such levels of return are unsustainable, and over the past month the credit market has collapsed. In a town where almost everyone has lent or borrowed through the informal networks, the pain has been severe. Wenzhou entrepreneurs' ability to access nonbank credit may have been one of the sources of the city's success, but it now threatens to bring the local economy down. And given the extent to which local entrepreneurs have invested throughout China, the shocks will likely be felt nationwide. Shanghai Daily calls the Wenzhou meltdown "China's subprime crisis."

      Cai's anxieties about slim margins in the eyeglass business are almost mundane compared with those of another Wenzhou entrepreneur known as the Kid. (For his safety, he asked that his real name and some identifying details not be divulged.) The Kid is a private moneylender. Some would call him a loan shark. He pools money from local investors and loans it out to businesses that need cash. He started lending in 2007 with about $1 million of his own, bank loans against family property and money from hundreds of investors. A year later, when the global financial crisis hit, the Chinese government initiated a $586 billion economic-stimulus package and ordered banks to flood the market with credit, all in an effort — ultimately successful — to keep the domestic economy humming. But even amid that sea of credit, SMEs in places like Wenzhou still found it difficult to get bank loans because state enterprises were soaking up most of the money. For private firms, the stimulus was "like the rain that never reached the land — it was intercepted in midair," the Kid says. "So the land had to draw water from underground."

That underground supply did not come cheap. The Kid made loans at 2.5% monthly interest, or about 34.5% annualized, far higher than the 7% to 8% charged to those getting bank loans. Things really took off for him over the past year as the central government tightened credit, raising benchmark interest rates and upping banks' reserve requirements. "You've got an environment where growth for the past few years has been driven by almost limitless easy credit," says Patrick Chovanec, an associate professor at Tsinghua University's School of Economics and Management in Beijing. "When the People's Bank of China began to impose limits on credit in order to rein in inflation, that demand for limitless credit as a driver of GDP growth didn't go away." Rather than squelching the demand for credit, those actions shifted it to the informal market.

       For a while, business was very good for the Kid. His fund grew to $15 million at its peak. Borrowers were paying back their debts quickly. In one week in May, for instance, the Kid took in nearly $8 million in repaid loans and interest. Many of the borrowers were small-scale real estate developers who needed money to fund projects — but that's precisely why the Kid and others like him face problems now. Continued economic uncertainties and tighter mortgage policies have made property buyers increasingly cautious, and real estate sales have slowed dramatically. The people of Wenzhou "plowed their money into high-interest loans," says Victor Shih, a political scientist at Chicago's Northwestern University who studies China's financial system. "That was unsustainable because the high-interest loans went back into real estate projects. Eventually all of them will go bust."

       For Wenzhou exporters facing ever narrowing margins, the temptation to put money into high-interest, informal syndicated loans has been especially high. Cai, the eyeglassmaker, resisted. "I never wanted that kind of money," he says. "It was too dangerous." But many others went ahead. The government estimated earlier this year that 60% of Wenzhou businesses and an astonishing 90% of households were involved in some form of private lending. Problems began to really emerge in late summer, when some large borrowers stopped repaying. In September, Hu Fulin, president of Xintai Group, another eyeglass manufacturer, fled to the U.S. to escape some $300 million in debts. He has since returned, but the situation remains dire — some 90 other company heads have absconded.

       The Kid collected about $3 million in August and early September, but says he recovered a mere $50,000 between late September and late October. "Everyone is hoarding money," he says. "Once they get it back, nobody lends it out again — not even to their closest friends." The Wenzhou bubble has burst.

       Everything appears normal in Wenzhou. The streets leading from the city center to the surrounding factory districts are jammed as usual with trucks and delivery vans, new Range Rovers and dilapidated Citroen taxis. Beneath the surface, however, a mad race to collect debts is under way. For much of October, the Kid says he slept only two or three hours a night as he pondered how to claw back outstanding loans. "If people could get their money back just by holding other people at gunpoint, there would have been a riot in Wenzhou," he says. "It seems calm on the surface, but the chaos is underneath." In early October, Chinese Premier Wen Jiabao visited Wenzhou, where he ordered local banks to lend more and promised a crackdown on abusive underground lending. The local government has organized a $160 million fund to help overstretched businesses, and the fund is likely to grow.

     The big issue, says Professor Hu, is what happens in January, ahead of the Chinese New Year, when Wenzhou's private lenders traditionally call in their outstanding loans. To come up with cash, indebted locals may unload real estate at discounted rates, which could truly burst the property bubble not just at home but also in Shanghai, Beijing and other cities where they have invested. "Should the liquidity chain in Wenzhou collapse to spark either sell-offs in the property market or the cutoff of liquidity for manufacturing or mining, this local crisis could evolve into a national problem," Xianfang Ren, Beijing-based senior economist for consultancy IHS Global Insight, wrote in mid-October.

     Still, Wenzhou accounts for just 1% of China's GDP. Manufacturer Cai says he plans to keep on churning out eyeglass frames, despite his ever tightening margins. "What else would I do?" he asks. And the Kid, if he can ever climb out of the massive hole he's dug, says he'll continue too. "When the market recovers, I'll still be willing to put 30% of my assets in private lending," he says. "If a Wenzhou person has 10 million renminbi, he wouldn't deposit it all in the bank. He'd at least spend 3.5 million on some kind of investment. Wenzhou people aren't stupid." The rest of China fervently hopes so.

— with reporting by Jessie Jiang / Wenzhou