WENZHOU, China — In a city that’s supposed to be the closest thing to paradise for private enterprise in China, the mood is surprisingly grim.

After years of easy loans and cheap labor, small-business owners in this prosperous coastal city of 9 million say they are facing strong headwinds: slowing export growth, rising worker costs and a drought of loans for anyone but the biggest businesses.

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With 400,000 privately owned firms, Wenzhou has long been renowned in China for its high concentration of entrepreneurs. To picture it, think less Silicon Valley and more late 19th-century Trenton, New Jersey.

Wenzhou is a sprawling, low-slung city dotted with thousands of small, family-owned factories that manufacture astonishing quantities of everything from buttons and bags to shoes, statues and eyeglasses — more glasses than any place in the world, in fact.

But all that could be shifting fast, as economic trends in China and the outside world have put Wenzhou’s small-business community under pressure.

Consider Zheng Pei Shen, 32, a slight, stylish man whose family owns and operates a small textile firm in Wenzhou. For the last five years, he and several relatives have built up a business exporting colorful, synthetic-leather coats to the Ukraine. But their hopes to scale up the factory have been thwarted by a lack of ready funds.

“If you have connections, you get things done. If you don’t, you can do nothing.” he says.

Lending in Wenzhou has dried up severely since a loan crisis rocked the city last fall.

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Whereas small businesses could once easily get loans from the city’s bustling “shadow banking” sector, a rash of defaults and suicides by debt-ridden businessman has caused the system to collapse.

“Shadow banking” here involved private lenders who illegally — though sometimes with government officials’ involvement — loaned money to small or medium-sized businesses at high interest rates. Many firms in Wenzhou used this underground financing because commercial banks typically loaned only to state-owned companies or huge corporations.

But the shadow-banking loans turned out to be hugely risky — both for lenders and borrowers. In one case, a businesswoman named Shi Xiaojie was caught trying to flee the city to avoid her debts of over $125 million. In another, a well-known shoe manufacturer jumped off a 22-story building when he could no longer find financing to stay afloat.

Since then, despite Beijing’s attempt to create a pilot program allowing Wenzhou’s underground lenders to register as banks, small-business owners say it is still extremely difficult to get capital.

Lack of funds is not the only thing preventing the Zheng family factory from expanding. Like many others in Wenzhou, their factory is small, with 100 workers spread out over several rented rooms in a dingy side street that rings with the sounds of hammers and sewing machines. The facilities are ramshackle, with low ceilings, wooden stairs, and no marked fire exits, despite the fact that Pei Shen and his brother, Zheng Pei Tao, smoke constantly.

“It’s informal in every aspect,” Zheng Pei Shen admits, gesturing at the piles of coats on the floor.

In order to improve the facilities, they want to purchase their own land, but the authorities rejected their application.

“The government won’t approve us,” says Zheng Pei Shen. “It’s impossible for a factory of this size to buy land.”

Economic slowdown

Because of economic tremors in Europe, this year has been a down one for the Zhengs. In previous years, their sales have hit as high as 40 million yuan ($6.3 million). Over half of that business comes directly from the Ukraine, with most of the rest coming from Eastern Europe.

The older brother, 35-year-old Zheng Pei Tao, spends 11 months of the year in the Ukraine handling sales. He hired a private tutor to learn Russian, and hawks their jackets at an open-air wholesalers’ market in Odessa. When they reach consumers, he says, the jackets ultimately sell for $30 apiece.

Dependent as they are on exports, the Zhengs closely watch the value of the yuan. In the long run, they expect that the Chinese currency will continue to rise, cutting into their overseas orders, so in the meantime they are trying shift strategically toward China.

Over the last year, a cousin of the Zhengs has begun selling the coats on Taobao, China’s equivalent of Amazon, but the China portion of their sales is still small. The brothers complain about the lack of online sales talent in Wenzhou. Another challenge is that the fashions are so different: Chinese women like flashy, colorful clothes, they say, whereas Ukrainian women are larger and prefer classic cuts.

“The clothes that sell there would never sell here. They are too conservative,” says Zheng Pei Tao, who evidently does not follow the fashion of his adopted Ukraine, as he sports green pants, a T-shirt covered in motorcycle decals, and tiny white leather loafers.

While their plans for growth have been thwarted, costs continue to rise. The Zhengs say that the price of labor has risen 20 percent every year since 2009. Like many manufacturers, they rely on cheap migrant labor, with half of their sewers coming from provinces outside Wenzhou.

When asked if he was optimistic about Wenzhou’s economy, Zheng Pei Shen hedged. “I have to be optimistic because I must do business here,” he said. “We’re local people.”

Some of the same challenges have cropped up in the last year for Han Cheng Cheng, 32, who makes and ships belts to the Japanese market under imprints like “Alligator King.” Though he’s been in the belt business for eight years, he opened his own factory just last year.

In a narrow alleyway near the airport that is full of dogs, crumbling tile roofs, and incessant hammering, he operates two workshops. In the larger one, a crew of 30 workers drill, paint, and pack fake-leather belts. In the other, three young people polish and assemble belt buckles in a toxic-smelling room pulsing with techno music. Han pays $2,200 a month to rent the facilities, which produce eighty to ninety thousand belts every month.

Han, like the Zhengs, developed his clients after living abroad for several years. After Han’s parents sent him to Japan for college, he worked for a belt manufacturer and made contacts with wholesalers. Now he speaks to Japanese clients 10 to 20 times a day, often over Skype. Han admits the quality of his belts still lags those made in Japan. He targets the lower-middle range of the market, with belts that sell for $12 apiece once they reach stores.

Because he could not get loans in Wenzhou, Han built his factory using his own money and loans from Japanese contacts.

Even in the year since he opened the factory, Han says the wages and perks demanded by workers have increased. He provides their food and housing—a dorm—since all of the 30 employees come from distant provinces.

“Now they have more demands,” Han says. “Better food, a better place to live, with air conditioning.”

Chu Shi Song, a smiling, pimply, 21-year-old wearing a T-shirt with the New York City subway map on it, is one of Han’s workers. Every weekday from 8AM to 6PM, he paints the edges of belts, staining his fingertips black. He says he comes from a peasant family in Hunan province.

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He’s one of China’s many young, itinerant workers, who leave poor rural families and follow higher-wage factory jobs around the country. Before coming to Wenzhou a year ago, he worked in Shanghai for three years as a waiter in an Italian restaurant and then as a ship-painter in the stockyards. At his peak, he made 3,000 yuan a month in the docks, but found the work exhausting. He decided to move to Wenzhou when a friend invited him to apprentice with a wallet-maker. He now makes 2,500 yuan a month--more than he made as a waiter, with better hours. He finds Wenzhou more boring than Shanghai, so after work he simply watches movies such as The Fast and the Furious on his cell phone.

In a many ways, workers like Chu are the best sign of China’s economic progress. A generation before, Chu would have stayed working on the family farm, but now he sends home 15,000 RMB of his earnings every year. When Chu describes his future, he says he dreams of traveling around China, and perhaps even going one day to Paris.

But for small-business owners like Han Cheng Cheng and Zheng Pei Shen, the rising expectations of factory workers are one of their biggest economic challenges. In the first half of 2012 alone, wages for migrant workers rose 14.9 percent over last year, according to China's National Bureau of Statistics.

When asked about his future business prospects, Han said he simply couldn’t predict whether things would get better or worse. Just two years ago, he said, it would have been impossible to anticipate that hiring employees would become so expensive.

“Young people nowadays know more than before, and will ask for more,” he said. “There’s only one child in the family, so the kids are more spoiled. They have more material demands than when there used to be five or six kids in a family.”