Image caption Chinese Premier, Wen Jiabao, recently announced on state radio that the monopoly held by the country's state banks should be broken up

Hundreds of thousands of small businesses in China are funded by private, often illicit, loans.

But as many turn bad, the government has announced a pilot scheme to create new, smaller financial institutions offering micro-financing and private equity. So is this the next step in China's economic revolution?

Private finance is very common in China - that is, lending and borrowing operating outside the realms of the state banking system.

Take the city of Wenzhou in Zhejiang province, the so-called home of Chinese entrepreneurs. Wenzhou has more than 400,000 small businesses that make a high proportion of the world's "stuff", such as cigarette lighters, shoes, spectacles and a lot more.

If you are talking about the country as a whole it is 3.7tn yuan (£366bn; $587bn) of private loans Zhou de Wen, Association of Small and Medium Business Enterprises in Wenzhou

Many of the factories in the city were started on the back of private loans because China's state-owned banks are not in the business of lending to manufacturing start-ups.

So, in order to fund their new business ventures, entrepreneurs have turned to private financiers.

These money men and women are often business owners themselves looking to get a better return on their cash than the rates offered by the state banks. And they have a lot of money to lend.

Zhou de Wen is the head of Wenzhou's Association of Small and Medium Business Enterprises. He told BBC Radio 4's In Business programme that the total amount of private loans in Wenzhou totalled about 120bn yuan (£11.9bn; $19bn).

In Zheijang province, where Wenzhou is located, it adds up to 1.5tn yuan, which is about half of China's total private lending of 3.7tn yuan.

Risky business

The problem with this private finance is that much of it happens underground. Officially, it is illegal, but the line between right and wrong has become blurred.

Image caption One of China's wealthiest women, Wu Ying, faces the death penalty for her role in private finance

The Chinese government turns a blind eye to much of the private finance market as long as the interest rates paid back to lenders do not exceed four times the interest rates of the state banks.

Many borrowers, however, often pay a rate that is much, much higher.

In Wenzhou the official state interest rate is 0.6% per month. By contrast, private lenders can get a return of anything between 3% and 6% a month on their loans, which are usually short-term and run for up to six months.

In that sector, state-owned industry is not that well developed. So a lot of people lend money under some private business agreement. He Gang, Caijing magazine

The practice hit the headlines recently after a 31-year-old businesswoman, Wu Ying, was found guilty of "financial cheating" by a Chinese court.

She was sentenced to death, though on Friday the country's supreme court overturned the sentence and ordered a retrial.

Ahead of the initial sentence, many had long seen Wu Ying as one of China's new capitalist heroes; a former hairdresser who went on to become one of the country's richest women.

So the court's treatment of her case stirred up much debate as many commentators felt it was harsh considering the nature of the offence.

Far from being an unusual crime, this kind of private lending is rife, says He Gang of Caijing financial magazine in Beijing, insisting it is almost the norm in the province of Zhejiang where Wenzhou sits to the south of Shanghai.

"In that sector, state-owned industry is not that well developed," he explains. "So a lot of people lend money under some private business agreement."

Winners and losers

With the rapid growth of China's economy, private finance has been a win-win situation for many.

Entrepreneurs have been able to access the capital they needed to build new businesses, which in turn enabled them to cash in on China's boom. Investors, meanwhile, have got a better rate of return on their money.

Media playback is unsupported on your device Media caption China's economic growth slows more than predicted

But the recent softening of global and Chinese economic conditions have seen some cracks appear in this previously smooth-running system.

Faced with issues such as tougher competition and weakening sales, a number of factory owners who borrowed money have not been able to repay their debts. Some have gone into hiding, others have committed suicide, leaving the small lenders with little hope of recouping their cash.

And while a great number of lenders are business people, many others are ordinary people who accumulated savings and had money to invest. Often they lent money on nothing more than a handshake and trust because their deals are between friends, family and close associates.

The 11 people persuaded to take action against Wu Ying were all known to her personally.

One of private lenders we spoke to for In Business explained how he lost 700m yuan (£69m; $111m) which he loaned to several investors in the property market.

The man, who asked us not to reveal his name, used to run a construction supply company that he set up with compensation money his family received after being moved from their land in Inner Mongolia to make way for a coal mine.

He was earning an interest rate of 2.5% per month on the money he was lending and like much private financing it was subsequently invested in real estate.

However, last year the Chinese government introduced measures to control the country's ballooning property bubble, including limits on the number of houses people can own, higher deposits and property taxes in selected cities.

This has meant some people investing in new property developments have found it harder to sell, or have made much less money than they anticipated, which is bad news for the private lenders.

"It had a huge impact on our loan business because our money is stuck in the market," says the lender. "Nobody is buying and we can't get our interest payments, not to mention the money we invested."

All the investors he loaned money to have disappeared, but he says he is not angry about it.

"At first I was very angry, furious," he explains. "But after some time I re-thought the whole process of the loan business. We should calm down, it's a difficult time. No need to be angry any more."

'Important missions'

The Chinese government has recently announced plans to reform this sector of the economy, developing a pilot scheme to create new, smaller, financial institutions.

The scheme will begin in Wenzhou and will create institutions including rural banks, micro-financing firms and most importantly a private equity fund led by the city's government to invest in its private companies.

This move is unprecedented in China and could be the beginning of the next phase in its economic development.

It comes in the wake of Premier Wen Jiabao's announcement on state radio last week that the monopoly of the state banks should be broken up.

And the government is not the only body to have taken the initiative to improve matters in Wenzhou.

Since May 2010, a young lawyer, Yen Yi Pan, has run a website where both borrowers and lenders can trade. The idea came to him after he noticed a run of cases at his practice involving the private loan business.

"The website has two important missions," he explains. "One is to provide an information exchange platform for lenders and borrowers. The second is for after both sides agree a deal.

If the financial system doesn't change then our country's economy cannot move forward Zhou de Wen, Association of Small and Medium Business Enterprises in Wenzhou

"We provide online legal support, draw up contracts, agree interest rates and provide some form of guarantee. In this way we are in a position to help regulate the market."

The influential head of Wenzhou's Small and Medium Business Association, Zhou de Wen, feels so strongly about a need to regulate private financing that he drafted a suggested law to this effect.

He says the financial system must be changed because the monopoly of the large state banks encouraged the growth of the private finance sector.

"We have a very irrational financial system in this country; it cannot meet the economic needs of the development of this country," he explains. "That's why you've seen a lot of crises in these medium and small sized enterprises."

"If the financial system doesn't change then our country's economy cannot move forward," he says.

Hear the full report on Radio 4's In Business on Thursday, 19 April at 20:30 BST and Sunday, 22 April at 21:30 BST.

You can listen again via the Radio 4 website or by downloading the podcast.