When formal finance meets the informal: the case of Wenzhou

Abstract

We examine the causes of the financial crisis of 2011 in the Chinese city of Wenzhou. While the crisis of 2011 has been attributed to weaknesses in the system of informal finance, including predatory interest rates, we suggest that the roots of the failure lay in the way that the formal and informal systems became intertwined in the period following the global financial crisis of 2008 and the expansionary monetary policy initiated by the Chinese authorities to counter its effects. We explore the effects of the over-supply of formal credit in this period and the encouragement of group lending, a practice relatively unknown prior to 2008, and which magnified the effects of the crisis. We suggest that the lesson to draw from Wenzhou is not that informal finance is inherently more instable or inefficient than formal finance, but that encounters between formal and informal finance can trigger instabilities in both.