ASIA BRIEFING:CHINA'S MOST entrepreneurial city, often called its cradle of capitalism, is Wenzhou in the eastern province of Zhejiang, a hotbed of industrial activity, whose ingenuity has been sorely tested by tightening credit in recent months.

Wenzhou may not be as well known among international investors as Shenzhen or Guangzhou, but it is a name to conjure with in China and could soon become shorthand for banking reform.

A new government project means Wenzhou is to be a test case in one of the most significant economic reforms in China since free enterprise was effectively enshrined in the constitution back in 1979. As state bank lending dried up late last year, following government efforts to stop a property bubble getting out of hand, local factory owners in Wenzhou were forced to resort to underground private lenders, effectively loan sharks.

Two shoe factory bosses took their own lives and about 10 local business owners fled the city, leaving thousands of employees in a state of shock and enormous unpaid loans of hundreds of millions of yuan.

The banking sector has stubbornly resisted attempts at reform, largely because there is no political will to make it happen. Bank lending here has traditionally favoured state-owned enterprises, many of them in bad shape and capable of, at best, low returns, while the capitalists who produce most of the jobs and generate most of the wealth qualify for only a small share of loans.

China’s state-owned banks are monopolies that need to be reformed and privatised to stop a rising tide of anger about the tens of billions of dollars in profit they earned last year and the low interest paid out on deposits.

To hear this kind of sentiment not from a Western analyst, but from a senior Communist Party executive, is remarkable.

In a speech last week, premier Wen Jiabao gave his formal backing to the “Wenzhou Experiment”.

The plan is to allow small businesses in Wenzhou to get access more easily to capital, and start generating jobs.

“I think those elements in Wenzhou that succeed need to be expanded nationwide and can immediately be introduced nationwide,” Wen said in a speech on Chinese radio.

Wenzhou was picked because of its excellent free market credentials and because industry there is suffering after a wave of defaults on underground lending that supported its businesses.

Under the “Wenzhou Experiment”, private investors will be encouraged to buy into local banks and to set up financial institutions such as loan companies and rural community banks, China’s cabinet, the State Council has said.

China’s banking system is arcane and monolithic, made up of 3,769 financial entities, with 196,000 outlets and around three million staff. Only the four biggest state-owned commercial banks actually matter – Bank of China, China Construction Bank, Agricultural Bank of China, and the Industrial and Commercial Bank of China (ICBC) – and they account for around half of all deposits.

ICBC is the biggest bank in the world by market cap and profitability, earning €25 billion last year.

Together, these banks, all of them state-owned, control 45 per cent of China’s financial assets. Foreign banks control less than 2 per cent of Chinese financial assets.

The government sets deposit and minimum lending rates, giving banks a guaranteed margin of about 3.5 per cent. It has begun allowing lenders to charge more for some commercial loans, which has increased profit margins still further.

“Our banks make money too easily. Why? Because a small number of big banks have monopoly status. To allow private capital to flow into finance, basically, we need to break the monopoly,” Mr Wen said.

Earlier this year, the World Bank said that China needed to reform its banking sector, saying that inefficiencies in the system would lead to slower growth, and also choke the private sector.

Premier Wen may be what we in the West call a “lame duck” – his tenure as the country’s prime minister is due to expire later this year or early next year to give way to Li Keqiang, his expected successor – but Chinese leaders wield undue influence long after their official reign is over.

Premier Wen has been busily talking up reform in the past few weeks in a way that suggests he wants his legacy to be that of a reforming leader, not just a safe pair of hands.

He made his comments as he was visiting Fujian province in the southeast, which is also important. Traditionally change in China comes from the south, which is more economically liberal because of its strong trading links. Fujian is one of the coastal regions which benefited from Deng Xiaoping’s “Southern Tour” 20 years ago, which kick-started the years of strong economic growth in China.

The handover of power, which begins later this year, will have to happen first, but by backing the Wenzhou Experiment now, banking sector reform will become one of the first items with which the new leadership of Xi Jinping and Li Keqiang will have to deal.