Sitting in his office fitted out with stylish black leather furniture and sipping green tea, Zheng Xiaozhong, who owns a garment exporting business in the southern Chinese city of Dongguan, is already looking ahead to next year.

He plans to open a second factory employing 2,000 workers. Because orders from Europe have declined, production will be aimed at the domestic market – sold through a chain of shops named after his four-year-old daughter. Mr Zheng is part of a global network of businessmen from Wenzhou, a city near Shanghai renowned for the entrepreneurial flair of its people.

As China’s economy has started to slow, albeit to gross domestic product growth of 9.1 per cent in the third quarter, and small and medium-sized enterprises have struggled with higher labour costs and an appreciating renminbi, Wenzhou has made headlines because of its loan-sharks. There is no solid data about the size of underground financing in China, though the central bank estimates it could be up to Rmb4,000bn ($627bn), or 8 per cent of formal lending in the economy. Wen Jiabao, China’s premier, visited the city a fortnight ago, along with Zhao Xiaochuan, central bank governor, and directed banks to provide credit support to small firms.

Most analysts agree that shadow financing is not big enough to pose a risk to the economy. Lu Ting, an economist with Bank of America Merrill Lynch, wrote after a visit to the city that Wenzhou’s grey lending market could be “a storm in a teacup for China as a whole”.

Andy Xie, an economist with Rosetta Stone Advisors in Shanghai, says shadow financing propels China’s small and medium enterprises.

Mr Zheng says he prefers to borrow from friends and relatives through the Wenzhou shadow financing system at 1.5 per cent a month. The businessman says he has invested Rmb10m over three years: of that, about Rmb4m was from the shadow financing system and most of the rest from profits and family savings.

The problems that have hit the headlines have more to do with speculation encouraged by loose monetary conditions, argues Mr Xie: “Only money-burning speculation needs to borrow constantly to stay afloat.”

An executive in a small government-owned bank in Wenzhou agrees: “There have been isolated cases of SMEs running into serious trouble. It is not so widespread.”

After Mr Wen’s visit to the city, moves have been made to ease credit to small businesses.

Mr Zheng and other Wenzhou businessmen in Dongguan say they rely on shadow financing because it is more flexible. “If we get loans from a bank we have to wait for a long time and if you return money in advance, you pay a penalty,” Mr Zheng says.

Zhou Dewen, head of Wenzhou’s small and medium enterprise association, says many small businesses have been caught out by a rising renminbi coupled with higher material and labour costs when order sizes are declining. “Tight capital has been the last straw for SMEs in trouble,” says Mr Zhou.

Wenzhou companies face a dilemma. They must retool to tap more sophisticated export niches or reorient themselves to sell to the domestic market. One of those businessmen adjusting to this environment is David Liu, president of Luca Angelo, another Wenzhou businessman in Dongguan. Luca sells handbags to a network of mostly Wenzhou retailers in France and Italy.

“Orders from Europe have dropped 20 per cent. It is difficult,” he says. The second half of the year is shaping up more favourably and he plans to increase prices by 3-5 per cent.

After the financial crisis in 2008, Mr Liu turned from exports to making bags for the home market, which now account for a quarter of his $8m revenues. Helped by his eldest son, a designer in Milan, he plans to invest to improve his designs and move upmarket to sell bags for €200 ($275) to €300 in Europe. Wenzhou businesses can overcome the risks facing the economy, he says, if they avoid making products with the low margins that bedevil small exporters.

Additional reporting by Zhou Ping in Hong Kong