SUZHOU China (Reuters) - Suzhou, an ancient city in Jiangsu province 100 km (60 miles) west of Shanghai, lives in legend as one of China's most beautiful, famous for its elegant gardens and charming canals.
More recently, it became an industrial powerhouse, sitting at the heart of the Yangtze River Delta region that, along with the Pearl River Delta in Guangdong, drove China's economic boom.
Now it is ground zero for a painful corporate de-leveraging that has tacit government approval. One third of all loan delinquencies come from the region, and credit is getting harder to come by.
"The more banks do this, the more they promote a vicious cycle, and companies are even less able or willing to repay their loans," said Zhou Dewen, vice chairman of the China Association of Small and Medium Enterprises.
The Yangtze River Delta (YRD) covers the financial capital of Shanghai and the eastern provinces of Zhejiang and Jiangsu. In 2012, it accounted for half of China's exports and attracted 57 percent of its foreign direct investment.
The outsized role of small, private firms, their savvy entrepreneurs and the vibrant underground financing networks that supported them have been a source of strength for the YRD.
But now it may be a vulnerability as the government shows it is prepared to let companies fail -- at least private ones.
Among the six largest domestic banks that classify their non-performing loans geographically, this region accounts for one-third of their bad debts.
"The YRD's economy has been pretty seriously battered. Risks are multiplying," said a risk-management executive at a mid-sized bank in Shanghai.
Economists say a series of isolated defaults would be mostly positive in the long run for China, by improving risk pricing and the efficient allocation of capital.
But there is a risk that defaults could trigger a chain reaction of credit problems that has the potential to destabilise China's financial system, similar to the way global markets froze after the collapse of Lehman Brothers in 2008.
The region can already claim China's first domestic bond default, after Shanghai Chaori Solar Energy Science and Technology Co Ltd missed a bond interest payment last month.
Last week, a synthetic yarn-maker in Zhejiang declared bankruptcy, raising the prospect of default. That firm's bond carries a guarantee from another textile company, highlighting linkages between firms that some worry can amplify risks.
The government's hands-off approach is a clear shift from its bailouts of the past -- including of Chaori, which in 2013 received assistance from a district government in Shanghai that enabled it to make a coupon payment.
There are still some traditional white stucco houses with red-tiled roofs along the east bank of the Jinghang Canal, which runs from central Suzhou to the once-thriving textile hub of Wujiang, but only in patches between factories and construction sites.
"Prices for raw materials are going up, but for finished goods they're going down. The room for profit is smaller and smaller," said Zhu Dongyang, a sales manager at Wujiang City Pinxin Textile Technology Co Ltd.
China's producer price index has fallen in annual terms for the past 25 months, while data this week is forecast to show economic growth at its slowest early 2009.
Then the government unleashed massive stimulus to shore up the economy. Now, it says there will be no repeat, in part to avoid worsening problems of overcapacity and debt.
Jiangsu Xinmin Textile Science & Technology Co Ltd, based in Wujiang, was one of the many firms that expanded rapidly during the heady years of China's credit-fueled economic stimulus from 2008 to 2010.
There are few obvious signs of distress outside its factory. Motorised tricycles piled high with fabric pass by regularly. But last month, the company warned it may be de-listed from the Shenzhen exchange after reporting a second straight annual loss.
As industry overcapacity and falling prices forced it to write down its assets, equity fell from 1.1 billion yuan ($177 million) at the end of 2011 to 441 million at the end-2013.
The firm has 316 million yuan in loans coming due in 2014. Its current ratio -- which measures cash and other short-term assets against liabilities due within 12 months -- was 0.57 at end-2013, suggesting it will need to raise more funds to meet its obligations.
As a relatively large listed firm, Jiangsu Xinmin has some access to bank credit. Many smaller producers are forced to tap the shadow banking system, where interest rates can be punitive.
The benchmark annual rate for a three-month private loan in Wenzhou, known as China's informal lending hub, reached 18.7 percent last Thursday, according data from the Wenzhou Private Lending Service Centre.
Jiangsu Xinmin declined to answer questions about its financial condition. The board secretary said that firms classified as "special treatment" – the designation that China's stock exchanges assign to companies under consideration for de-listing -- aren't permitted to do media interviews.
Private companies in the YRD control 28 percent of assets held by industrial firms, compared to a national rate of 19 percent, according to Reuters calculations based on official data. The true ratio in the YRD is likely higher, since official figures only cover firms with annual operating revenue above 20 million yuan.
"Some specific industries bring risk," said Xu Chengming, professor at Nanjing University of Finance and Economics, located in Jiangsu's provincial capital.
Xu said solar panels and steel were the biggest sources of non-performing loans in Jiangsu. The channelling of funds into speculative investments, such as real estate, has further amplified risks.
Not surprisingly, Jiangsu was the first local government to establish its own bad-loan asset management company, modelled on the asset managers that Beijing used to clean up the balance sheets of the country's four biggest banks, followed by Zhejiang and Shanghai.
Most analysts think bad loans, both in the YRD and nationally, are higher than official figures indicate, as banks can extend overdue loans and use other techniques to disguise delinquencies.
"These are China's most developed places. The most developed places are growing the slowest," said Zhu Tian, chair of the economics department at China Europe International Business School in Shanghai.
"If growth is slowing, you are going though some kind of transition, and some low value-added industries will have to die."
($1 = 6.2113 Chinese Yuan)
Additional reporting by Koh Gui Qing, Xiaoyi Shao and Shanghai Newsroom; Editing by John Mair