In this wealthy eastern Chinese city known for its shrewd merchants, the owner of a factory that makes spectacles faces a difficult task: closing his money-losing business and dismissing his workers.

The impending demise of this workshop typifies the struggles of small manufacturers in China, where soaring borrowing costs are eroding already-thin profit margins, forcing firms to either fold or cut production.

This business is not tenable anymore. We are quitting! the owner cried as he chased two Reuters correspondents from his sparsely-furnished factory. His workers, surrounded by styrofoam trays of eyeglasses, looked on in uncomfortable silence.

As China enters its ninth month of monetary tightening, small- and mid-sized private businesses increasingly find themselves in a bind, caught between stubbornly high inflation and a lack of financing stemming from the government's effort to combat those same price rises.

Everything from property to raw materials is getting more expensive. At the same time, interest rate rises and lending curbs since October that force banks to ration loans have deprived many of funding. That relegates them to an underground lending market where rates spiral as high as 120 percent.

Wenzhou's problems are not unique. Companies across China's eastern manufacturing belt are struggling with surging costs and dwindling profits.

With small- and medium-sized enterprises accounting for 80 percent of all jobs and 60 percent of industrial output, according to government officials, it's a problem China can ill afford to neglect.

It's an unintended and unfortunate consequence when credit is tightened through quotas, said Tao Wang, an UBS economist in Hong Kong. Small companies suffer first, and suffer the most.

HELP WANTED

The difficulties confronting Wenzhou's businesses aren't immediately apparent on the streets of the city, a five-hour drive down the coast from Shanghai.

High-rise towers are under construction and luxury cars roll past bars and cafes catering to the city's entrepreneurial class, many of whom have become rich from real estate and stock market speculation.

But inside the town's factories, it's another story.

The price of everything is rising, except the price of our products, said a woman surnamed Chen, adding that she worries about the future of her business, which makes sparkling plastic beads for fashion accessories.

She needs to leave the run-down building soon as it is due for renovation. But she cannot afford to rent a similar space as rents have surged beyond her budget.

We just can't hire any workers. The minute they step into the factory, all they want to talk about are wages, she said, as she pinned the beads onto a metal frame to be spray-painted silver to add luster to their shine.

Her workshop runs 12 hours a day now, from 24 hours before.

Chen is not alone. The gates of nearby factories were plastered with help-wanted ads, and other factory owners said they are rejecting sales orders because they cannot find workers.

Like other Chinese cities, monthly wages in Wenzhou are rising an average 20 percent annually. Still, some workers say that is not enough as rising expenses have outstripped gains in salaries, which start from 1,310 yuan ($202) per month.

Businesses say they cannot pay more because they do not have the flexibility to lift their own prices enough to fund higher wages, especially with profits already shrinking.

Our costs have gone up a lot, but we can't pass it on to customers, said Yu Jiabin, a manager at Wenzhou Yaorui Lighters Pte Ltd. Market competition is still very intense.

Some economists warned, however, that the Chinese government will not be in a hurry to ride to the rescue of all SMEs.

It's necessary for China to squeeze out some low-end companies and give more space to high-value-added firms to expand, said Chen Yong, an economist at Huatai United Securities in Shanghai.

GOING UNDERGROUND

Despite China's efforts to tackle inflation with tools ranging from reserve rate hikes and outright bans on certain loans, inflation is still elevated. It ran at an annual pace of 5.3 percent in April and is expected to have accelerated in May.

The policies are affecting lending: growth in new yuan loans on banks' balance sheets dropped to 17.5 percent in April, from December's 20 percent.

Small firms are disproportionately hit by the slowdown.

For banks, it pays to avoid SMEs as they need to lend less this year to keep policy tight. To play it safe, they lend to big state firms instead of small private ones, which are deemed to be riskier.

We have grown very selective of our clients, a banker at a mid-sized Wenzhou bank said. We only lend to small companies that have very good growth prospects or are involved in new energy and new technology.

For the majority of small firms that do not make the cut, even offers to pay well over one-year benchmark lending rates of 6.31 percent get rebuffed, for banks want to be seen as socially responsible.

Chinese banks report that SME loans make up about 40 percent of total lending. But analysts say the figure is likely overstated as there is no one definition of what counts as a SME loan in China -- it varies between 1-10 million yuan.

Off-balance sheet loans, a category that includes wealth management products, are growing, the banker said, but few of these are going to small firms.

Cash starved, many Wenzhou companies turn to the underground lending market to take out people's loans, as they are known locally.

Made up of cash-rich families eager to put their money to work by lending to businesses, the grey market works by word of mouth, giving firms relatively fuss-free access to cash.

For that, businesses typically pay annual interest rates of between 72-96 percent, said Zhou De Wen, chairman of the Wenzhou Council for the Promotion of SME Development.

Zhou estimated that about 70 percent of small firms in Wenzhou tap its 600-800 billion yuan worth of savings not held in banks, a pool bigger than the city's bank loan market.

The steep costs of people's loans eventually catch up with many companies, however, and some leave the trade to chase easy but risky profits from stock and property speculation.

Those bets can end in tears. One Wenzhou leather maker went bust last month after its owner gambled with company funds, and lost. Another factory owner told Reuters that his brother-in-law had gone into hiding to avoid creditors. No one in his family knows where he is.

Banks and private lenders say they do their best to suss out borrowers before parting with their cash: they comb tax and power bills, and visit companies more frequently to ensure factories are really in production.

We care the most about borrowers' probity and cash flows, said Zhang Haile, who works in a credit guarantee firm that helps SMEs get bank loans by vouching on their behalf.

Yet the reality is small companies are rarely on the radars of Chinese banks, regardless of their quality.

During a trip to Wenzhou last month, Jiang Jianqing, chairman of the Industrial and Commercial Bank of China <1398.HK>, the world's largest bank, promised over 100 billion yuan of loans to the city in coming five years, but made it plain that he prefers key state-backed infrastructure projects.

There are two knives sitting on top of the heads of SMEs -- credit and production costs, said Zhou from the SME council. Capital is like blood for firms. The choking off of capital could be the final knife in their backs.

(Editing by Kim Coghill)

China Inflation