The Chinese city of Wenzhou, an entrepreneurial city in the eastern province of Zhejiang, has set a legal threshold for interest rates on private loans, taking its first step to regulate the rampant underground loan market.

Any private loans with rates exceeding four times China's benchmark interest rate would not be entitled to legal protection, the government of Wenzhou said in a statement seen on Monday.

China's benchmark one-year fixed deposit rate now stands at 3.5 percent.

Lenders and debtors should revise their previously-agreed loan rates to be within the legal guideline, the government said on its website. (www.wenzhou.gov.cn)

For loans that continue to have rates exceeding the limits, the debtor can refuse to pay the excess.

The move is seen as baby step that the local government is taking to control the previously unregulated private lending sector, which has exploded amid a credit clampdown by Beijing.

According to local media reports, these private lending rates, set at between 6-10 percent a month, have driven some smaller property developers into bankruptcy and triggered a string of Chinese entrepreneurs to go into hiding to avoid repaying loans.

Outstanding private loans in Wenzhou have climbed to 110 billion yuan ($17.2 billion) this year, up from 80 billion last year, according to central bank estimates, and are now the focus of local media reports about a wave of bankruptcies.

The China Securities Journal cited a July report published by the People's Bank of China branch in Wenzhou which estimated that 89 percent of households and 60 percent of companies in the city were engaged in private lending, charging rates of nearly 25 percent a year.

Some analysts believe the risks to China's economy, the world's second-largest, could be contained since the rampant lending is outside of the banking system and such loans are generally not used to fund speculative bets.

However, in its annual survey of Chinese banks released this month, accounting firm KPMG noted that credit woes faced by one small firm can affect its peers through debt triangles.

This happens when a firm that is short of cash delays payments to its suppliers, causing suppliers to suffer cash flow problems which in turn can affect others higher up the supply chain.

(Reporting by Fayen Wong; Editing by Kim Coghill)

China