By staff reporters Luo Changping and Ouyang Hongliang

Tens of thousands of small investors who rioted recently in the southern city of Jishou were venting frustration over an underground loan racket run by local companies, Caijing has learned.

Moreover, a source told Caijing that a post-riot government investigation into the illegal financing scheme could spread to include “many more” companies than the 12 mining and real estate concerns initially at the center of the probe.

The local government has formed “work groups” to oversee the investigation, and the Hunan Province government arranged a settlement plan for investors following the two days of unrest that broke out September 3.

Soldiers and riot police broke up the protests, which were widely reported by China’s official media.

Small lenders had fronted the targeted companies – which have not been named -- more than 6 billion yuan between 2004 and this year on promises of monthly interest rates as high as 10 percent. But the scheme started unraveling in July as investors started to lose confidence.

After the riots, the provincial government announced September 8 that affected companies must return to small lenders all loan principle without interest, and that any lenders who earned interest in the past must return it to improve the companies’ balance sheets. Meanwhile, all company assets have been frozen.

The loan system seemed to be a win-win situation when it began four years ago in relatively undeveloped Jishou. Real estate developers, mining companies and other local enterprises raised money through the underground network, which was embraced by eager investors ranging from government officials to unemployed laborers.

Some small lenders joined the frenzy by recycling cash borrowed from banks, using their apartments as collateral. In addition to local residents, the scheme attracted investors from neighboring Chongqing municipality and Hubei Province.

Interest earnings created the appearance of an economic boom in Jishou, as lenders celebrated with extravagant entertainment spending and major purchases such as cars. But the cash-flush companies neither performed nor invested well.

The flimsy capital chain started disintegrating in July after some lenders lost confidence and reclaimed their principal. Over the following two weeks, investor demands increased and the companies returned about 1 billion yuan, which hurt many real estate developers struggling in a sluggish housing market.

Lender-borrower tension mounted until, in mid-August, some companies threw in the towel by publicly admitting they could no longer pay interest.

Angry lenders started gathering in the streets September 3 outside the Fuda real estate company, demanding repayments. The crowd swelled, spreading to government offices as well as the train station, where rail transportation was temporarily disrupted.

The police and military eventually restored order, and local officials started investigating the companies. Nevertheless, a large number of police officers were continuing to patrol outside banks one week later.

As the investigation got under way, Caijing learned, legal representatives and financial officers for the companies were ordered to remain in their offices until cleared by one of the government work groups.

At the same time, Jishou officials ordered a halt to all underground fund-raising and prevented targeted companies from paying either interest or principal to lenders. In addition, all affected borrowers and lenders were given three months to register with a special government agency.

A source close to the investigation told Caijing that the 12 targeted enterprises represented the probe’s first wave, but that many more engaged in underground fund-raising behind the scenes.

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