In the chapter on China’s Two Markets in my book, Managing the Dragon, I describe how every product in China has two markets: a highly visible market that resembles those in the most developed economies in the world, and a second, much less visible one that is purely local and unique to China. While the world focuses on the first, much of China’s population deals on a daily basis with the latter.

This is true even in the case of capital. On the one hand, China’s commercial banks are now among the largest in the world and have become highly active, and visible, players in global financial markets. In the stock market, the ups and downs of the Shanghai Stock Exchange are reported on in the same breath as those of the exchanges in New York or London. At its peak last year, the valuation of China’s A share listed companies was a lofty 43.7 times earnings, more than double valuations on most stock markets around the world. Even with the 55 percent decline from last October’s peak prices, A share companies trade at 18.5 times earnings, slightly more than the price/earnings multiple for the S&P 500.

While China’s largest companies enjoy rich stock market valuations and can readily borrow money from banks at interest rates less than 8 percent, most private companies in China are forced to resort to a large and growing network of illegitimate, unregistered and unregulated private lenders that charge interest rates of 20 percent or more. This underground network constitutes China’s less visible, purely local market for capital. Though it has always existed in one form or another, China’s recent credit tightening measures are drying up bank financing that most private companies find it difficult to obtain even in the best of times.

Rampant entrepreneurialism in China and the 85 million private enterprises that Ted Fishman, author of China, Inc., estimates exist in the country, belie the fact that being an entrepreneur in China is no easy matter. Despite the enormous amount of capital that has flowed into the country over the past thirty years, and the vast amount of wealth that has been created during that period, obtaining capital to start or build a business in China is one of the biggest hurdles faced by budding entrepreneurs.

Bank loans, a traditional source of financing for new companies in other countries, have been largely reserved for state-owned enterprises in China, where the implicit guarantee of the state makes it unnecessary for loan officers to learn how to analyze a business plan. A survey by the Guangdong provincial government showed that small and medium sized enterprises in that province only got 2 billion yuan in bank loans in 2007, 2 percent of the total loans extended in the province.

Leasing and other institutionalized forms of secured lending are still in an embryonic stage of development in China. Even selling shares in the stock market, an option available to companies of all sizes in most other stock markets around the world, is not an option for private companies in China, no matter how promising their growth prospects. Which companies go public in China is determined by state regulators, not the investment bankers.

With traditional channels for obtaining capital closed to them, a purely local market for capital has developed as many private companies have been forced to go “underground” to obtain start-up or working capital. A recent story in China Daily Business described some of the aspects of this purely local market and the dilemma faced by entrepreneurs in the country.

When Yuan Xing needed 800,000 yuan to start his organic farm, he turned to private lenders in his hometown for financing at a 20 percent annual interest rate.

“I knew I could get a better rate from a bank,” said the 29-year-old fruit and vegetable producer. “I tried Bank of China and Industrial and Commercial Bank of China, but they didn’t even want to look at my business plan.”

“A lot of small firms come to us. Only the bigger enterprises go to the banks,” said an underground lender, who declined to be named. He has lent out 10 million yuan - he declined to say how he made that kind of money - at 30 percent annual interest rate.

“Interest is not an issue. They will go bankrupt if they don’t get our short-term loans,” he said. “Our money is available at short notice. We can deliver the cash within 24 hours, while a bank loan might take at least six months.”

Despite usurious interest rates, underground lending is becoming a big business in China. In a survey conducted by Beijing’s Central University of Finance & Economics, it was estimated that underground lending totaled 1.98 trillion yuan in 2007, equal to 28 percent of the amount lent by banks.

China is a study in contrasts and nowhere is this more apparent than in its capital markets. Countries like the United States have found that the biggest sources of new jobs are the small and medium sized enterprises, not the large Fortune 500 companies. One of China’s biggest problems is its lack of effective capital markets to distribute capital to those individuals and companies that can use it most effectively. One of China’s biggest opportunities is to develop capital markets that do.