In wealthy Chinese city, debt guarantees spark default contagion
* Private firms use loan guarantees to gain access to credit
* Guarantee chains can transmit risk through local economy
* Isolated defaults could spark chain reaction
* Local government urges banks not to withdraw loans - report
SHANGHAI, April 28 (Reuters) - A network of loan guarantees set up to improve companies' access to credit in one of China's richest districts is creating new risks of default as some debts sour, another sign of how private firms are bearing the brunt of an economic slowdown.
Chinese media have reported on a credit crunch developing among steel and textile manufacturers in Hangzhou city, 175 km (110 miles) south of Shanghai in Zhejiang province, as the failure of some to repay loans pushes their burden onto healthier firms.
Hangzhou is part of the Yangtze River Delta (YRD), an engine of growth during China's boom years but now the source of a third of non-performing loans in the country.
The government ranks the city's Xiaoshan district as China's seventh wealthiest. One of the main drivers of its prosperity -- small, private firms -- is now a handicap.
"The textile industry is not a big borrower in the banking sector. The problems that we see arise when mutual guarantees go bad and textile firms are dragged in," said Robert Yang, assistant to the president at the China National Textile & Apparel Council.
Concern about the huge growth in Chinese corporate debt since the global financial crisis has intensified this year as the government allows market forces to play a bigger role in deciding winners and losers.
Private firms often struggle to obtain credit from state-owned banks, which prefer to lend to state-owned firms due to their government backing.
That trend has worsened as economic growth slows, credit conditions tighten, and authorities work to reduce excessive investment and overcapacity in some sectors.
Steel and textile manufacturers in Xiaoshan, like other private firms around the YRD, sought to overcome such obstacles by providing loan guarantees for each other to gain bank credit.
Now defaults by a few companies threaten a chain reaction that could ensnare even profitable firms, as the guarantees have left them on the hook for debts of their bankrupt competitors.
"Currently, Zhejiang's economic structural adjustment and (industrial) upgrading is at a critical stage. The risk from guarantee chains is still rather large," the Zhejiang branch of the China Banking Regulatory Commission warned in February.
Unlisted polyester yarn producer Hangzhou Jianjie Chemical Fiber Co Ltd was recently liquidated following the default of another textile firm whose debts Jianjie had guaranteed, China Business News, a national newspaper, reported.
Jianjie's collapse in turn affected five other textile firms. In all, 3 billion yuan ($480 million) in bank loans to the six firms are at risk, the paper said.
"After (Jianjie Chemical Fiber) went bankrupt and was liquidated, companies with mutual guarantees had to take on more debt," the paper quoted Zhu Rujiang, director of the Xiaoshan District Funding Chain Risk Prevention and Mitigation Leadership Group, as saying.
"They can still handle this debt, and they will have no trouble surviving, but a key requirement is that banks can't withdraw their loans," he said, according to the paper.
Zhu's group was set up to mediate between banks and companies, according to the district government's website. Zhu declined to comment when Reuters reached him by phone.
China Business News also reported that Hangzhou Zhongxin Steel Structure Manufacture Co Ltd, which makes scaffolding, had shut down and could place another 1.2 billion yuan in bank loans to four other companies at risk.
Zhongxin, whose website is no longer accessible, couldn't be reached for comment.
"The crisis of mutual guarantees is very serious and there is no good solution for this problem," said Zhou Dewen, vice chairman of the China Association of Small and Medium Enterprises in Wenzhou, another prosperous city in Zhejiang.
($1 = 6.2489 Chinese Yuan) (Additional reporting by Koh Gui Qing and Shanghai Newsroom; Editing by John Mair)