Dec. 13 (Bloomberg) -- Mushroom exporter Lu Haulei was working at his factory in Sanligang, a market town in central China, one day last summer when three executives from HSBC Holdings Plc arrived unannounced.

Told that Lu needed 10 million yuan ($1.4 million) to expand his business, the bankers offered the 46-year-old entrepreneur funding and services he couldn't get anywhere else. Lu says he's hoping the loan will be approved after London-based HSBC opens its first branch in rural China today.

``I never expected HSBC to come here,'' Lu says. ``They understood my financial needs, so I think I have a pretty good shot.''

HSBC, Europe's biggest bank by market value, is the first international lender to move into the vacuum created as Chinese banks closed 31,000 rural branches over the past nine years because of mounting bad loans. Citigroup Inc. and Standard Chartered Plc also are seeking licenses to operate in the countryside, where China's banking regulator estimates residents will need 20 trillion yuan of bank loans by 2020.

The HSBC outlet in Cengdu, Hubei province, about 650 miles (1,050 kilometers) southwest of Beijing, is the prototype for at least six rural branches to be opened next year. HSBC plans to draw on its experience running rural outlets in India and Mexico to make the business profitable.

The bank will start out making loans of as much as 500,000 yuan to export-driven agricultural companies, said Peter Wong, chairman of HSBC's rural China arm, in an interview. It may introduce micro-credit and loans to farmers in six months.

``We know it's not going to make a lot of money in the first couple of years, but we do expect to break even in about three to four years,'' Wong said.

Chinese Banks

Chinese banks have struggled to make a profit in the countryside.

Agricultural Bank of China, formed in 1979 to serve the nation's 800 million farmers, is now saddled with $100 billion of bad loans. About 23 percent of its loans aren't being repaid, the bank said in its most recent annual report.

``China needs foreign banks' expertise in managing rural banks and making small loans in other countries,'' said Jiang Dingzhi, vice chairman of the China Banking Regulatory Commission.

China is opening the rural market to international lenders as President Hu Jintao tries to extend the country's economic boom to the countryside. HSBC received the first license issued under a government program that provides tax breaks and other incentives to banks that venture out of the cities.

Rural-Urban Divide

Two-thirds of China's farmers have no access to banking services, exacerbating the rural-urban income gap. The average per capita income in the countryside is 3,254 yuan annually, about a third of that for city dwellers.

Opening rural outlets may help foreign lenders win licenses in more lucrative regions, said Nick Lord, associate director for regional banks at Macquarie Equity Market Group in Hong Kong.

``Hopefully, that'll allow them to maintain very good access to the Pearl River Delta, Yangtze River Delta and Bohai Rim,'' he said, referring to growing urban areas.

HSBC's Wong denied the bank was trying to curry favor with the government.

``We are not going to use rural banking as a bargaining chip for opening more businesses in cities,'' he said.

New York-based Citigroup, the biggest U.S. bank, and London- based Standard Chartered declined to discuss their plans for China's hinterlands.

Rural Opportunities

Rural areas provide an opportunity for international lenders because the urban market will be saturated in five years, said Zhang Xi, a Beijing-based analyst at Galaxy Securities Co., China's largest brokerage by assets.

``The countryside is the only untapped area with growth potential,'' he said.

The primary way for Chinese farmers to get financing now is through rural cooperatives, which control 10 percent of the country's 37.8 trillion yuan in deposits yet tend to make small loans of 500 yuan to 20,000 yuan.

That's not enough to help mushroom exporter Lu, whose business had $60 million of sales last year, mostly in Europe, the U.S. and Japan.

Hubei Sangyou Food, which Lu owns with a partner, spent 30 million yuan to build its factory and needs loans to increase the number of shiitake mushrooms it buys from farmers. The delicacy, grown on dead logs, is dried and packaged at Lu's factory.

``The credit co-op's system is too outdated and too small to help as our financial needs become increasingly sophisticated,'' Lu said.

Shiitake Countdown

HSBC has set up shop on two floors of a four-story brick building in downtown Cengdu. Most of its 22 employees were recruited from local banks and co-ops, and one of them knew of Lu's business plans.

In addition to loans, HSBC executives promised letters of credit and instant money transfers, Lu said. Currently, he sometimes has to wait weeks for payments to arrive before he can buy more mushrooms.

``These are the products you won't be able to get at local Chinese banks or the credit co-op,'' he said. ``I just hope it won't take too long. The best harvest will be gone if the money arrives later than January.''

To contact the reporters on this story: Luo Jun in Shanghai at jluo6@bloomberg.net.

Last Updated: December 12, 2007 19:16 EST