China's Looming Real Estate Crisis Threatens its Vast Shadow Banking System

Subscribe to CNN's Meanwhile in China newsletter to stay updated on the country's growing influence and its global impact. This week, Moodys unexpected downgrade of China's credit outlook has added to worries about the impact of the real estate crisis on the broader economy.

Analysts warn that the risk of contagion, especially through losses at shadow banks, is increasing in China. While this does not signal a "Lehman moment" like the 2008 collapse, investors worldwide should still take notice due to the potential impact on the country's growth, according to Larry Hu, chief China economist at Macquarie Group.

The recent decline in property values has had a significant impact on the Chinese economy in recent years, and is currently seen as the greatest potential risk. Of particular concern is the potential impact on the "shadow banking sector," a substantial and enigmatic part of China's financial system.

The industry is valued at approximately $3 trillion at its narrowest definition, and as much as $12 trillion when including asset management products and consumer loans. It has garnered attention in recent months due to two major players failing to make owed payments to investors, both of which have substantial exposure to the property market.

Zhongzhi Enterprise Group, one of the country's largest financial conglomerates, declared insolvency last month after failing to make payments on numerous investment products. The company is now the subject of a criminal investigation by the police.

Shadow banking meltdown

Wanxiang Trust, an investment and asset management firm in Hangzhou, has delayed payments worth several hundred million dollars on a number of investment products, as reported by Chinas state media, two weeks after Zhongzhi revealed its financial troubles.

The issues at both investment firms have sparked concerns about the potential financial ripple effect of the declining property market on investors who were not directly involved in home purchases. Major developers like Evergrande and Country Garden have failed to meet their debt obligations.

Shadow banking refers to financial activities conducted outside of the conventional banking system. In the Western countries, it mainly encompasses lending by private equity firms or hedge funds, while in China, it includes various forms of financing activities, some of which are connected to banks. This includes the use of wealth management products, trust products, and entrusted loans.

Silvers said the problems affecting shadow banks likely arent restricted to Zhongzhi or Wanxiang, adding "a wider meltdown [in the industry] seems imminent."

This aerial photo taken on November 27, 2023 shows fog over residential buildings in Wuhan, in China's central Hubei province.

Stringer/AFP/Getty Images

Shortly after Moodys announcement on Tuesday, S&P Global Ratings also cautioned that the impacts of China's real estate industry could have widespread effects on the economy, including potential losses for financial institutions and negative effects on investor and consumer sentiment.

A report by China's top banking regulator revealed that the shadow banking industry, broadly defined, reached a total size of $12 trillion, accounting for 86% of China's GDP in 2019. This report was the first government document to shed light on the opaque sector.

Trust firms, which aggregate savings to offer loans, experienced rapid growth within the shadow banking industry over the last decade. This sector has been widely used as a means for cash-strapped property developers and local governments to secure funding from millions of Chinese individuals.

As of 2022, the assets held by trust firms amounted to 21 trillion yuan ($2.9 trillion), marking an eightfold surge from 2010, as reported by the China Trustee Association.

The number of defaults on trust investment products, particularly those tied to real estate, has seen an increase in the last two years. In 2022, defaults on real estate trusts reached 93 billion yuan ($13.1 billion), a slight uptick from 91.7 billion yuan ($12.9 billion) in 2021, as reported by Chinese data provider Use Trust.

Zhongrong International Trust, partly owned by Zhongzhi, allocates approximately 10% of its funds to real estate investments, the company confirmed. It has provided loans to various struggling property developers, including Evergrande Group and Sunac China, both of which have defaulted on their debts.

Wanxiang Trust's significant investment in real estate comprises 58% of its assets under management. One of its trust products, which is currently facing difficulties, had invested in Kaisa Group. The company defaulted on its debt in 2021 and is currently dealing with a winding-up petition in a Hong Kong court.

The office building of Zhongrong International Trust, a trust company partially owned by Zhongzhi Enterprise Group, in Beijing on August 22, 2023.

Florence Lo/Reuters

Debt pressures

The liquidity crunch at trust firms may cause turmoil in the local bond market and put financial pressure on Chinese companies and local government entities.

Trust companies may be required to offload a greater number of liquid assets in their investment portfolios, such as corporate bonds and local government bonds, in anticipation of the maturity of trust products, according to Citi analysts in a note issued in August. "This action could potentially lead to a correction in bond prices and impede companies' ability to access financing," they explained.

The potential increase in debt could create challenges for companies and local government financial entities with upcoming debt payments, potentially leading to default. China's local government debt has risen significantly due to decreased land sale revenues from the property market decline and the ongoing economic impact of pandemic-related lockdowns.

In 2022, China's local government debt soared to 92 trillion yuan ($12.9 trillion), marking a 50% increase from 2019. An analysis by research firm Mars Macro suggested that the "hidden debt," largely held in local government financial vehicles and not reflected on official balance sheets, could be as high as $10 trillion.

No systemic risk

Chinas shadow banks may be mired in problems, but theyre unlikely to cause a wider banking crisis, according to experts, as they are still a small part of the banking system.

Hu stated that in his opinion, the current difficulties in the shadow banking industry will not result in a widespread crisis, largely due to the fact that traditional banks have minimal involvement with these trust companies. Additionally, Hu pointed out that trust products are primarily marketed to individuals with high net worth, rather than the general public.

Individuals who meet the criteria to invest in trust products in China must have a minimum net worth of three million yuan ($421,793) or an average annual income of at least 400,000 yuan ($56,239) in the past three years.

According to calculations by CNN using data from the China Trustee Association and the Peoples Bank of China, trust assets made up only 5.3% of the banking industry's assets in the first quarter of 2023.

Trust firms have been decreasing their involvement in the property market, with property trust investments accounting for 5.3% of total trust investments and 0.3% of the banking systems assets in the first quarter of this year, totaling 1.13 trillion yuan ($159 billion). This represents a 28% decrease from the same period last year.

Ming Tan, director at S&P Global Ratings, stated that the manageable risk due to the significant drop in the trust industry's property exposure suggests that trust defaults will not lead to a banking crisis, as wealthy investors and corporates will bear the losses.

Analysts are also confident that Beijing would step in to prevent widespread damage.

Despite the property market downturn, Chinese authorities maintain a strong determination and capability to ensure the stability of the financial system. This is due to the quasi-policy roles played by domestic banks, the majority of which are state-owned," Moodys stated last month. They also added that the government has a range of tools to prevent a domino effect, including providing liquidity to distressed financial institutions.

Last month, Chinas leaders pledged to address risks more systematically across the financial sector and preserve stability.