China’s economic recovery from three years of strict Covid restrictions appears to be losing momentum. The property sector, which holds 70% of Chinese households’ wealth, is ailing with home prices sliding by 9% in July alone in some of the major cities, the steepest decline in a decade. China’s property developers are under duress again, re-igniting concerns about a debt crisis. With a faltering economy and falling confidence amongst households and companies many are now questioning whether the ingredients are there for a broader financial crisis for the first time.
China’s indebted property sector can’t catch a break. First there was infamous Evergrande’s bankruptcy filing in the US; now, a property-focused trust has failed to make payments. What follows is likely to be one of three options: a huge bail-out, a shaky but stable upkeep of the status quo, or a complete financial crisis.
Shadow Bank Risks
Under-the-radar “shadow” banks in China hold nearly $3 trillion in assets, while listed Chinese developers have estimated debt at risk of default of around $1.75 trillion. Zhongrong International Trust is an affiliate of Zhongzhi Enterprise Group, one of China’s biggest private wealth managers with more than $137 billion of assets under management. A top-ten trust, Zhongrong lends to firms that can’t access funds from traditional banks, charging higher rates in return. According to reports out earlier this month, it missed payments on high-yield investment products owed to thousands of investors.
Shadow trusts operate outside many of the commercial banking sector’s normal rules, taking deposits from wealthy individual investors and companies and investing that in stocks, bonds, and other assets. The total amount managed across various trusts is estimated to be close to $3 trillion.
Some of Zhongrong’s loans were to troubled developers and they now seem to be experiencing a liquidity crisis. If Zhongrong can’t find the cash it needs to keep up with payments, the trust could collapse. If Zhongrong or another trust firm crumbled, that would likely undermine further confidence in the financial system. That’s not entirely unlikely, with other firms besides Zhongrong already struggling to manage debt. Country Garden Holdings Co, for one, is edging closer to a public bond default after missing a $22 million bond payment earlier this month. Country Garden’s debt is piling up, clocking in at $194 billion at the end of 2022. In China real estate makes up nearly 70% of private wealth, clearly declining property prices is likely to further undermine consumer confidence.
Debt isn’t just a problem for real estate developers. China encouraged its local governments to borrow and spend on infrastructure projects like roads and railways. The IMF estimates these local government financing vehicles (LGFVs) have accumulated circa $7.8 trillion in debt.
Broader Macroecomic Challenges
The macroeconomic climate in China is more challenging than its has ever been since the reforms and opening in the 1970s. There are also cyclical and structural problem with weak exports, a confidence problem, and local governments, which were an important contributor of growth for China in the past as they were told to borrow money to prop up activity, focused this year on managing their implicit debt burden. Essentially, they are saying they can’t borrow more because the central government is pressuring them.
There is definitely scope for the Chinese government come in and bail out local governments, with central government debt to GDP about 25% to 30%. But there seems to be an implicit unwillingness to do that. They want to keep the central government’s balance sheet as pristine as possible. If they drew on the balance sheet to bail out developers and then the trust products, their ability to help in the future obviously lessens. They have been adamant on this point for several years.
The Confidence Problem
The confidence problem is something not seen at this magnitude in a very long time. The real risk in the coming months is if the macroeconomic situation doesn’t improve, China is stuck with confidence problems. Whether China is now vulnerable to a financial run similar to what U.S. regional banks experienced this spring with Silicon Valley Bank is an interesting question.
There isn’t an ability to redeem most investment products at will like there is with bank deposits, which is a key reason why things remain relatively quiet for now. What we don’t know is whether recent trust defaults have made investors more reticent to roll their investments over when they mature. If so, we are likely to see more defaults like Zhongrong and Zhongzhi. If not, the system can remain fairly quiet and stable.
The most telling form of a confidence issue spreading into the financial sector would be households and corporates not only deciding they would be more comfortable with their money in bank deposits but rather in deposits at state banks, which could trigger a migration of funding away from smaller banks akin to what we saw in the U.S. earlier this year. None of this is happening now, but the ingredients are there in a way they haven’t been before.
Beijing could seek to rebuild confidence by cutting rates more dramatically, but officials will need to be mindful of how much currency pressure they want and how much they want to erode banks’ net interest margins. For now, the hope seems to be that property will bottom and that this inventory destocking cycle in the U.S. and Europe will rebound, increasing export demand in 2024.
Many people keep looking at this as a cyclical short-term problem and expect China to get back to the growth path it was on, and everything will be fine. For China to go back to pre-pandemic growth levels many structural issues need to change. Layer on the demographics and it seems highly unlikely they will get close to the growth rates of the past. As the post-pandemic period has failed to bring a sustained recovery in consumer spending, or to thaw the near-frozen property market, most analysts now are confident the world's second-largest economy is going to miss its 5% growth target for this year.
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