A Major Chinese Trust Is On The Edge. A Collapse Could Tumble Onto The US Too.

A Major Chinese Trust Is On The Edge. A Collapse Could Tumble Onto The US Too.
Russell Burns

6 months ago6 mins

  • 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.

  • A meaningful policy response and a bazooka-type bail-out are needed, as attempts to solve the crisis so far have failed to restore confidence.

  • While the US economy and stocks are holding up throughout China’s slowdown, the real risk is a financial crisis with China selling its US bonds.

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.

A meaningful policy response and a bazooka-type bail-out are needed, as attempts to solve the crisis so far have failed to restore confidence.

While the US economy and stocks are holding up throughout China’s slowdown, the real risk is a financial crisis with China selling its US bonds.

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China’s indebted property sector can’t catch a break. Infamous Evergrande’s filing for bankruptcy in the US, and closer to home, a property-focused trust has failed to cough up on its payments. What follows will be one of three options: a bazooka-sized bail-out, a shaky but sort-of-stable upkeep of the status quo, or a complete financial crisis – one that could tumble markets in the US.

What is “shadow banking” in China?

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 in its grasp. A top-ten trust, Zhongrong lends to firms that can’t access funds from traditional banks, charging higher rates in return. And 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 (which explains the name), taking deposits from wealthy individual investors and companies and investing that in stocks, bonds, and other assets. That’s big business. Remember, group owner Zhongzhi has $137 billion in assets, and the total amount spread across various trusts is closer to $3 trillion. Now, some of Zhongrong’s loans were to troubled developers – a common tactic for Chinese trusts. That was a wallet-liner when the property market was scorching, but now that prices in the dampened market are hitting lows, not so much. As Buffett said, “Only when the tide goes out do you learn who has been swimming naked.” Well, it seems China’s full of skinny dippers.

Zhongrong seems to be experiencing a liquidity crisis – essentially, there’s no cash to pay the bills. And for the investors owed money, that’s reason to be angry. While protesting in China is more than frowned upon, there’s already been a small, short-lived protest outside Zhongrong’s Beijing HQ. Plus, dozens of folks across China who had invested in these wealth management products have received visits from police urging them to avoid public protests.

But there’s more at stake than public outrage. If Zhongrong can’t find the cash it needs to keep up with payments, the trust could collapse. And that’s no small risk: if Zhongrong or another trust firm crumbled, that would likely undermine already dwindling 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.

Just think of Evergrande, which was once China’s second-biggest property developer. The company defaulted back in 2021, but only filed for Chapter 15 bankruptcy in New York last week in an attempt to restructure its debt. Evergrande’s US dollar debt might be small, but its onshore debt in China is gigantic. According to the company itself, it hit $340 billion at the end of last year.

Zoom out, and Bloomberg recently estimated that the total debt at risk of default in China’s publicly listed property sector is a mammoth $1.75 trillion. To make matters worse, real estate also makes up nearly 70% of private wealth in China. And remember, because a home is the biggest asset most folk own, declining property prices drastically undermine consumer confidence.

Mind you, 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. And borrow they did: the IMF estimates these local government financing vehicles (LGFVs) may be loaded with as much as $7.8 trillion in debt, and that’ll hold them back from financially supporting their local economies.

The global financial crisis of 2008 was mainly caused by dipping housing prices, mounting borrowings, and undercapitalized banks. Sounds familiar, hey. Bear in mind, though, that these Chinese property market concerns have been brewing for a few years. Essentially, it’s a timebomb with a very long fuse. The scary bit is that no one’s sure how close we are to the boom.

What is China’s solution?

Authorities have jumped into action: the People's Bank of China (PBOC) sliced interest rates last week with hopes of revitalizing the economy. Plus, a media report over the weekend said that those highly indebted LGFVs may receive emergency loans directly from the central bank. Markets were underwhelmed though: stocks are still struggling and the country’s currency is faltering.

Officials and the central bank met with bank executives, instructing them to increase loans to encourage spending and, in turn, buoy up the economy. But demand for loans is still languishing: July’s monthly demand for loans in China was the lowest since 2009. To fix all that, the government may need a sizeable bail-out package.

Why should I care?

The US treasury secretary recently said that China’s economic slowdown will directly impact its Asian neighbors, and the US will see some spillover effects. Already, China’s weaknesses are clear in recent earnings results. Commodity prices – think iron ore and copper – have fallen sharply, with related firms like Rio Tinto and BHP getting hit where it hurts: profit. And many companies with Chinese exposure are also seeing the impact. In the US, Caterpillar and Dupont. In Japan, robotic manufacturer Fanuc. And in Germany, Siemens and Volkswagen, to name just a few.

So far, the US has held up. That’s partly because the government has huge spending programs to encourage investment in companies within its own borders. So while China had been the lucky recipient of foreign investment over the last decade or so, companies are now favoring the US, plus Mexico and India. That’s a bolster for the US economy, employment, and the stock market – but a drag for China’s domestic economy. If you want a piece of US markets, an equal-weighted S&P 500 like the Invesco S&P 500 Equal Weight ETF (ticker: RSP; expense ratio: 0.2%) could be a balanced option.

Stay cautious, though. If China, the world’s second-biggest economy, suffers a financial crisis, the US is unlikely to emerge unscathed. And get this: China’s the second-biggest holder of US bonds, just behind Japan. Over the last few months, China’s US bond holdings have dipped to their lowest level in 13 years. That matters: if China stops buying US bonds, yields in the US may move higher – bad news for stocks as investors’ attention could sway. And China may even decide to sell its US bonds in a bid to support its currency. The final kick: Japan could do the same, as yields start to look more attractive back home.

All that said, if China pulls out its big bazooka, all negative sentiment could disappear. After all, the country has a managed economy, where policies are regulated by the government, so a decision could very well be made to bail out private and public developers alike.

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