Alarm bells are ringing louder in China as its financial cancer spreads

The self-declared “severely insolvent” status of one of China’s largest shadow banks has revealed another crack in a financial system stressed by abrupt and disruptive shifts in the country’s economic growth model and trajectory.

Last week, Zhongzhi Enterprise Group warned investors it would be unable to repay them, saying it had conducted a due diligence exercise that showed it was severely insolvent and “facing high risks of sustaining normal operations”.

Chinese President Xi Jinping. Beijing has little choice but to intervene, given the property sector’s crucial role in the economy.Credit: AP

In the near term, it said, “the amount of assets that can be used to repay investors is far below the total liabilities”.

Zhongzhi has total liabilities of between 420 billion yuan ($91.1 billion) and 460 billion yuan ($99.8 billion) but total assets of only 200 billion yuan ($43.4 billion), so it has a deficiency of as much as $56 billion.

The company, which said it had been “largely out of control” after the December 2021 death of its founder, Xie Zhikun, and a subsequent exodus of senior executives, once managed more than a trillion yuan of assets. The first signs that it was under pressure came in August, when it missed payments to an estimated 150,000 investors.

Zhongzhi is among the largest of the trust companies – or shadow banks – in China that raise funds from households by offering much higher returns than banks and investing them in stocks, bonds, commodities and real estate, including loans to developers.

Zhongzhi appears to have heavy exposure to China’s troubled property development sector, both through loans and ownership of properties bought from some of the teetering property giants like China Evergrande and Country Garden.

It’s not alone. The $4.5 trillion trust sector is thought to have an exposure to China’s depressed real estate sector of more than $1 trillion – although the sector is so opaque, it could even be more.

While the sector represents only about five per cent of China’s financial system, its links with property developers and developments – and the developers’ importance to local governments’ revenues – create a worrisome, self-fuelling and destructive loop for policymakers in Beijing.

The downturn in the property sector that is now continuing to spread like a cancer within China’s economy and financial system started when Xi Jinping introduced limits on developers’ leverage in late 2020. It came after decades of an increasingly speculative boom in property, aided by central and local governments that saw construction and infrastructure investment as vehicles for stimulating the economy with whenever growth was threatened.

Last week, Zhongzhi Enterprise Group warned its investors that it would be unable to repay them.Credit: Bloomberg

He wanted to shift China’s economy away from speculative activity towards a more sustainable, albeit lower-growth, economic model.

The sector imploded almost instantly and is still reeling, with a host of developers defaulting on their debts and leaving a vast number of housing projects uncompleted – homes that households and trusts had paid for under the pre-sales model the developers used to finance their projects.

It also undermined the finances of local governments, which relied on land sales to the developers and value-added taxes for much of their revenue.

Previous efforts to stabilise the property sector have been piecemeal and largely ineffective. Beijing has made it easier and cheaper for prospective buyers to get mortgages, lowering the amounts needed as down payments and reducing interest rates on new mortgages. The authorities have also extended some new loans to some developers to try to get projects completed.

Property investment and sales, however, have continued to shrink.

The International Monetary Fund has recommended Beijing allow distressed developers to fail, let house prices find their own level, fund completion of half-finished developments and help any viable developers to repair their balance sheets. However, the authorities have, until now, preferred to keep the companies on life support while allowing foreign investors in their bonds to be wiped out.

That might be about to change, with the authorities mulling a new approach as they try to salvage the better-managed developers.

One of the key measures in a new support package envisages a direction to state-owned banks to provide unsecured short-term loans – working capital – to 50 designated developers. Apparently Country Garden, China’s biggest developer, is on the list.

China made it easier and cheaper for prospective buyers to get mortgages, lowering the amounts needed as down payments and reducing interest rates on new mortgages, but its property sector continues to sink. Credit: Bloomberg

With an estimated $670 billion needed to stabilise the sector, even limiting the aid to the 50 developers regarded as worthy of assistance is going to involve significant new loans to troubled borrowers being taken on by banks that, while well capitalised, are already experiencing a significant increase in non-performing loans and pressure on their margins from a slowing economy.

Granting unsecured finance to companies already in trouble is akin to taking up equity in them and accepting the equity risk, but authorities obviously think the risk of failing to halt the continuing deterioration of the property sector is greater than the risks that would be taken on by the banks.

If the industry is to be stabilised, China needs to keep the better developers alive and able to complete the millions of currently incomplete apartment projects. This would defuse the threat the sector poses to economic growth and financial stability.

Zhongzhi’s distress is a warning bell that the property crisis has infected the trust sector and is impacting, or could impact, the millions of investors and trillions of dollars of assets within it.

While the sector represents only about five per cent of China’s financial system, its links with property developers and developments and the developers’ importance to local governments’ revenues create a worrisome, self-fuelling and destructive loop for policymakers in Beijing.

Zhongzhi isn’t the only trust company that is insolvent – earlier this year, New China Trust became the first to be declared bankrupt in decades – and more failures would only compound the challenges in stabilising the property sector while putting the other asset classes the trusts are invested in under pressure if they are forced into distressed sales to generate liquidity.

The key to preventing the steep downturn in property from doing more damage to China’s economy and financial system is halting the downward spiral in prices and helping those developers experiencing liquidity rather than solvency issues stay afloat.

Whether directing state-owned banks to prop the developers up is the best way to approach the problem is questionable, but it is clear that either Beijing bails out a significant number of large developers and helps fund completion of their projects or, as the IMF recommended, it allows them to fail and leaves it to the market to decide which companies and projects are salvageable.

Given how central property is to China’s economy and financial system, it isn’t surprising that the authorities’ preference is for intervention, rather than leaving it to market forces to sort out the mess, with all the destructive waves that might create within the financial system.

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