China’s trust deficit crisis prompts calls for policy response on shadow banking.

China's trust deficit crisis prompts calls for policy response on shadow banking.

China’s Property Sector at Risk: A Wake-up Call for Economic Stability

Chinese Real Estate

HONG KONG/NEW YORK, Aug 15 (ANBLE) – Chinese fears of a spillover from missed payments on some shadow banking linked trust products and worsening consumer sentiment are expected to hasten a policy response to revive the country’s cash-starved property sector.

Concerns about the outsized exposure of China’s $3 trillion shadow banking sector, roughly the size of Britain’s economy, to property developers and the wider economy, have grown over the past year as the sector lurched from one crisis to another.

Recently, Zhongrong International Trust Co, which traditionally had sizable real estate exposure, has missed repayments on some investment products, fueling contagion fears. Trust firms operate outside many of the rules governing commercial banks and mainly channel the proceeds of wealth products sold by banks to real estate developers, other sectors, and even some retail investors.

Barclays said in a note that regulators were likely to step in if the market environment deteriorates significantly, and measures used by China in the past to deal with spiking financial volatility have included liquidity injections. “The risk of a systemic shock to the Chinese financial system is not great, but the downward pressure on the economy will intensify,” said Yan Wang, chief emerging markets and China strategist at Alpine Macro. “These issues are all related, thus the contagion is already happening, and the risk of further spread is material. The government needs to act promptly and aggressively to contain the risk,” he added.

The Upcoming Policy Response

Beijing took a step in that direction on Tuesday by cutting key policy rates after a broad array of data highlighted intensifying pressure on the economy, mainly from the property sector. The latest challenge came from the shadows, with two companies saying over the weekend they had not received payment on maturing Zhongrong International Trust investment products.

Nomura said a wave of defaults on trust products could cause “substantial ripple effects” for China’s broader economy as losses suffered by individual investors, lured by higher returns, would have an acute impact on consumption. “This is something where the problems are probably not going to be confined to this individual trust but are going to spread to or become more evident in the trust industry as a whole,” said Arthur Kroeber, partner and head of research at Gavekal in New York. “I think they’re within the ability of the government to manage without any sort of dramatic explosion or blow up. But it’s a long, slow-burning problem.”

Behind the Scenes of China’s Property Problems

Even as China’s property problems have torn through the economy in the last few years, Beijing has so far managed to contain the impact on the financial industry. The trust sector had been a major fundraising channel for property developers seeking rapid expansion. But since 2021, when real estate slipped into a downturn, some of them have gone bust, while others have divested investments in property firms.

Beijing has also ramped up efforts since 2017 to reduce the size of the shadow banking sector amid concerns over financial stability. As of end-2022, assets held by trust firms totaled 21 trillion yuan, down about 20% from end-2017. The outstanding value of trust products invested in the property sector was 1.2 trillion yuan as of end-2022, down about 30% year-on-year. Still, exposure to the real estate sector varies from different trust firms.

“The real contagion may just be what we are already seeing – weak consumer and business confidence which is dragging down growth. The government is well aware of this but has so far been very timid in its response,” said Kamil Dimmich, partner and portfolio manager at North of South Capital LLP, in London. Barclays said since trust product clients tend to be wealthy individuals or companies, the authorities may have some “tolerance for market forces to play out”.

Rayliant Quantamental China Equity ETF co-portfolio manager Phillip Wool said the rise in defaults by trust firms would result in another hit to confidence, as home buyers will not feel comfortable putting down a big down payment. “As for whether Beijing steps in, I think we’re getting to a point where that has to happen. The deeper confidence sinks, the harder that is to reverse,” Wool added.

As the concerns over missed payments on trust products and the deterioration of consumer sentiment grow, China’s policy response becomes crucial to revive the cash-starved property sector. The fear of spillover effects from the shadow banking sector to the broader economy has fueled calls for prompt and aggressive action from the government. With the country’s shadow banking sector facing an outsized exposure to property developers, the risks and challenges have intensified over the past year.

Zhongrong International Trust Co’s recent missed repayments on investment products have ignited contagion fears, highlighting the need for regulators to intervene if the market environment deteriorates further. For China, the risk of a systemic shock to the financial system may not be great, but the downward pressure on the economy is expected to intensify. The interrelated nature of these issues has already triggered contagion, and the risk of further spread is significant, necessitating swift government action.

In response to the growing pressure, Beijing has taken a step by cutting key policy rates, reflecting the need to address the intensifying economic pressure. However, challenges persist, with some companies reporting non-payment on maturing trust products. This wave of defaults has the potential to cause substantial ripple effects on China’s broader economy, impacting consumption as individual investors face losses. The woes are not confined to a single trust, but there is a likelihood of widespread impact within the trust industry.

Behind China’s property problems lies the shadow banking sector, which has been a significant fundraising channel for property developers seeking rapid expansion. In recent years, as the real estate market has experienced a downturn, some developers have gone bankrupt, while others have divested their investments in the property sector. Beijing’s efforts to reduce the size of the shadow banking sector have contributed to diminishing assets held by trust firms. While this has somewhat mitigated the risks, exposure to the real estate sector continues to vary among different trust firms.

The real contagion of China’s property problems may already be evident in weak consumer and business confidence, which is hampering economic growth. Despite this, the government has been relatively cautious in its response. Given that trust product clients are often wealthy individuals or companies, authorities may exhibit tolerance for market forces to play out. However, defaults by trust firms will further damage confidence, making potential homebuyers reluctant to make significant down payments. At this critical juncture, the government may need to step in to reverse the deepening loss of confidence.

The future of China’s property sector rests on the government’s ability to effectively address the issues at hand. While the risks and challenges are significant, there is still room for the government to manage the situation without a dramatic explosion or blow-up. However, time is of the essence, as the slow-burning problem requires prompt and decisive action to safeguard the stability of the economy. By actively containing the risks and implementing appropriate measures, China can revive its cash-starved property sector and restore confidence in its financial industry.

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