Shadow Banking - A Danger To Stability

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By Brett Hurll

12th September 2023

In the labyrinthine world of Chinese finance, the recent collapse of Xinhua Trust serves as a grim milestone, marking the first bankruptcy of a Chinese trust company in over two decades. The firm's assets, now being auctioned on Taobao at a 30% markdown, are symptomatic of a larger malaise afflicting China's trust industry, a sector that manages a staggering 21 trillion yuan. The bankruptcy is not just an isolated incident; it's a harbinger of systemic vulnerabilities that are now becoming glaringly apparent.

The Chinese economy, once a juggernaut, has been showing signs of fatigue, and nowhere is this more evident than in the beleaguered property sector. Trust companies, which have long acted as conduits channeling funds from investors to various sectors including property, find themselves in the eye of this storm. While the bankruptcy proceedings for Xinhua have been relatively uncomplicated, the alarm bells are ringing louder for Zhongrong, another behemoth in the trust industry, which recently defaulted on client payments. The market is rife with speculation that this could be the tip of the iceberg, and the tremors from these defaults could ripple through the economy.

During China's halcyon days of economic expansion, trust companies were the darlings of high-net-worth investors, often promising and delivering annual returns north of 10%. The sector thrived in a regulatory environment that was far more lenient than that for traditional banks. But the landscape has shifted dramatically. The once-implicit guarantee that the state would back these investments has evaporated, and as property developers begin to default en masse, the trust industry finds itself on increasingly shaky ground.

Take, for instance, Zhongrong, which managed a portfolio of around 630 billion yuan in trust products as of last year. The company has become a case study in how the woes of the property sector can metastasize into the financial system. When Sunac, a top-tier property developer, defaulted, local governments took the unprecedented step of freezing corporate funds to ensure the completion of ongoing projects. Among the cities that took this step was Wuhan, where investments tied to Zhongrong were frozen. According to ANZ Bank analysts, as much as 30% of trust investments could be exposed to the property sector when indirect investments are accounted for.

The potential for contagion is not to be underestimated. The trust industry is deeply entangled in a web of investments that include stocks, bonds, and local government projects. Jingwei Textile Machinery, a state-backed firm and Zhongrong's largest investor, recently opted for delisting from the Shenzhen stock exchange, citing "market changes," a euphemism that barely conceals underlying distress. Local governments, already burdened with an estimated debt of 57 trillion yuan, find themselves in a precarious position, raising questions about their ability to meet financial obligations.

Adding another layer of complexity is Zhongzhi, the parent company of Zhongrong. Managing about 1 trillion yuan across various asset classes, Zhongzhi is also grappling with a liquidity crisis, reportedly owing 230 billion yuan to a diverse investor base. The tremors from Zhongzhi's struggles are being felt across the investment management landscape, with a surge in inquiries from anxious investors, many of whom are ordinary white-collar workers.

Investor sentiment has been further rattled, contributing to the dismal performance of the Chinese stock market. The CSI 300 index, a barometer of market health, plummeted by over 6% in August. Government interventions, including a recent cut in stamp duty, have done little to stem the tide.

Regulatory authorities, while not oblivious to these challenges, have their work cut out for them. Since 2017, there has been a concerted effort to bring shadow banking activities into the light, but the regulatory clampdown has had the unintended consequence of sapping liquidity and confidence from the market. The issuance of shadow banking products is at its weakest in a decade, according to Capital Economics.

In the immediate term, the fallout is likely to be felt most acutely by affluent investors, given the high entry barriers for trust investments. However, this is cold comfort. The government has a narrow window to address these systemic issues, and the clock is ticking. A task force has reportedly been set up to scrutinize the problems at Zhongzhi, but given the intricate financial linkages, the findings could well open a Pandora's box.

In sum, the bankruptcy of Xinhua Trust and the tremors at Zhongrong are not mere blips on the radar; they are symptomatic of deeper, systemic issues that could have far-reaching implications for the Chinese economy. The trust industry, once a cornerstone of high returns, now finds itself at a crossroads, and the path ahead is fraught with uncertainty.