China’s Zhongzhi Enterprise Group headline-making revelations have investors uttering global markets’ least favorite word: contagion.
A liquidity crisis at the troubled shadow bank comes just days after property development giant Country Garden missed coupon payments. Concerns surrounding Country Garden’s finances echo the China Evergrande Group default debacle of 2021.
Yet trouble in China’s US$3 trillion shadow banking sector raises the stakes considerably. The extreme opacity that pervades the industry means that neither investors nor credit rating companies know the true magnitude of leverage in the financial system.
Zhongzhi, with businesses ranging from mining to wealth management and high exposure to real estate, is a microcosm of the problem.
Its stumble has triggered broader fears of additional dominoes among Chinese conglomerates to fall. PTSD from earlier collapses of Anbang Insurance Group and HNA Group is just below the surface.
Since the end of July, Zhongrong International Trust Co, a leading company controlled by Zhongzhi, has missed dozens of payments on investment products.
It’s the latest sign of how China’s property debt woes are rippling through the economy and imperiling global markets.
“The worry is that a ‘Lehman moment’ beckons, threatening the solvency of China’s financial system,” says economist Xiaoxi Zhang at Gavekal Dragonomics.
Economist Ting Lu at Nomura Holdings adds that “markets still underestimate the aftermath of the significant collapse in China’s property sector.”
Concerns about Zhongzhi, which has more than 1 trillion yuan of assets under management, Zhang says, is a reminder that “debt strains from property developers and local government financing vehicles are spreading across China’s economy.”
The good news, Zhang adds, is that regulatory vigilance means a rerun of the 2008 US crisis is unlikely. The bad news is that debt strains are popping up in too many sectors for comfort.
In the case of Zhongzhi, its affiliated companies offer trust products and private “directed financing” wealth-management products to high-net-worth individuals.
These target aggressive returns — typically above 6% per year — in part by investing heavily in so-called “non-standard assets,” a residual category that spans products from trust loans to accounts receivables.
The end borrowers, Zhang explains, are often firms that can’t access traditional bank loans so they turn to these more expensive shadow-financing channels.
They include many property developers and off-balance sheet local government financing vehicles, which face serious debt problems this year.
“The elevated risk of this type of lending is reflected in returns on ‘collective’ trust products,” Zhang says, “which raise funds from more than one investor — the majority of trust products. These returns have remained elevated in recent years, even as bank lending rates and corporate bond yields have fallen.”
Goldman Sachs analyst Shuo Yang notes that “given the recent net asset value markdowns and redemptions, we expect growth in trust products to slow, which could result in tighter property financing conditions, and affect banks’ earnings and balance sheets.”
Those financing conditions are partly contingent upon the direction of central bank policies from Washington to Tokyo.
Economists at ING Bank wrote in a note to clients that “we think the Fed will indeed leave interest rates unchanged in September, but we don’t think it will carry through with that final forecast hike.” They worry that further rate hikes could heighten the chances of recession.
Yang’s Goldman colleague, chief economist Jan Hatzius, says the US Federal Reserve’s first rate cut after tightening 11 times in 17 months, will likely be in the second quarter of 2024.
By then, “we expect core personal consumption expenditure inflation to have fallen below 3% on a year-on-year basis and below 2.5% on a monthly annualized basis, and wage growth to have fallen below 4% year-on-year.”
Hatzius adds that “those thresholds for cutting align roughly with the annual forecasts in the [Fed’s] summary of economic projections and the conditions at the outset of the last cutting cycle motivated by an intent to normalize from a restrictive policy stance as inflation came down in 1995.”
In 2022, Hatzius adds, “We initially took the view that the Fed was unlikely to cut until a growth scare emerged, but we softened our stance earlier this year and have since assumed that a convincing decline in inflation would probably be enough to prompt cuts.”
This could relieve pressure on the People’s Bank of China to manage a widening gap between US and Chinese debt yields. In the meantime, though, analysts at Citigroup expect more trust defaults as headwinds bear down on China’s property sector. But in a recent note to clients, they stopped short at predicting of Lehman Brothers-like reckoning.
“As the problems in the property development sector are not new and have already been unfolding for several years, we think investors would have already psychologically prepared for the potential of defaults,” Citi writes.
Yet the opacity that surrounds the property sector is intensifying worries that Country Garden won’t be the last company to delay payment on private onshore bonds.
“Unlike banks, which have holding power and are able to roll over credit to wait for an eventual resolution, alternative financing channels such as trusts may default once trust investors are unwilling to roll over the products,” says analyst Katherine Lei at JPMorgan.
“The default events may lead to a chain reaction on developer financing, adding stress to privately-owned enterprise developers and their creditors,” Lei said.
The geopolitical scene is adding fresh headwinds for President Xi Jinping’s economy. Last week, US President Joe Biden banned US investors from investing in sections of China’s chips, quantum computing and artificial intelligence industries.
The step could upend efforts to lift Sino-US ties from their historic lows, adding to the reasons why investors are worried about China’s trajectory.
This latest step is “spectacularly bad timing for China,” says economist Eswar Prasad at Cornell University. It comes as confidence is “falling, growth is stalling” and China “seems to be sliding into a downward spiral” amid deflation, low growth and lack of confidence all feeding on each other, Prasad says.
Analyst Gabriel Wildau at political risk advisory Teneo notes that “the investment restrictions largely mirror export controls already in place, including those that ban exports to China of machinery and software used to produce advanced semiconductors.”
Wildau adds that “unprecedentedly tough restrictions that the US Commerce Department issued in October – soon to be expanded – already rendered new US investment in advanced Chinese semiconductor production effectively impossible, since any such factory would need imported equipment covered by those restrictions.”
All this, warns Jens Eskelund, president of the European Union Chamber of Commerce in China, amounts to a “perfect storm” damaging foreign investors’ confidence in Asia’s biggest economy.
“From an FDI perspective, China is experiencing a perfect storm in which there are many factors now conspiring,” Eskelund told the South China Morning Post, referring to supply chain chaos, manufacturing disruptions, geopolitical tensions and slowing economic growth that “affect investor sentiment.”
In the second quarter of 2023, multinational companies turned “less optimistic” on China in terms of macro trends, consumption, labor and cost metrics, according to Morgan Stanley’s mainland sentiment Index.
Morgan Stanley analyst Laura Wang notes that this marks the first time since late 2021 when all four areas showed deterioration.
What’s needed, analysts say, is for Xi’s Communist Party to make good on its 2013 pledge to give market forces a “decisive” role in Beijing’s decision-making. This means, in part, taking steps to put the proverbial horse before the cart.
Over the last decade, Xi’s party tended to over-promise and under-deliver reform-wise.
During the Xi era, China has opened equity markets ever wider to overseas investors. Beijing has done the same with government bonds, which are being added to a who’s-who of global indexes.
Trouble is, access to exchanges in Shanghai and Shenzhen often outpace the domestic reforms needed to ready China Inc for the global prime time.
China, as is often said, is working from its own playbook, one that even detractors grudgingly admit has a way of beating the odds. Myriad times since 1997, analysts, investors and shortsellers predicted a credit-and-debt-fueled crash that has yet to arrive.
Even so, there are certain laws of gravity that still apply to economies transitioning from state-driven and export-led growth to services, innovation and domestic consumption.
One of those laws states that developing economies should build credible and trusted markets before trillions of dollars of outside capital arrive.
This means regulators must methodically increase transparency, prod companies to raise their governance games, devise reliable surveillance mechanisms like credit rating players and strengthen the financial architecture before the world’s investors show up.
On Xi’s watch, China has become less transparent and the media less free. And this is the problem facing Xiconomics: too often China has believed it can build a world-class financial system after, not before, waves of foreign capital arrive.
Follow William Pesek on X, formerly known as Twitter, at @WilliamPesek