Chinese ‘shadow banks’ & “Trust” Firms faces major financial trouble

Concerns are rising over China's $3 trillion shadow banking sector, equivalent to the size of Britain's economy, due to its significant exposure to property developers and the broader economy. The sector, marked by unregulated financial activities, represents around 40% of China's outstanding loans. Originating in the 1980s, after the People's Bank of China became the central bank, it saw commercial enterprises and private investors channeling funds into non-traditional financial products, fueling industry growth. The government's recent efforts to curb risky lending aimed to prevent wider economic risks, but worries persist about the financial stability of shadow lenders, including large institutions within this secretive industry. Trust firms, integral to China's shadow banking, are now under scrutiny, prompting renewed concerns about the sector's stability. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees. In the shadow banking system, credit is intermediated through a wide range of securitization and secured funding techniques, including asset-backed commercial paper (CP), asset-backed securities (ABS), collateralized debt obligations (CDOs), and repurchase agreements (repos). Credit intermediaries’ reliance on short-term liabilities to fund illiquid long-term assets is an inherently fragile activity that can make the shadow banking system prone to runs.

The “Parallel” Banking System: China's shadow banking system operates as a "parallel" banking system, driven by specialization rather than regulatory arbitrage. This includes nonbank finance companies that can be more efficient than traditional banks due to specialization and economies of scale in various financial activities. Notably, the dominance of the state in China, with the largest banks being state-owned, makes it challenging for non-state-owned businesses to access financing from traditional banks. The state-dominated financial system has fostered an implicit guarantee that the state would always provide support, shaping the borrowing and lending dynamics. Estimates of the size of China's shadow banking system vary widely but reach into the trillions of U.S. dollars.

Types of Shadow Banking Products

?? Wealth Management Products

?? Trust Products: Trust products encompass various financial instruments such as trust loans, unlisted equity, and asset trading. Non-bank financial institutions (NBFCs) like trusts, brokers, insurance companies, and securities firms design and issue these products, catering to both private investors and corporations. In China, financial firms, operating as trust companies, manage assets and invest on behalf of clients. Over the past decade, Chinese regulators have sought to curb the use of trusts by banks, as funds from trust products often flow to riskier borrowers through trust loans. In 2012, the trust industry became the second-largest sub-sector in China's financial industry.

?? Entrusted Loans: ?loans between companies with a bank serving as the intermediary

?? Alternative Financing: ?shadow banking activity involving smaller investments, and smaller, often rural investors and borrowers.?It includes peer-to-peer lending, micro-financing, pawnshop financing and financial leasing

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Shadow banking and real estate

China's property sector, constituting approximately one-fourth of the economy, is intricately linked to shadow banking, local government finances, and household assets. Real estate companies, driven by surging prices over the last two decades, acquired land from local governments, providing them with crucial revenue and fostering regional development. The rush among Chinese citizens to own homes or speculate on property further fueled the sector's growth. Developers, leveraging shadow banks to bypass borrowing limits for land purchases, sustained rising land prices and elevated housing costs to preserve profit margins.

Beijing's recent restrictions on shadow banking prompted developers, traditionally reliant on such financing, to seek alternative sources to repay existing loans. Consequently, developers turned to pre-sales of apartments through mortgages to homebuyers, while also cutting construction to minimize costs. This shift coincided with the financial struggles of major Chinese property giants like Evergrande and Country Garden, facing challenges in repaying substantial debts due to declining home sales and drying cash flows. Simultaneously, reports emerged of trust fund Zhongrong's failure to repay investors on certain products, revealing the interconnected financial woes within China's property and shadow banking spheres.

Hiding money in trust funds: Real estate companies in China are under scrutiny for concealing debt in trust funds, raising concerns about the loose controls and aggressive accounting practices prevalent during the boom years. Recent revelations suggest that struggling real estate firms kept some debt off their books. As of March, approximately 7.4% of trust funds' value in China, totaling about 1.13 trillion Yuan ($159.15 billion), was exposed to real estate, according to data from China Trustee Associations cited by Nomura. However, Nomura estimates that the actual level of developers' borrowings from trust companies is significantly higher, exceeding 3.8 trillion Yuan as of the end of June. This revelation underscores potential discrepancies in reporting and transparency. Some trust products invested in the property sector may not have disclosed the actual use of funds, intentionally obfuscating information to navigate financial regulations and maintain opacity regarding their financial positions.

UBS analyst who called Chinese bank turmoil says US$2.9 trillion trust industry is next

China's trust industry, responsible for nearly 10% of total loans, is facing warnings of distress and potential insolvency. Analyst Jason Bedford, renowned for predicting issues in China's regional banks, highlights concerns about the $3 trillion trust sector. Of the 55 trust companies reporting for 2022, 14 showed alarming levels of non-performing assets. Many trust firms, heavily involved in lending to troubled real estate developers, are grappling with the fallout from the government's crackdown on reckless borrowing. The sector's challenges underscore the impact of the property downturn on the financial sector, prompting warnings from credit rating agencies like Fitch and Moody's. As local governments face financial strains, China's leadership emphasizes addressing risks systematically to preserve overall stability. The era of high-interest rate lending to real estate developers by trust companies may be coming to an end, signaling a shift in the sector's landscape.

·???????? At least a quarter of trust firms seen deeply distressed

·???????? Many of these firms are “deeply distressed, potentially with their capital solvency at risk”

·???????? Trust industry has seen protests, bankruptcy this year

What risks do China’s shadow banks pose to the economy?

China's shadow banking sector presents escalating risks of a financial crisis, contributing to systemic risk in the country's banking sector. Chinese banks utilized trust companies to conceal true risk levels on their balance sheets, profiting from lending to restricted borrowers, such as property developers and local governments. From 2012 to 2016, shadow banking accounted for nearly one third of all lending in China, but Beijing's crackdown on the sector resulted in a 50% reduction in credit growth. Currently, Beijing faces the challenge of balancing the crackdown on shadow banking and real estate developer debt with other forms of economic support. The deleveraging campaign initiated in 2016 aimed at reducing systemic financial risks marked the beginning of China's structural economic slowdown. The country's future economic growth hinges on effectively redirecting financial resources from property-related lending and local government projects to more productive private sector firms. Without this shift, China's economic growth rates are likely to slow to 2% or below over the next decade, exacerbated by a shrinking labor force and high debt levels.