The contagion risk of Zhongzhi’s bankruptcy filing is not only about trust companies but wealth management products

The domino effect of China's shrinking real estate sector is not a new story. However, investors and regulators are usually in extra high alert mode when it is related to the financial sector for a vital reason – the contagion risk. Zhongzhi is a good example due to two dangerous sets of linkages in trust companies and wealth management products (WMPs). Such fear is amplified by its recent bankruptcy filing. This note analyzes the severity of Zhongzhi's collapse and the implications.

Due to the regulatory changes since 2018, the direct exposure of China's trusts to real estate fell from 15% in Q2 2019 to 6.2% in Q3 2023, equivalent to a reduction of RMB 1 trillion. But there could be indirect risks that are not easily identifiable. For example, the rapid increase in allocation towards bonds from 14% to 29% may include exposure to asset-backed securities (ABS) and local government financial vehicles (LGFVs) without identifying real estate as the underlying assets. We expect the situation to be largely under control as leading players can absorb the losses at a cost. Still, it is possible to see a fallout of some trust firms with real estate exposure as high as 40% of total assets.

What worries us more is the potentially large amount of WMPs issued through private placement notes and financial asset exchanges, which can be loosely regulated. Financial asset exchanges are approved at the local government level, which is a prerequisite for WMPs. Unlike the formal issuance by commercial banks, some entities take advantage of the easy approval process to set up "camouflaged financial asset exchanges", which may not even be properly licensed. That said, some non-bank entities can fly below the radar and raise capital without proper disclosure to investors and risk management. It can be done with entities with some reference to exchanges but in other wordings, such as asset or industry registration firms. This is Zhongzhi’s case, and the size of the problem remains unknown on the industry level as the data is incomplete.

All in all, Zhongzhi's bankruptcy filing points to the rippling effect of real estate and some failures in the shadow banking sector. Although trust companies have reduced their exposure to real estate, the uncharted waters of wealth management products by non-bank entities can pose more credit risks.

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