Growing Financial Instability In China Due To Shadow Banking

China’s “shadow banking” sector is experiencing a growing crisis, posing a threat to an already troubled economy. Simultaneously, doubts are emerging about Beijing’s capacity to use fiscal stimulus as a rescue strategy, according to a recent report.

Bloomberg News reported on Wednesday that Chinese authorities have engaged Citic Trust Co., a subsidiary of China Construction Bank, to assess the condition of Zhongrong International Trust Co. This move is reminiscent of a previous assessment Citic conducted in 2021, which preceded a massive bailout package designed to prevent a major asset manager’s collapse.

Zhongrong, a significant player in China’s $2.9 trillion trust industry and a subsidiary of Zhongzhi Enterprise Group, holds nearly $90 billion in investor assets. Recently, it failed to meet payments on multiple investment vehicles, raising concerns about its financial stability.

This financial instability in the trust sector coincides with Beijing’s struggles to sustain economic growth. While economists suggest the need for a fiscal stimulus package, a fresh analysis by Rhodium Group, a U.S.-based research firm specializing in the Chinese economy, indicates that the central government’s ability to address the crisis through spending may be more limited than previously assumed.

The term “shadow banking” refers to a sector in China that channels money into various investments across different sectors outside the traditional banking lending system. These companies are prominent in China and have offered Chinese investors higher returns on savings than bank deposits, often with the promise of capital protection.

These high returns were feasible when China’s economy was growing at double-digit rates, but they have become challenging to achieve in recent years. A significant portion of trust sector assets was funneled into the volatile Chinese real estate market.

Goldman Sachs estimates potential losses of up to $38 billion across the Chinese trust sector.

Zhongrong sells numerous investment products designed to provide regular income, making it challenging to conceal a severe crisis. Analysts have identified multiple products that have missed payments to beneficiaries, and some short-term investment vehicles are reportedly no longer allowing investors to withdraw their funds.

The real estate industry’s struggles appear to be a significant factor in Zhongrong’s crisis, as the company heavily invested in this sector with the expectation of a rebound that has not materialized.

Although the Beijing government has taken steps to boost the economy, such as rule changes to support the stock market, some economists believe that a fiscal stimulus package may ultimately become necessary. In the past, China relied on large government investments in infrastructure and industry for economic growth. However, Rhodium Group’s analysis suggests that the central government’s ability to provide such relief may be more restricted than before.

Despite the perception of low government debt levels giving Beijing ample “fiscal space” for significant stimulus, Rhodium Group’s researchers argue that structural issues in revenue collection pose more limitations than commonly understood. They state that China’s fiscal capacity is highly constrained, with revenues declining relative to the economy’s size. Persistent deficits, even though they can be financed internally, will restrict both strategic spending ambitions and the use of fiscal stimulus to support growth in the coming years.