Most economists tipped 2023 to be China’s year. As the dragon finally emerged from its lockdowns, it was assumed the Chinese economy would experience the same resurgence that its global counterparts enjoyed across 2022. There was also some optimism that China could ‘save’ the global economy.
The reality has been far from the optimistic hopes in the start of the year.
The last month alone has proven particularly challenging for China as it faced firstly another property crisis, with Evergrande in bankruptcy protection and Country Garden barely avoiding default, and now a crisis in its shadow banking sector.
You can read more about the structural issues in the Chinese economy in this wire by my colleague David Thornton.
While the saying goes “when the US gets a sniffle, the world catches the flu”, this could equally be true of China. Here’s what you need to know.
Shadow banking is finance or bank-like activities, primarily lending, outside traditional banks. It occurs in all countries and can actually be positive for increasing alternative funding channels.
China’s sector is particularly large and valued at around $3 trillion. Estimates range for its size, though the Reserve Bank of Australia suggests it is around 40% of GDP. The sector surged to fund construction activity and, at one stage, represented around 60% of GDP.
A range of reforms and restrictions were introduced in recent years to better regulate the industry, such as cutting down interest rates that shadow banks were able to charge. The crackdown cut credit growth by around half in China.
Chinese property developers have relied heavily on the shadow banking sector in the past to fund construction activity. This allowed them to bypass limits on borrowing for land purchases with traditional banks. Developers have started to struggled to repay their debts as land prices have risen, but home sales have fallen.
Two notable developers on this front have been Evergrande and Country Garden. Another developer, Shimao, also revealed it owed more debt than previously declared.
Trust companies are a significant part of the shadow banking sector used to fund developers. China Trustee Associations data indicates 7.4% of Chinese trust fund value is exposed to real estate, though Nomura suggests actual levels is more than three times that.
Off the back of the challenges in the property sector, shadow banks will start to feel the impact of unpaid debts. Xinhua Trust went bankrupt back in May and one of China’s largest trust funds, Zhongrong, which managed around $87 billion as at December 2022, missed payments to clients in August, amidst whispers of worse to come.
Traditionally the Chinese government has been swift and successful in implementing stimulus. The Global Financial Crisis was a key example of this, with the government implementing one of the largest packages in the world and being the first major economy to recover. But times change and to date, the Chinese government has been implementing smaller measures.
In the past two weeks, it relaxed requirements on mortgage down-payments and mortgage interest rates, cut trading fees on the stock market and lowered the reserve requirement for most banks by 25 basis points last Friday. It's also expected to hand down cuts to its loan prime rate this week.
Time will tell whether this will be enough to restore confidence in the economy, spark an increase in new loan issuance, and stem the crisis. At this stage, there is little to suggest that the Chinese government has the appetite for a larger stimulus boost.
The Chinese shadow banking sector can be quite opaque in its dealings but there is a lot of cross-lending, and trusts like Zhongrong are a significant part of the sector. The Chinese property sector is obviously quite leveraged to the shadow banking sector so with crises in both parts, there is a contagion risk to other industries.
Bear in mind that a lot of Chinese consumers invest in the shadow banking industry due to the more attractive rates on offer compared to traditional banks. A collapse in the sector will affect millions – this in turn is likely to mean a hit to Chinese consumption across the board.
It’s also hard to assess the extent that Chinese shadow banks – particularly investment trusts – have invested across the globe – or have borrowed across the globe. Defaults in the sector could have implications for global lenders and institutions.
Australia is significantly tied to China, with the bulk of our exports heading there and commodities are top of the list. The crisis in the property sector was an early challenge for imports in iron ore in particular. That said, in the wake of trade sanctions, many Australian exporters diverted their partnerships to other countries.
We’re in a better position than we may have been a few years back, though we’re hardly out of the woods. At this stage, concerns over China have seen the Australian dollar decline against the US. There are some concerns for our property sector, given companies like Country Garden operate here too on major projects.
Chinese A-shares and the Hang Seng may experience volatility in both the short and medium term.
Global equity markets may experience some volatility in the wake of crises in China, particularly in markets like Singapore and Australia with a greater reliance on and exposure to the Chinese economy.
How long this volatility persists will depend on the extent of the crisis - if we see more big trusts fail, that has obvious implications for Chinese consumer spending and a range of sectors off the back of that.
From a direct share perspective, companies with a greater percentage of sales to China may experience challenges should the shadow banking sector crisis develop further and affect consumer confidence.
Typically weakness in the Chinese economy would also spell weakness in commodity prices though prices have remained resilient at this stage, and even risen. That said, the likes of BHP (ASX: BHP) and Rio Tinto (ASX: RIO)
will obviously be wary of activity in China affecting exports, though they have done some work in recent years to diversify trading partners.
Any collapse in the Chinese shadow banking sector would lead to some defaults in Chinese bonds – both from the traditional banking sector as well as the shadow sector.
The intertwine of the shadow banking sector and property sector in China may mean implications for various property markets that Chinese developers have operations in too.
In terms of positioning assets for this, the usual rules of investing apply. Think long-term, think quality and keep broadly diversified.
From an historic point of view, it’s also worth not underestimating China and the power of even small policy measures. China has risen before from crises, and if not, sometimes the best opportunities come from a wildfire – perhaps a crisis will simply sift out the quality from the over-leveraged in the Chinese market.
This article was originally published for Livewire Markets on Monday, 18 September 2023.
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