Chinese trusts and wealth management companies have been struggling under the weight of tightening regulations and China's persistent property crisis - two phenomena that have hit the country's 'shadow banking' industry particularly hard and could have knock-on effects for Europe.
Shadow banks, such as Sichuan Trust and Zhongzhi, are non-bank financial institutions, such as credit guarantee companies, hedge funds and asset management companies, that provide some of the key services of banks despite not being traditional lenders.
It's a significant sector: according to the International Monetary Fund (IMF), at the end of 2015, the shadow banking industry across the G20 economies clocked in at about $92 trillion (€84.9 trillion).
However, despite providing similar services as banks, shadow banking institutions are not regulated in the same way as most traditional commercial banks, thus existing in the “shadows”.
The rules governing regular banks that their shadowy counterparts are exempt from include things such as meeting certain capital reserve requirements, transparency requirements and performing thorough background and credit checks in certain instances.
The shadow banking industry can be key to propping up a country’s economy, due to often filling a gap that traditional commercial banks leave: for example, traditional banks usually shy away from issuing risky, high-interest short-term loans based on an applicant's upcoming paycheque, whereas shadow banks can be quick to lap them up.
Why are China’s shadow banks failing?
In China, the shadow banking industry accounts for about 40% to 60% of the country’s gross domestic product (GDP), although estimates vary significantly.
Back in November 2023, one of China’s biggest asset and wealth management companies, Zhongzhi, revealed that it was “severely insolvent”, having liabilities of about 460 billion yuan (€59.0 billion).
By contrast, the firm’s assets only came up to around 200 billion yuan.
In a letter to shareholders at the time, as reported by The Guardian, Zhongzhi said, “ The group deeply apologises for the losses caused to investors. We fully understand the urgency, importance and seriousness of resolving this overall risk”.
The company blamed this situation on the exodus of a number of senior executives, which in turn, severely disrupted internal management. However, experts believe the underlying Chinese property crisis could be the real reason behind China’s shadow banking industry struggle at large.
This is because much of the funds that shadow banks earn from selling investment products are then funnelled to the country’s vast property sector. However, in the past few years, this sector has been on the brink of collapse.
One of the main causes of the property sector crisis was when one of the biggest Chinese property developers Evergrande defaulted on its bonds back in December 2021, triggering a chain reaction across other major real estate developers such as Country Garden.
Tighter regulations, such as a limit on property developer debt levels, have also added to this crisis.
Back in March 2023, according to Japanese bank Nomura, about 7% of Chinese trust fund assets were exposed to the property and real estate sector. This was estimated to be about 1.13 trillion yuan. However, due to the lack of transparency in this sector, the actual figure could be much larger.
In May 2020, another trust, Sichuan Trust, also admitted a deficit of about 20 billion yuan, which was later thought to be as much as 30 billion yuan.
Although the company also blamed this on the tighter regulatory environment, there had been several concerns about the company in recent years. These included questionable practices such as illegally transferring money to shareholders and illicit loans.
As reported by The Guardian, Diana Choyleva, chief economist at Enodo Economics said, “Sichuan Trust was one of the earliest to fail. But its issues are broadly representative of issues that face the whole industry because of the rolling crisis in real estate.”
Real estate developers in China can often find it difficult to borrow large amounts of funds from traditional commercial banks, due to them being seen as riskier companies. This has led to them relying heavily on trust for the required financing.
Choyleva explained that Chinese trusts heavily invested in the property sector will likely need to alter their business approach over time.
“They may shift their financing to the government’s preferred industries, such as hi-tech manufacturing,” she said. “But banks are much more willing and able to lend to these companies than they were 20 years ago, reducing the demand for trust products.”
“As the potential investment returns in this area are much more uncertain than during the peak years of property growth, the attractiveness of their products to retail investors will also decrease,” Choyleva added.
The rise of fintech lending in China is also threatening the shadow banking sector.
It allows a wide variety of apps, including non-finance-related apps such as the microblogging platform Weibo and news aggregator Toutiao all offering micro-lending packages.
With loan applications being easy and very fast, several borrowers may take out multiple loans simultaneously, eventually leading to default.
The almost instant nature of these loans also means that most companies don’t have the time to properly vet borrowers and establish safe lending practices.
How could China’s shadow banking industry woes impact Europe?
The European Union is heavily dependent on China as an import and export partner.
In 2022, the EU’s top imports from China included telecommunications equipment, automatic data processing machines and electrical machinery, according to Eurostat, the bloc's statistical office.
On the other hand, some of the top exported goods from the EU to China included motor vehicles and electronic tubes and valves.
The wavering of the shadow banking industry could go much beyond the financial sector, potentially impacting European foreign direct investment (FDI) in the country as well.
Currently, the food processing, automobile, pharma and biotech, consumer products manufacturing and chemicals sectors are some which see the most FDI in China.
Companies like Volkswagen, Daimler, BASF and BMW are heavily invested in China. However, the collapse of several Chinese trusts can also mean less demand for European products, especially in the consumer products and automobile sectors.
Furthermore, if shadow banks start to wind back their investments in the property sector, this could also lead to fewer incentives for European companies such as cheap land and facilities such as massive industrial parks.
As such, China may not remain such an attractive investment option for European companies anymore, who may have to find other cheap Southeast Asian manufacturing options then.
The tightening regulations impacting shadow banks could also deter more European investment in China, especially as both the EU and China are working on methods to increase self-reliance currently.
One of these includes attempting to produce high-demand goods such as electric vehicles entirely domestically, without relying on foreign supply chains.
