China's shadow banking in structural decline as key lender defaults

Defaults by one of China's largest shadow banks points towards ongoing structural decline in the non-bank lending industry, despite a rebound in recent months.

By early September, at least four China Mainland and Hong Kong listed companies reported that state-backed Zhongrong International Trust Co. Ltd. had missed payments on maturing trust products, coming amid media reports that its controlling shareholder, Zhongzhi Enterprise Group Co. Ltd., was facing liquidity problems.

The Chinese government has been clamping down on shadow banking as the industry became too big and unregulated. The Zhongrong event is seen as a remnant of practices that regulators are squeezing out of the trust industry, S&P Global Ratings said in an Aug. 21 note.

While there are concerns that the broader financial sector may be hit, the type of trust sector products coming under pressure represents a fraction of assets in the financial system, Ratings said. This means that wider contagion risk is low even under the assumption that trust companies will still face pressure to repay customers for failed trust products that function as loans.

"What we are seeing is the last gasp of risky practice in the trust sector, which the regulator has explicitly banned for years," Yiran Zhong, credit analyst at Ratings, said in the note. "Events like this serve not only as reminder to the sector to exit such practices but also to investors that they are ultimately responsible for their risks."

Core shadow banking assets

Trust products, including entrusted loans and trust loans, make up the core shadow banking assets under the definition of the People's Bank of China. As of end-July, core shadow banking assets — including outstanding entrusted loans, trust loans and undiscounted bankers' acceptances — totaled 17.66 trillion yuan, up 1.67% from a year earlier, according to central bank data. Such assets have declined in recent years, the data shows.

Low systemic risks

China's shadow banking regained some strength during the COVID-19 pandemic after years of being squeezed since an anti-leverage campaign started in mid-2017, said Alicia Garcia-Herrero, chief economist for Asia Pacific at Natixis Corporate & Investment Banking. Several local governments leaned on shadow banks after their natural funding avenues, especially land sales, collapsed and pandemic-related expenses surged.

"I think Zhongrong has not only been a surprise the Chinese regulators but also to China's investors," said Garcia-Herrero.

Still, there may not be widespread defaults in the shadow banking industry as the government is "now very worried about the contagion effects" and may offer other solutions, such as forced or induced mergers, Garcia-Herrero said.

Despite the multiyear property market downturn in the world's second-largest economy, China has been trying to tightly control shadow banking and shrink it to a size where failures in the sector would not pose systemic risk. Shadow banking, where investors are mainly wealthy individuals and companies, has traditionally been a lifeline to cash-strapped businesses that do not qualify for direct bank loans. Property developers are among shadow banks' key clients.

The size of shadow banking assets was equivalent to 7.7% of that of bank lending by the end of July 2023, according to PBOC data, down from 20.1% in June 2018.

Shadow bank risks

"The recent development will probably speed up the Chinese authorities' campaign to bring the off-balance sheet problem loans back to the formal banking sector's balance sheet and put them under proper supervision," said Redmond Wong, Hong Kong-based Greater China economist at Saxo Markets.

The Zhongrong default "highlights the risks of the shadow banking sector, which grew out of regulatory arbitrage, channeling banks' funds or banks' customers' funds to lend to industries and entities that banking regulations would otherwise restrict," Wong said.

China Banking and Insurance Regulatory Commission (CBIRC), which has since been replaced by an umbrella supervisor for the financial services industry, expanded the definition of shadow banking in December 2020 to include a wider range of products such as wealth management and even pawn shops.

Legacy shadow banking activities, such as wealth management products that serve as loans, have nearly halved to 3 trillion yuan from the peak in 2020, and the industry's property exposure has dropped by 62% to 1.1 trillion yuan, or 5% of assets under management, according to Ratings. That is small, relative to the 400 trillion of assets in China's banking system.

As of Sept. 11, US$1 was equivalent to 7.29 Chinese yuan.