Throughout the past months, the shadow banking system and real estate sector in China became a topic of great concern. This is illustrated by the debt crisis at Country Garden - China’s largest property developer in 2022 - and missed payments at Zhongrong International Trust, one of China’s largest shadow banks. How deep is the problem?
To start the discussion, let us take a step back and note the importance of the real estate sector in China. In 2022, it only made up 6% of the Chinese GDP. But real estate also significantly impacts other sectors such as construction (7% of China’s GDP), manufacturing (28%) and financial intermediation (8%). Taking the direct and indirect contribution into consideration, real estate accounts for roughly 20-30% of the GDP.
Real estate was once a key driver of the Chinese economy but became increasingly a structural problem in the past years that could seriously impact economic growth. This issue is not exclusive to the private sector but affects local governments, which often fund their expenditures through selling land to property developers. The issues in the real estate sector are not new and still, we know little about the difficulties the sector faces due to the scarcity and quality of official statistics. The lack of reliable data drastically decreases transparency and thus increases risk for investors.
One of the main knock-on effects from the real estate slowdown can be found in the shadow banking sector. Shadow banking refers to a parallel financial system that operates outside the traditional regulatory framework. It consists of wealth management products, trust products, entrusted loans, and alternative financing and has played a crucial role in providing alternative financing channels for real estate developers and investors. The bank-dominated shadow banking system offer loans and credit to participants in the real estate market who may not qualify for traditional bank financing. But those financial instruments often come at a higher cost than those offered by the traditional banking sector, reflecting the higher risks taken.
Although shadow banking has helped fueling rapid growth in the Chinese real estate market, it also brings inherent risks. One major concern is the potential for excessive leverage and speculative behavior. Estimates about the scale of the shadow financing system vary across sources, but a report published by the Reserve Bank of Australia estimates that the size of the shadow finance system in China was ca. 40% of its GDP in 2019. While shadow banking was very lightly regulated until 2016, Chinese authorities have implemented various regulations aimed at curbing shadow banking activities in the real estate sector since. These measures include stricter lending standards, increased transparency requirements, and enhanced monitoring of off-balance-sheet transactions. The increased regulation reduced funding options in the real estate sector which was followed by the default of several property developers in the recent months. Opinions about the severity of the real estate and shadow banking issue diverge among economists.
We consider the brewing Chinese real estate crisis a lingering drag on growth, which exacerbates wider weaknesses that have surfaced over past months. These are sluggish growth in export trade, a literal standstill in domestic consumption momentum amid weakening labor markets, and slumping business investment activity due to higher uncertainty regarding China’s economic and financial performance over coming quarters.