Behind the Great Wall: China’s banking system and the real estate quandary

Approximately 40 percent of all bank loans are directly tied to the property sector
Behind the Great Wall: China’s banking system and the real estate quandary
The mounting debt levels of real estate groups have reached a critical point

In recent times, a persistent concern has emerged: “What is unfolding within China’s banking system?” This question stems from concerns regarding the substantial exposure of banks to the high-pressure real estate sector and the associated fluctuating risks, ranging from instability to potential bankruptcy.

China boasts a colossal banking system and ranks as the world’s second-largest economy after the United States. Currently, this financial behemoth is grappling with a substantial impact brought about by a real estate crisis. Approximately 40 percent of all bank loans are directly tied to the property sector, presenting significant challenges for the country’s financial institutions.

The pressure on these banks is exacerbated by multiple real estate developers failing to meet their obligations to the banks or defaulting on foreign bonds. A prominent example is China’s real estate giant, Evergrande, which holds the title of being the world’s most indebted developer.

In recent decades, China’s real estate sector has undergone a remarkable expansion, enabling developers to sell properties prior to their completion and thereby acquire the financial resources necessary to support further projects. However, the mounting debt levels of real estate groups have reached a critical point, prompting authorities to intervene and impose restrictions on the expansion of these companies since 2020.

Consequently, there has been a notable reduction in credit accessibility for these groups, resulting in a situation where some are unable to complete their projects. This has undermined the confidence of potential buyers, leading to a decline in property prices.

In recent months, this unprecedented crisis has also impacted Country Garden, a prominent company in the real estate sector renowned for its previous financial resilience. Looking ahead, the magnitude of China’s real estate challenges suggests that the government might need to allocate substantial financial resources to safeguard banks.

In response to the intricate challenges presented by real estate debt, Beijing officials have introduced specific measures that highlight the difficult choices confronting policymakers. One such measure was the extension of repayment periods granted to borrowers, a step that carries the inherent risk of merely postponing the issue without providing a sustainable, long-term solution.

In an article by The New York Times, Andrew Collier, founder and managing director of Orient Capital, a Hong Kong-based economic research firm, emphasized the following: “If China fails to order the banks to write off bad loans in the property market, interest costs will continue to chip away at the economy, while too much capital will continue to be wasted on investments with no value.”

Despite concerns about the decline in China’s real estate prices, it is widely expected that the country’s banking system will not experience a series of major and uncontrolled collapses akin to what occurred in the U.S. some 15 years ago. This can be attributed to the significant size of China’s banking system, which holds an enormous four-fifths of the nation’s financial assets, including a majority share of bonds. Consequently, the government possesses substantial capacity to prevent the system from failing.

The primary reason for this resilience is that the Chinese government holds direct or indirect controlling stakes in almost all banks, providing it with significant influence over its future, even with its extensive regulatory powers. China’s financial system primarily relies on long-term bank loans rather than tradable securities, distinguishing it from the situation in 2008 when the global financial collapse was triggered by the decline in the value of such securities.

Additionally, stringent regulations are in place to control the movement of funds within and outside the country, effectively safeguarding China’s financial system against the sudden withdrawal of foreign funds that caused the Asian financial crisis in neighboring countries during 1997 and 1998.

Nevertheless, policymakers face a significant challenge due to the ongoing real estate issues in China, stemming from a history of excessive lending and speculative investments.

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Shadow banks

In the past, real estate developers enjoyed significant borrowing freedom from shadow banks, exceeding established borrowing limits to acquire land.

The concept of “shadow banking” originated in the U.S. in 2007, denoting financial services offered outside the formal banking system. These services are now subjected to stringent regulations and close monitoring.

China boasts one of the largest shadow banking sectors globally, with approximately 40 percent of the country’s existing loans tied to shadow banking activities. Despite their flexibility in lending to various entities, shadow banking institutions lack the same level of support as traditional banks. Consequently, a sudden and widespread demand for repayment can trigger a chain reaction of financial instability.

Credit companies play a prominent role within the “shadow banking” system, managing assets for clients and directly selling high-return investment products to both companies and individuals. The proceeds from these sales are diversified across various assets, including direct loans to companies or real estate enterprises. Notably, these borrowers often struggle to secure traditional financing from banks or the bond market.

However, due to Beijing’s restrictions on shadow banks, developers have been compelled to seek alternative financing avenues to repay their shadow bank loans. One primary strategy involves an increased reliance on pre-sales of apartments to homebuyers, facilitated through mortgage arrangements. Developers also opt for a slower construction pace to minimize costs.

In contrast, a significant portion of struggling real estate companies choose to conceal a portion of their debts from their official financial records. S&P has noted that many of these undisclosed debts have been absorbed by trust companies, operating within China’s shadow banking system.

Data from Chinese Industry Associations, cited by Nomura, reveals that about 7.4 percent of China’s trust funds, equivalent to approximately 1.13 trillion yuan ($159.15 billion), were linked to the real estate sector as of the end of March. Nomura estimates that the true extent of trust loans extended to developers is three times larger, reaching 3.8 trillion yuan by the end of June.

Within China, banks employ credit companies to mask the actual risk levels reflected in their balance sheets, simultaneously profiting from lending to restricted borrowers such as real estate developers and local governments. Estimates indicate that shadow banking services accounted for approximately one third of China’s total lending from 2012 to 2016. However, following Beijing’s crackdown on the sector, China experienced a 50 percent reduction in credit growth.

At present, Beijing faces the challenge of finding alternative avenues for economic support. Therefore, the future economic growth of China hinges on the financial system’s ability to efficiently channel its resources away from lending associated with domestic government investment projects and towards more sustainable paths.

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