[Song Seungseop's Financial Light] '4000000000000000 Won' Shadow Finance Becomes China's Trigger

Lending Money but Not a Bank?
Shadow Banking Hidden in Regulatory Blind Spots
China's Economy Growing Through Real Estate Development
Shadow Banking Stumbles as Limits Are Reached
Concerns Rise Over a Possible China-Version 'Lehman Crisis'

The capital of Hebei Province, Shijiazhuang, China, with a population of 11 million. Located adjacent to Beijing with excellent accessibility, unfinished apartment buildings that have been left abandoned for several years remain as eyesores. (Photo by Kim Hyunjung)

Can you imagine the number ‘4000000000000000 won’? You have to count from the very end to barely confirm that it equals 4000 trillion won. Even then, it’s hard to truly grasp how enormous 4000 trillion won is. It’s more than seven times South Korea’s budget this year (639 trillion won) and twice the total amount of credit loans held by all Koreans (1862 trillion won), making it an extremely large sum.

Such a staggering amount of money exists in China. It is in what is called ‘shadow banking.’ Recently, there have been claims that shadow banking is one of the causes behind China’s economic crisis, especially centered around the real estate market. How did shadow banking bring down China’s rapid growth?

Lending money but not a bank? ... Shadow banking hidden in regulatory blind spots

Paul McCulley, an American economist who first used the term "shadow banking."

Shadow banking is a term first coined by economist Paul Krugman in 2007. It refers to companies that perform roles similar to banks but are not subject to financial regulatory oversight and supervision. Investment banks, hedge funds, and private equity funds are typical examples. They tend to lend money without collateral or without fully disclosing investment risks. They create risky products and lend money, but their investment structures are complex, making profit and loss structures unclear.

Shadow banking is not inherently bad. It increases market liquidity. Imagine if there were no shadow banking and you could only borrow money from banks. It would have been much harder to get loans than now. Banks would reject loans if the business potential was even slightly lacking. Many projects that needed to be pursued despite risks would have failed one after another. From an investor’s perspective, shadow banking provides a variety of products. If you want higher returns than bank deposits, even if a bit risky, why would investing in related products be a bad thing?

A resort under construction that was built in anticipation of coastal tourism demand but whose construction has been halted. Such sites are abandoned throughout Dalian. (Photo by Kim Hyunjung)

The problem arises when market conditions are unfavorable. Shadow banking can cause losses larger than expected depending on market conditions. As mentioned earlier, low transparency makes it difficult to anticipate losses in advance. There are no safety nets. Banks can sell collateral they have secured in advance to recover losses, but shadow banking can lose the entire investment amount. The money flow structure is complex, involving numerous stakeholders, and a crisis in shadow banking can spread to the entire economy.

China’s economy grew through real estate development... now ghost cities emerge

China’s recent economic crisis is closely related to shadow banking. Until the outbreak of COVID-19, China achieved an economic growth rate of 6-7%. This was thanks to a solid domestic market, infrastructure development, and a booming real estate market. From 2008 to 2021, 44% of China’s Gross Domestic Product (GDP) was related to infrastructure and real estate development. This is much higher than the global average of 25%. The construction of much-needed roads, airports, power plants, and apartments created a strong economic stimulus effect.

A residential complex built by Chinese real estate developer Evergrande in Huai'an, Jiangsu Province, eastern China.
[Image source=Yonhap News]

Of course, large-scale development projects require enormous funds. The providers of this money were China’s shadow banking entities?investment trust companies. They played the role of financiers for real estate developers. They raised money by recommending investment products to individuals and companies and invested in real estate development projects. Instead of banks, China’s investment trust companies lent money to real estate developers. China’s investment trust industry rapidly grew to reach $2.9 trillion (3,893 trillion won) by the end of March, with real estate exposure reaching $155 billion (208 trillion won).

However, over time, problems of overinvestment and overlapping investments surfaced. While building buildings initially yielded excellent profits, after a long time, vacancies appeared and losses began to accumulate. Eventually, ghost cities were created. This means cities were built with borrowed money but no one actually lives there. It is known that dozens of such cities exist throughout China. Recently, even in the center of Beijing, buildings left unfinished due to halted construction and vacancies have started to be observed.

Chinese real estate firms facing default crisis, lenders also hit

A sign with the phrase "Rights Protection for Biguiyuan Home Buyers" is placed on a vehicle near a construction site on the outskirts of Beijing, operated by the large Chinese real estate company Biguiyuan.
[Image source=Yonhap News]

Then, real estate companies began to collapse. Last month, a subsidiary of the real estate developer Wanda Group faced a default crisis. They had to cover $400 million (about 535 billion won) in bonds maturing, but were short by $200 million. They barely overcame the crisis by selling shares, but it was a worrying sign. Recently, private real estate company Biguiyuan, with total assets of 330 trillion won, failed to pay $22.5 million in interest on two $1 billion bonds. Another real estate company, Yuanyang, failed to repay $20.94 million in bond interest.

When real estate companies failed to pay interest, the fallout hit shadow banking lenders. Zhongzhi Group and its affiliated trust companies, with assets exceeding 1 trillion yuan (about 182 trillion won), notified thousands of customers of suspension of principal and interest payments. Among its affiliates, Zhongrong International Trust played the role of lending money to real estate developers to build buildings, but due to investment failures, it reportedly entered a payment suspension state of 350 billion yuan (about 64 trillion won). Investors gathered in Beijing to protest, demanding their money back.

Real estate-related debt has already ballooned enormously. According to the National Bureau of Statistics, the debt ratio in the real estate sector rose from 274% in 2012 to 403% in 2017. Local governments, which led the projects, took a direct hit. China’s local governments borrowed money to build major infrastructure, but as real estate projects stalled, they ended up buried in debt. According to the International Monetary Fund (IMF), as of February this year, the total debt of China’s local governments is estimated at a staggering 66 trillion yuan (about 1,240 trillion won). Local governments have been selling or leasing owned land to construction companies to cover fiscal revenues, but even this has become difficult.

Chinese version of the 'Lehman crisis' looms... Chinese government takes measures

Foreign media are viewing this situation seriously. If China’s economy collapses due to the real estate crisis, other countries will also be affected. Some fear a Chinese version of the Lehman crisis. The Lehman crisis refers to the global financial crisis triggered by the bankruptcy of the U.S. investment bank Lehman Brothers in 2008. The cause of the Lehman crisis was also shadow banking that indiscriminately lent money in the real estate market.

Front view of the People's Bank of China. [Image source=Reuters Yonhap News]

To prevent the situation from worsening, China’s government, led by the People’s Bank of China, the China Banking and Insurance Regulatory Commission, and the China Securities Regulatory Commission, has allowed the issuance of special loan bonds worth 1.5 trillion yuan (275 trillion won). This is to help local governments repay their debts. Also, the People’s Bank of China lowered the loan prime rate (LPR), the de facto benchmark interest rate, by 0.1 percentage points to 3.45% in two months amid concerns over the real estate crisis and economic slowdown.

Editor's NoteFinance is complicated. Confusing terms and complex backstories are intertwined. Sometimes, you need to learn dozens of concepts just to understand one word. Yet finance is important. To understand the philosophy of fund management and consistently follow the flow of money, a foundation of financial knowledge is essential. Therefore, Asia Economy selects one financial issue each week and explains it in very simple terms. Even if you know nothing about finance, you can immediately understand these ‘light’ stories that turn on the ‘light’ of financial insight.

This content was produced with the assistance of AI translation services.