China is in trouble.
The world's second-largest economy is grappling with growing financial distress, which means big problems for the nation's nearly $3 trillion shadow banking industry.
Chinese households are spending less, factory production is falling and businesses are investing more slowly than last year. Youth unemployment has jumped so much that Beijing decided to stop releasing the data. Meanwhile, the real estate market is in a free fall with home prices dropping and some big developers have defaulted.
What's happening: Shadow banks, or trust firms, which mostly operate outside of the formal banking system, are a hugely important financial sector in China. These institutions facilitate the movement of funds from investors to infrastructure, property and other areas of the economy.
China's government-backed banks have long maintained notoriously low interest rates on bank deposits, enabling these trusts — which often pay rates between 6% and 8% — to lure investors with the promise of higher returns. For years they've enjoyed a reputation as safe investment vehicles, protected against loss of capital. But now, China's economic woes have led some trusts to fail and saddled others with the risk of massive financial losses, leaving billions of dollars at the mercy of a crumbling economy.
The growing risk has stoked fears that a larger financial crisis is looming.
Recent developments have been less than encouraging: Some trusts are already falling, according to Chinese state media. Others are teetering on the edge. Zhongrong, one of the country's largest trusts that managed about $87 billion worth of funds for corporate client and wealthy individuals as of the end of 2022, missed payments to clients in August.
Experts worry that the fall of these trusts could potentially trigger a domino effect, spreading through the global economy. That's because shadow banks are not just a problem in China.
"These types of organizations exist throughout the world, especially in Europe. What's happening in China creates headline risk and contagion risk," said Phillip Toews of Toews Asset Management. The US has its share of shadow bankers too, according to the IMF.
The key concern, said Towes, is whether Western organizations have loaned to shadow banks and are now vulnerable. "That can create problems and affect the broader economy or the broader stock market," he said.
What may come next: The threat is grave enough that investors may unite in a call to action for China's government to push its regulatory bodies to rein in the unruly shadow banking sector.
So far, "we've seen defaults where the Chinese government is not stepping in," said Toews. That lack of intervention has led to a wave of protests by angry investors and heightened police presence outside of the offices of Zhongrong. The protests could indicate that the trust's problems run deeper than previously believed.
"The real interesting question to see is if [these protests] expand and if the government will step in. It doesn't really matter whether it's a real bank or a shadow bank, it's still money that's effectively vaporizing from the economy and they certainly can't tolerate a lot of additional money disappearing through shadow bank vaults."
Global equities sold off 3% in August, largely because of China worries.
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