Consumer credit defaults, particularly in the real estate sector, have sharply risen since 2020. Last year, 8.5 million individuals were blacklisted for missed payments on mortgages, business loans, and various financial obligations. This marked a significant increase compared to 5.7 million in 2020. Missed payments and defaults are exerting immense pressure on lenders, who are selling off bad debts at record levels. This year, at Beijing’s urging, banks are set to issue 40% more securities backed by non-performing loans (NPLs) than last year. The buyers of these bad-debt-backed securities include fund managers and wealth management firms, demonstrating how a string of defaults in one market could send ripples through others.

In order to maintain their stability, the lenders are issuing special-purpose bonds. Since most of China’s large banks are state-owned, a banking crisis could easily spread to the rest of the economy, which is already growing at the slowest rate in decades.

Real estate losses have the potential to hit $4 trillion. Housing overcapacity in China is at epidemic levels, with enough empty apartments to house roughly 3 billion people. While in a free-market economy, these surplus properties would naturally undergo substantial price reductions to stimulate demand, Beijing is hesitant to allow real estate prices to plummet to market levels. This reluctance stems from the fact that these properties currently serve as collateral for loans. Selling off these properties at a discounted rate of 40% or 50% would inevitably lead to loan defaults.

Compounding the issue is the role of shadow banking in financing the real estate sector. Shadow banks, operating outside the traditional banking system, have provided alternative sources of funding, often with less regulation and greater risk. Their exposure to the real estate market leaves them vulnerable to defaults. In the narrowest definition of shadow banking, the industry is worth about $3 trillion. However, if that definition is expanded to include asset management products and consumer loans, the number balloons to $12 trillion.

Local governments in China, reliant on revenue from land sales, fund development projects through local government financing vehicles (LGFVs), which total around $13 trillion across the entire country. A decrease in land sales reduces the income of local governments, making it challenging to repay debts and fund essential projects.

LGFVs are intricately linked to the shadow banking industry. These vehicles are essential for local governments to finance infrastructure projects and other initiatives, as they have limited access to direct bank loans due to regulatory constraints. LGFVs allow local governments to raise funds while keeping the debt off their books, employing various methods associated with shadow banking including off-balance sheet financing, wealth management products (WMPs), and bond issuance. This practice involves entities like asset management companies (AMCs) and trust companies that repackage the debt as wealth management products (WMPs), which are sold to the public.

Late last year, several of China’s top shadow banking and WMP firms were late on or missed payments to investors. A leading shadow banking firm, Zhongzhi Enterprise Group, declared itself insolvent, while investment and asset management firm Wanxiang Trust was responsible for millions of dollars in delayed payments. Some experts claim that a collapse in China’s shadow banking system would not have profound, direct repercussions for traditional banks because the financial trust business only comprises about 5.3% of the portfolio of traditional banks and a collapse would mostly affect high-net-worth individuals. A counterargument, however, is that losses from defaults in the shadow banking sector would disrupt short-term funding at traditional banks while also causing a loss of depositor confidence.

The combined effect of these factors raises concerns about insolvency among property developers, shadow banking institutions, and local governments. Such insolvencies could precipitate a full-blown banking crisis and economic instability in China. Despite the gravity of the situation, the Chinese government faces the delicate task of supporting economic growth while averting a financial meltdown.

Possible scenarios range from a limited collapse, manageable by traditional banks, to a widespread collapse akin to the 2008 financial crisis in the United States. In response, the Chinese government has not intervened by providing emergency funding. Beijing has, however, begun facilitating mergers among smaller banks and rural banks, where the non-performing loan ratio was double that of the larger, urban banks. The large banks have also tightened standards for interbank lending, subjecting the assets of smaller banks to greater scrutiny. Local governments have also been selling special-purpose bonds to inject cash into the local financial system.

Over the past year, at least ten small banks have defaulted on commercial paper. The failure of a few small banks would not be a crisis, but there are about 4,000 small banks, and if a large enough number of them failed, this could negatively impact the entire banking system.

The government has signaled that it would allow real estate companies to go bankrupt, rather than bail them out. This is a bold strategy, given that real estate accounts for about a quarter of the country’s GDP. It is also worrisome because real estate loans account for nearly a quarter of loans held at banks. It seems that Beijing may allow small banks to fail or be absorbed into bigger banks, but it is unlikely that they will allow the biggest banks and the entire financial system to collapse with it. In order to prevent the real estate loans from tanking the banks, there is speculation that the central government may begin taking over failed developers.