Chinese Shadow Bank Can’t Pay Up (2024)

Welcome toForeign Policy’s China Brief.

The highlights this week:A major Chinese wealth management firm declares itself insolvent, former U.S. Secretary of State Henry Kissinger is remembered in China, and Chinese President Xi Jinping makes an appearance in Shanghai.

Firm’s Insolvency Highlights Risks of Shadow Banking

Late last month, the Zhongzhi Enterprise Group, a big Chinese wealth management firm, declared itself “seriously insolvent.” The company disclosed that it held assets of around 200 billion yuan (about $27.98 billion) and an estimated 460 billion yuan ($64.37 billion) in liabilities. Five days later, China’s government opened a criminal probe into the firm, and now, two of its top executives are missing.

The problem for Beijing is that Zhongzhi is a key part of China’s so-called shadow banking system, or lending that takes place outside of conventional banks. This type of credit proliferates in China, meaning that the government needs to manage the company’s collapse or restructuring even as it determines criminal responsibility for its insolvency. It’s unlikely to be the only shadow banking firm that fails amid the country’s multifaceted economic crisis.

Shadow banking—broadly defined—is a $3 trillion industry in China; it includes institutions that aren’t conventional banks but lend money anyway. In China, that means microfinance companies, credit guarantee firms, and even pawnbrokers. (For example, pawn shops in China lent around $43 billion in 2017 alone.) Conventional Chinese banks are owned by the state, and lending is heavily regulated.

Shadow banking activities aren’t necessarily illegal, although the institutions involved sometimes do illegal things. They provide vehicles for conventional banks to dodge regulation: A 2015 report estimated that two-thirds of shadow banking activities in China were undertaken with conventional bank funding. When regulators prevented banks from getting involved in potentially profitable sectors, they turned to shadow banking to make the loans instead.

Some of these operations are legitimate finance, but many other activities fall into a gray area—carried out without formal approval from authorities but without breaking specific laws, for example. The degree of shadiness involved in shadow banking varies. One of China’s biggest shadow banking institutions is a government-run asset firm. Microfinance firms in China are government-approved and charitably inclined businesses, while loan sharks, of course, are not.

Shadow banking provides an easier flow of credit to small and medium enterprises (SMEs), which are the industry’s chief borrowers. The role of shadow banking soared after the 2008 financial crisis, when huge stimulus packages led to significant credit growth in China. Much of this money was invested in the real estate market, where developers were then able to access easy credit, and later moved into equity and commodity markets.

Aware of the risks, Chinese financial regulators still found themselves engaging in what Rhodium Group analyst Logan Wright called “regulatory whack-a-mole.” As regulators tightened rules, conventional banks shifted methods. Money that once came through regular lending now passed through the shadow bank system—even if much of it was ultimately provided by conventional banks.

By 2016, “[f]ar from controlling flows of credit, Chinese regulators were struggling to monitor where money was going within the financial system,” Wright writes.

That prompted a crackdown on shadow banking, but new regulations had two unwanted side effects. First, because private sector firms—and especially SMEs—found it more difficult to get credit, economic growth slowed. Then, the real estate bubble grew bigger. Conventional banks encouraged high interest-rate mortgages, especially presale mortgages. Developers used these funds as a replacement source of credit. This knot of credit, regulation, and construction created new opportunities for fraud and corruption.

One persistent problem facing regulators is working out whose interests are at stake in any particular scheme, and who they can afford to take down. For example, cleaning up the peer-to-peer lending industry in 2018 mostly affected ordinary people who were sucked into the ease of app-based investment. The government was tasked with managing public anger with frauds, mostly by crushing protests and offering partial compensation to those affected.

But Zhongzhi’s investors are wealthy individuals and corporate clients with ties to Chinese Communist Party (CCP) leaders; they now face considerable losses. Finding a way to clean up the economy without further damaging it—or disturbing the vast wealth of the people in charge—is a daunting prospect for Beijing.

What We’re Following

Kissinger’s death felt in China. The death of former U.S. Secretary of State Henry Kissinger prompted a flood of praise and reminiscences in Chinese state media. Kissinger, who passed away at 100 last week, was admired in China for his role in opening relations with the United States in 1972 by arranging then-U.S. President Richard Nixon’s visit to the country—and for his work promoting U.S.-China engagement in his post-government career.

Chinese officials saw meeting with Kissinger as a status marker. Then-Communist Party Secretary of Chongqing Bo Xilai brought him to the city in 2011 as part of Bo’s self-promotion efforts, and Qin Gang boasted of meeting him in 2021 while Qin was China’s ambassador to the United States. Kissinger represented a powerful connection to the past: A man who was photographed with former leaders Mao Zedong, Zhou Enlai, and Deng Xiaoping was a man that they could be photographed with, too.

Kissinger’s work after he left government also offered Beijing a direct line into influence in Washington. Yet the Chinese tended to overestimate his importance, especially as he aged; nominally retired but still prominent officials matter more in China than in the United States. But at its core, Kissinger’s realist approach to the world—in which superpower wishes mattered and human rights didn’t—made sense to his Chinese counterparts.

Xi in Shanghai. Chinese President Xi Jinping’s visit to Shanghai last week—the first in three years—saw him return to familiar platitudes about deepening “reform andopening-up” and making “greater contributions” to a “business model with Chinese characteristics.” As China’s biggest economic hub, Shanghai played a key role in Deng’s famous 1992 tour of southern China, where he reasserted the need for economic reform.

However, Xi’s goal is quite different from Deng’s: His messaging is about the need for ever-greater CCP control of finance and business. The regime’s main answer for the ongoing economic crisis is to tighten its grip on the economy.

FP’s Most Read This Week

• Chinese Hospitals Are Housing Another Deadly Outbreak by Annie Sparrow
• Henry Kissinger, Colossus on the World Stage by Michael Hirsh
• What Ridley Scott’s ‘Napoleon’ Gets Wrong About War by Franz-Stefan Gady

Tech and Business

U.S. tightens EV regulations. Recent regulations related to the U.S. Inflation Reduction Act (IRA) are bad news for Chinese firms—and perhaps for the U.S. energy transition. The rules, announced last week, disqualify electric vehicles made with parts from a supplier with ties to China from the generous IRA tax credit. That is likely to significantly slow down the production of electric vehicles, although advocates hope it will spur domestic development and break Chinese-controlled supply chains.

The Biden administration has made clear that it is serious about regulatory limits, especially on semiconductors. In a recent speech, U.S. Secretary of Commerce Gina Raimondo not only called for more funding for enforcement, but also singled out firms such as Nvidia for attempting to evade regulations.

Unearthing data. A fascinating recent paper by Oliver Kim and Joel Ferguson takes a new look at a critical moment in Chinese modern history: the introduction of the Household Responsibility System in 1978, which returned control of land back to individual farming households rather than the collective. The reforms marked a critical move away from state control and are widely credited with kickstarting China’s 1980s economic boom-times.

However, using weather satellite data that started in 1978 as well as modern machine learning techniques, Kim and Ferguson were able to measure wheat and rice production in China on the ground at the time through the Normalized Difference Vegetation Index. They found that the Household Responsibility System made no measurable difference to yield growth. This is a great example of how to use new tools to circumvent unreliable official data in China—a challenge that researchers have taken up with ingenuity.

As Kim emphasized when I spoke to him, this doesn’t mean that the Household Responsibility System had no impact at all. It could be that privately managed farmland was more productive, and it took less labor to produce the same yield, freeing up people for other work. But the new research also supports political scientist Joshua Eisenman’s suggestion that the official narrative about the system is a myth, and that real reforms had taken place earlier in the 1970s.