Zhongzhi shows China’s fear of losing control
The travails of Zhongzhi, a key player in China’s poorly regulated $3 trillion shadow financing market, underline why a future crisis in the country is more likely, not less.
Zhongzhi Enterprise Group declared itself on Thursday to be 'severely insolvent', with a debt pile of up to Rmb460 billion ($64.7 billion), against assets of just Rmb200 billion.
In the ensuing days, more details about the travails of the conglomerate, a key player in China’s sprawling and poorly regulated $3 trillion shadow financing market, spilled out into the public domain.
Beijing police accused the firm of having committed “illegal crimes”. In a letter to investors, the company admitted its management had run “wild”, resulting in investment products defaulting “one after the other”.
According to some estimates, three quarters of investor cash, as much as $56 billion, will be lost. Clients, most of them wealthier individuals, may recoup at little as $14 billion.
Zhongzhi’s case is far from unique. Beijing has allowed Baoshang, a regional lender once owned by a private conglomerate, to fail. An investment firm in central Henan province was accused of running a Ponzi-like scheme, with billions of dollars in deposits being frozen at village lenders. A local asset manager from the rustbelt northeast bailed out Shengjing Bank after borrowing heavily from the very company it was saving.
And this is just since the start of the pandemic. Moreover, that list only encompasses recent financial bailouts, scandals and insolvencies that have come to light.
China’s challenges run far deeper. In recent years, a host of once-mighty conglomerates have gone under. The property sector is in dire straits, with no end in sight. The country's demographics are a slow-moving crisis with no obvious solution. The Belt and Road Initiative has saturated many smaller or fragile nation states in debt.
All this runs counter to the ruling Party’s every instinct. It loves to project an aura of power and control. So why are the crises piling up so fast? Why are global investors fleeing a market that was tipped to rebound sharply in 2023, but instead is struggling for momentum? And why is a sizeable chunk of the financial sector in such startlingly bad shape?
Much of this comes down to control. Be it economic, financial, societal or political, Beijing covets it above all else.
Yet ironically the matter of control has become its collective Achilles heel.
Back in 2018, analysts Logan Wright and Daniel Rosen wrote in a paper published by the Washington-based Centre for Strategic and International Studies, that single-Party rule is perceived as being unstable by the Chinese people and even by China’s leaders.
A need to maintain stability at all costs makes market participants “more confident that Chinese authorities will intervene in the case of financial instability”, the authors said.
This leads those operating within the system (in other words, everyone) to assume that even if the financial risk of putting money to work in, say, a wealth management product, is high, it is nonetheless controllable, because the state will always step in to save the day.
The upshot is that financial market participants typically “continue lending to one another, even though the net result is to increase the overall level of risk within the system,” they added.
Risk levels are higher in China than elsewhere because authorities will almost always act to save a troubled financial asset
In other words, risk levels are acceptably higher in China than they are elsewhere precisely because authorities will almost always act to save a troubled financial asset (see Shengjing Bank, for instance).
Beijing’s desire for control will, counter-intuitively, always put it out of reach.
China’s political system “fosters implicit guarantees,” says Wright, who today is head of China markets research at New York consultancy Rhodium Group. “Investors believe Beijing will value social harmony/stability above all else, which drives lenders to make risky loans, and investors to buy risky products, based on the belief that Beijing will provide meaningful assistance in case of any financial distress.”
That conviction holds until the losses accumulate and those implicit guarantees are tested and found wanting.
China-watchers will also note that the Party never lets an important financial institution endanger the system. All the big commercial lenders except Shanghai-based Bank of Communications, which on Wednesday was added to the Financial Stability Board’s list of domestic lenders deemed too big to fail, are headquartered in Beijing.
They are all well-run with low levels of distressed debt and good risk management teams.
But as you venture out into smaller cities and towns, then the rural hinterland, quality and control recede. Sometimes it evaporates completely. China’s worst and riskiest financial firms, from banks and wealth-managers, to trust firms and state-linked financing vehicles – are all local companies that drive the local economy and benefit the local government.
“The central state just doesn’t have the capacity to get down to the local level where these issues often appear,” says Fraser Howie, co-author of 'Privatizing China'.
It is a reminder that the old proverb of the mountains being high and the Emperor far away – out of sight and mind and not in control – is as true today as it was 700 years ago during the Yuan dynasty.
Two more factors help to explain why China today faces so many compounding crises, financial and otherwise.
The first is that despite its self-image, the Party is a reactive, not a proactive, governing body. It let risky peer-to-peer lending networks balloon in size, complexity and influence before belatedly cracking down.
It long knew of a looming demographic crisis but only scrapped its one-child policy in 2016 – at least a decade too late.
It knows many local lenders, asset managers and government financing vehicles are in terrible shape, but overworked regulators only step in once their problems become terminal.
The second is a tendency for its current leaders to create problems for tomorrow’s leaders to solve.
In this way at least, China is like a functioning Western democracy. Only in this case, its president Xi Jinping, having surely granted himself a job for life by changing the constitution, is both yesterday’s and tomorrow’s man.
The buck stops with him.
China-boosters have answers to all of this. They can point to IMF data, with the economy projected to grow 5% this year and 4.2% in 2024. The country dominates the green-energy space, and its electric vehicle makers are well on the way to wresting control of the auto sector away from Germany and Japan.
It continues to generate countless great young companies, each desperate to sell shares to investors at home and abroad.
But so long as it continues to let problems mount perilously before stepping in, to slap errant financiers with fines after they run their firms into the ground, and to kick cans down roads in the hope that unsteady local banks will resolve bad-debt woes or find their own way out of insolvency, the Chinese government will continue to court danger.
Eventually, one of these financial mini-crises will mutate into a real monster. One that it cannot control.