Haro on shadow finance in China. Beijing denounced "illegal crimes" and carried out "criminal coercive measures" – the official terminology for arrests – against officials of the financial institution Zhongzhi Enterprise Group (ZEG) on Saturday (November 25th). Expressions that the Chinese authorities reserve for the most sensitive cases, such as when Xu Jiayin, the chairman of the near-bankrupt real estate giant Evergrande, was placed under house arrest in September 2023.

This time, Beijing has taken on another pillar of China's economy. Unknown outside China, ZEG nevertheless represents "one of the most powerful players in shadow finance in China," said Xin Sun, an expert on the Chinese economy at King's College London. It is a part of the Chinese economy encompassing all the actors who finance the economy outside the traditional banking circuits.

In this parallel universe to traditional banks, Zhongzhi is one of the top of the class. It is a group that lends to both real estate developers and local governments, and also manages the billions of dollars that wealthy Chinese have entrusted to it.

'Severely insolvent'

As such, Zhongzhi Enterprise Group is seen as a key cog in a sector – shadow finance – that has long been an important driver of Chinese growth.

But ZEG is no more... as a shadow of its former self. The arrest of "numerous suspects" by the police is only the latest episode in a rapid descent into hell by the group specialising in parallel finance.

A few days before the authorities' intervention, Zhongzhi had declared himself "seriously insolvent" in a letter sent to investors. Specifically, the bank said it had amassed at least $59 billion in debt and had only $28 billion in assets. The group's officials also acknowledged that they did not know how to close the $31 billion hole.

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It's a debacle "that has been anticipated since at least this summer," Xin Sun said. In August, police had already had to intervene at the Zhongzhi headquarters to disperse a demonstration by Chinese who complained that they could no longer withdraw the funds they had placed in the hands of ZEG financiers.

The causes of Zhongzhi's downfall are well known: "The group is bearing the brunt of China's real estate crisis and the general slowdown in the economy," Xin Sun said. Founded in 1995, ZEG has over the years become the symbol of triumphant shadow finance in China.

Much more opaque and less regulated than the traditional financial sector, this alternative banking system often allows funds to be raised more quickly and offers investments at more advantageous rates than those of traditional institutions.

More than the French GDP

The sector soared after the 2008 global financial crisis, "when access to traditional credit became more difficult," notes the Wall Street Journal. The "shadowy" establishments then became the "best friends" of real estate developers and local authorities, quickly requiring astronomical sums of money to finance their extravagant new infrastructure projects, or to build entire cities.

Even traditional banks have "used these alternative structures as intermediaries to lend money to property developers," Xin Sun said. They were thus able to free themselves from some of the rules laid down by Beijing and limit risk-taking.

Shadow finance has emerged as a central part of China's real estate boom over the past two decades. And a coin that is worth a lot of money, since the economic weight of shadow finance is estimated at more than $2.900 trillion, a little more than the GDP of France (€2.639 trillion in 2022, or $2.881 trillion).

As long as China's growth was good, business was good for these alternative financial institutions. Traditional banks provided them with money that they then knew how to put to work, allowing the largest of them to diversify. As a result, Zhongzhi has become an important fund manager for wealthy Chinese and has been able to invest in areas as varied as mining and electric cars, according to the Financial Times.

But when real estate began to show signs of fatigue, these properties found themselves faced with developers finding it increasingly difficult to repay. Not to mention that with the slowdown in the economy, the investments made by these institutions have become much less profitable than expected. Hence Zhonghzi's setbacks, which are "a good indicator of the health of the Chinese economy," Xin Sun said.

Risk of contagion?

On the other hand, it is much more difficult to assess the consequences of the collapse of this conglomerate. Starting with the effects on the Chinese banking sector. Even less than a decade ago, it might have faltered due to the collapse of a piece of the puzzle of Zhongzhi's magnitude, but "since 2015, the government has encouraged traditional banks to distance themselves from these institutions, and they are now much less exposed to this sector," concludes a note from King's College London on the links between shadow finance and the banking sector, Published 2023.

"I don't think Zhonghzi's woes will have a contagion effect on the rest of the traditional banking sector," Xin Sun said. On the other hand, the shock wave will certainly be felt on the whole of shadow finance. "What is important to understand is that in recent years, these institutions have reinvented themselves as wealth managers offering more attractive returns than normal banks. But to attract investment, investors need to have confidence," notes Xin Sun.

Thus, beyond the banking sector alone, the difficulties of one of the most important players in this parallel financial circuit risk triggering a movement of mistrust that can be very costly. Many small and medium-sized enterprises in China still depend on the bets that these "shadow banks" were willing to make.

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