Risks of a financial crisis resurface: China holiday wrap-up – Part 3

Economics: Deflation, property stress and financial contagion

• Summary: The past weeks saw another turn in sentiment on China as property stress resurfaced, signs of shadow banking problems appeared and economic data disappointed. The new financial challenges is a blow to China's efforts to restore confidence and lift private demand and it highligts downside risks to growth in coming quarters. The set-back followed shortly after rising optimism on the back of the Politburo meeting in July, which pointed to more forceful efforts to support growth. Below is a short overview of the recent events and economic data:
• Property stress returns: China's biggest private developer Country Garden is seeking to delay payments on a private onshore bond for the first time, according to a source. The developer has been seen as one of the stronger names, and its' prospect of default underlines the amount of big stress in the sector. Weak home sales give developers too few cash to meet their obligations feeding a negative confidence spiral as the negative headlines hurts buyer sentiment and home sales even more. There is a clear need for the government to step in more forcefully to lift home sales and provide adequate funding for the stronger developers. Chinese policy makers continue to be behind the curve and while it adds stimulus it is so far not strong enough to turn the tide. 
• Contagion to shadow banking: On top of the property woes, signs of contagion to other parts of the financial system has emerged this week. Trust funds linked to the financial giant Zhongzhi Enterprise Group have missed payments on several high-yields investment products. Many of these trust products are linked to developer loans and clearly exposed to contagion from developer stress. As these products are held by private households, it provides a risk that money is pulled out of the shadow banking system if big losses start to materialise. This could trigger a drain of liquidity and a credit crunch, again adding to current financial challenges. With confidence already weak, there is a real risk the a financial snowball keeps getting bigger making it more and more difficult for Beijing to rein it in. While it controls a large part of state funding via state-owned banks, there are no guarantees on trust products and money could start to flow out of these quickly if fears rise. While I do believe Beijing understands these risks (it is a key reason it has cracked down on shadow banking since 2016), it doesn't rule out that they come too late or with too little force because the underestimate the magnitude of the challenge. When financial confidence is shaken the policy response is crucial. I do expect policy makers to take steps soon to stabilize confidence and for example provide life lines to big financial companies and developers. But risks have clearly increased and this space needs to be monitored closely

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