The recent turmoil in China’s banking sector, highlighted by the sudden disappearance of 40 smaller banks and the collapse of Jiangxi Bank, has raised alarm bells both domestically and internationally. The root causes of this crisis are multifaceted, involving an economic downturn, poor risk controls, and selective government support, which have culminated in significant challenges for Chinese banks, especially the smaller ones.

Economic Downturn and Poor Risk Controls

China’s economic landscape has been significantly affected by a downturn in the property market, a critical driver of the nation’s economy. This downturn has not only led to a decline in property prices and sales but has also severely impacted the banking sector. Banks, particularly smaller ones, have been burdened with an increasing number of non-performing loans (NPLs) as borrowers struggle to repay their debts. Reports indicate that some banks have NPL ratios as high as 40%, a figure that underscores the severity of the issue.

The situation is exacerbated by poor risk management practices within many of these smaller banks. These institutions have historically operated with less stringent risk controls, resulting in a build-up of risky loans. The lack of adequate risk assessment and mitigation strategies has left these banks vulnerable to economic fluctuations, particularly in sectors like real estate, which are highly sensitive to economic cycles.

Regulatory Actions and Government Support

In response to these challenges, Chinese regulators have initiated a consolidation process, absorbing smaller banks into larger, more stable institutions. This strategy aims to stabilize the banking sector by creating stronger entities capable of weathering economic shocks. For instance, in June 2024, 40 smaller banks were absorbed by larger ones, with 36 of them merging into the Liaoning Rural Commercial Bank, a new entity established to manage failing banks. This approach, while providing temporary relief, has raised concerns about the potential creation of “bigger, badder” banks, which could pose even greater systemic risks in the future.

Moreover, the Chinese government has become increasingly selective in providing financial support. Unlike in previous crises, where government bailouts were more widespread, current efforts focus primarily on larger, strategically important banks. This selective support approach leaves many smaller banks to fend for themselves, increasing the likelihood of further collapses.

The Shadow Banking Sector: An Emerging Threat

Parallel to the issues in the formal banking sector, China’s shadow banking industry faces its own set of challenges. Shadow banks, which include trusts, wealth management companies, and other non-bank financial institutions, operate outside traditional banking regulations. They have played a crucial role in China’s financial ecosystem, particularly in providing credit to sectors that traditional banks find too risky, such as real estate.

However, the shadow banking sector is now under strain due to tighter regulations and the ongoing property market crisis. Major players like Sichuan Trust and Zhongzhi have reported significant losses, with the latter publicly apologizing to investors for the losses incurred. The root of the problem lies in the substantial exposure of these institutions to the property sector, which has been on the brink of collapse since the default of major property developers like Evergrande in 2021.

Implications for Europe and the Global Economy

The turmoil in China’s banking and shadow banking sectors has far-reaching implications, particularly for Europe, which has significant economic ties with China. The European Union (EU) relies heavily on China for imports and exports, with key sectors like telecommunications, automobile manufacturing, and consumer products being deeply interconnected. The weakening of China’s financial sector could lead to reduced demand for European products and services, affecting companies like Volkswagen, Daimler, BASF, and BMW, which have substantial investments in China.

Furthermore, the potential collapse of shadow banks in China could reduce the availability of cheap land and facilities, such as industrial parks, which are crucial incentives for foreign direct investment (FDI). This could lead European companies to reconsider their investment strategies, possibly shifting their focus to other Southeast Asian countries that offer similar benefits.

Conclusion

The crisis in China’s banking sector and the struggles of the shadow banking industry present a complex and multifaceted challenge. While consolidation and selective government support provide short-term stability, they may not address the underlying issues of poor risk management and economic vulnerabilities. The ripple effects of this crisis could extend beyond China’s borders, impacting global markets and economies, particularly in Europe. As such, stakeholders must closely monitor developments and prepare for potential disruptions in global financial and trade systems.

____________________________________________________________________________________________________________