How property-hungry Chinese millennials and shadow banking could fuel a financial crisis

Millennials are borrowing heavily to invest in property, counting on the government to keep property prices buoyant. However, the rise of shadow banking means the government lacks the levers it has historically pulled to prevent a debt crisis

Andy Xie

Published: 4:15am, 1 Dec 2020

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China’s household debt has surged again after the Covid-19 pandemic was brought under control in May, driven by bets on property prices rising. By the end of 2020, household debt could reach 150 per cent of disposable income. Moreover, the debt seems to be concentrated among millennials. This generation may be collectively betting on the government keeping property prices rising for many years to come. If the government cannot keep this assumed promise, a financial crisis is likely.

China’s household debt has roughly quadrupled in the past five years to 62 trillion yuan (US$9.4 trillion). While detailed statistics are sketchy, data from some banks suggest that millennials are the main driver and betting on property appreciation the main motivation. The generational concentration makes it a higher risk to financial stability.

China’s financial system has been extraordinarily stable. Even when non-performing loans hit 40 per cent in 1998, the banking system kept going with minor tinkering. The bad banks that held non-performing loans recovered due to subsequent asset inflation, not serious structural reforms.

After China grew out of this banking crisis, the government’s financial strategy appears to have remained the same. When there is a financial problem, let time take care of it.

It worked because China had high growth potential and low leverage. China’s growth model has focused on investment and exports, backed by an undervalued exchange rate. Because of its size, China has been able to delay the inflationary pressure of monetary expansion by channelling excess liquidity into asset markets. Asset inflation has been the financial system’s main source of capital.

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The above model has been running into difficulties in the past five years, mainly because of declining growth potential. The productivity gain from investment has shrunk due to its repetitive nature. China’s labour force has been declining. When growth is low, rapid monetary expansion to prop up asset markets leads to rising debt, which makes the financial system increasingly fragile.

One critical element of China’s financial stability is state ownership of the banking system. When asset markets experience downturns, the banking system can postpone debt servicing and keep borrowers from going bankrupt. Hence, debtors usually have a chance to wait for asset prices to recover.

The rise of the shadow banking system is weakening this factor. The 2015 stock market crash was largely prompted by shadow banking firms liquidating their positions. The government couldn’t control a fragmented shadow banking system.

The shadow banking system has been growing in importance. Down payment financing, for example, is an important driver of the property market. Given the extreme property price-to-income ratio, similar to what Japan saw during its bubble heydays, down payment financing is becoming important for keeping demand up.

As banks hold the collateral, when push comes to shove, could borrowers simply stiff shadow lenders? When the market is on the upswing, this issue is not pressing. The debt payment can be securitised as the additional capital value provides comfort to the lenders. The trouble starts during a long-term market downturn.

The shadow banking system plays a bigger role for developers. Offshore corporate bonds are wired into onshore project companies as equity. Credit funds, either offshore or onshore, provide another layer of financing. Onshore banks lend on the basis of such equity and semi-equity funds.

The funds from such shadow lenders probably exceed 10 trillion yuan, much bigger than the subprime market that triggered the 2008 financial crisis. When the shadow banking system judges that the property market is entering a downtrend, a chaotic unwinding is likely.

There are some early signs that the shadow banking system is the chink in the armour of the state-owned financial system. The leverage-fuelled lending for stock market speculation in 2015 was one example. The latest are the bankruptcies of residential rental operators.

These entities rent properties from owners and re-lease them to end users, often at a loss. They keep cash flow positive by borrowing from shadow banks against the rental income. This is essentially a Ponzi scheme. They are now going bust in droves. The impact on the shadow banking system is yet to fully land.

The third party in this scheme are usually millennials. They are big believers in “clever” schemes that defy conventional logic. Because they have grown up during a prolonged period of asset inflation, they believe in debt-financed speculation. Even though the stock market crash in 2015 taught them a lesson, apparently the lesson wasn’t painful enough. All sorts of Ponzi schemes have mushroomed since.

Sales representatives talk to potential buyers in front of a model of a residential complex at a real estate exhibition in Wuhan, Hubei province, in May 2015. Photo: Reuters

Betting on property is the biggest among them. Most of China’s credit, estimated at three times GDP, is in property. It hasn’t been entirely smooth sailing for the market. The correction in 2008 was quite sharp, though government statistics always show a smooth trend. It did not snowball into a bigger crisis because Chinese banks wouldn’t foreclose properties and liquidate assets during a downturn.

Both banks and punters have adopted the strategy of waiting it out. Hence, the desire for more leverage has become ever more intense. It seems like a one-way bet. This is why demand for down payment loans has mushroomed.

Shadow banks promise their investors high yields in a low-interest-rate environment. They want to be sucked into Ponzi schemes because their operators see no downside from taking risks. If it doesn’t work out, they lose nothing. Their investors may demonstrate before the financial regulator’s offices, but few operators suffer real consequences.

As millennials’ desire for ever more leverage develops, bigger debt Ponzi schemes will emerge in the shadow banking system. The government is now trying to control some fintech platforms, really just shadow banks. The effort may be too narrow in scope and not long lasting.

The government ultimately depends on property speculation to sustain fiscal revenues. The shadow banks exist because the government needs them. The government is riding a tiger, one that isn’t likely to have a soft landing.

Andy Xie is an independent economist