The acute plight of a Chinese financial trust company has cast light on how a crisis in the Chinese property sector is coming to pose serious challenges to the broader financial system in the People’s Republic of China (“PRC”).

Zhongzhi Enterprise Group’s failure to pay out is just the latest event in a slow-motion crisis now under way in the property and financial markets, exemplified by the insolvency of China Evergrande Group on 17 August 2023. The default has also made crystal clear that any failure to examine the structure of investments, or to conduct rigorous due diligence can, and usually will, lead to substantial losses for investors.

This is not a localised situation affecting Chinese enterprises only. Financial contagion is now a risk, and the Chinese government could further tighten capital controls if the situation worsens – not least as trusts have often moved funds offshore. Should it do so, then permission for the movement of funds out of China may become much harder to secure than presently.

The longer-term impact may include tighter regulation of the financial sector more broadly, which will also test investors. Looking forward, SVA can help foreign businesses anticipate and navigate such substantial financial, regulatory, and geopolitical risks.

A stop on payments

Zhongzhi Enterprise Group (“ZEG”) failed to make payments owed on investment products on 12 August 2023. Another affiliate, Zhongrong International Trust, also apparently halted certain payments in mid-August 2023, because of “a lack of liquidity”. KPMG is now reportedly helping the company restructure its debts.

ZEG had been a success story within its sector, but the malaise in the property market has taken its toll. Indeed, China Evergrande Group reported in May 2023 that ZEG had sued for repayment of a CNY1.9 billion (USD261 million) investment, before declaring insolvency in August 2023. Analysts consider that other losses are likely on ZEG’s books; some may relate to Country Garden Holdings, another property company defaulting on its debts.

The scale of the fallout is not yet clear – but it will be large. ZEG is reportedly managing some CNY1.37 trillion (USD189 billion) in assets, and some unconfirmed reports suggested that at least 30 wealth products sold through ZEG have or will cease payouts. Other ZEG affiliates, across a complex group, are managing even greater amounts.

Reasons for concern

These recent developments are significant because ZEG is amongst China’s biggest and most important trust companies. The trust sector had a value of more than USD2.9 trillion in 2022 and plays a crucial role in intermediating between savers and borrowers for investments in real estate and securities.

In reality, trusts operate as the “pipes” of the financial sector and lend where Chinese banks shy away. The sector, though, is loosely regulated, operating in the “grey economy”, and some trusts have historically helped local governments move debts off their balance sheets, or have even assisted in the movement of substantial funds out of mainland China.

Their exposure is hard to track, meaning that contagion is a real concern.

The regulatory response

The PRC government is clearly alive to the threat. On 12 August 2023, the National Financial Regulatory Authority (“NFRA”), a newly established enforcement agency, launched an inquiry to quantify and map the debt problems affecting ZEG.

Its actions suggest that official concern about possible financial contagion is strong – and growing. After all, this latest crisis is badly timed. The failure to pay out comes despite the authorities’ requesting trusts to scale back investments in real estate companies since 2018, and amidst a property slowdown, with major companies defaulting, or entering insolvency.

ZEG’s troubles have already affected the stock markets, prompting the government to intervene directly – as it did in August 2015, to prevent a market rout. China’s markets on 15 August 2023 reportedly requested that mutual funds delay the selling of securities, to ease the fall (although such measures have previously tended not to work).

More overt government intervention is possible – perhaps with the “national team” buying shares.

The longer-term consequences

This situation will have longer term consequences, too.

Closer regulation of the trust sector is now almost inevitable. This crisis will provide impetus to previous efforts to regularise the “grey” economy, so improving financial stability, but potentially also crimping lower-level lending – to the detriment of growth in many sectors, including property.

Similarly, the crisis will encourage measures by the government to rein in the broader financial sector, building on recent efforts to stamp out corruption in finance, to reduce the power of online payment providers, and to limit the availability of data to outsiders.

After all, financial instability will be viewed as a national security concern, justifying a range of further measures, with possible significant downstream consequences to the private sector.

Furthermore, the crisis may have implications for efforts to control giddying levels of local government debt. The State Council, in August, deployed teams to regions to examine local government books, much of which relates to property development.

It is likely that these teams will find that trust companies have played a role in the management (or hiding) of the local government debt burden, and that new, more aggressive investigations may follow.

How to respond

Investors will need to act swiftly to protect themselves and mitigate risk.

One consideration for foreign investors is that this crisis is occurring in an increasingly hostile geopolitical climate, with Sino-US tensions already extremely high.

The crisis may thus encourage some officials in China to look for scapegoats, as during the 2015 stock market crisis. The propensity for a heavy-handed response against foreign businesses, and associated miscalculations, is therefore real.

A related factor will be the structure of investments. A feature of many international bonds issued by Chinese property, and other financial, companies has been a reliance on a legally nebulous structure – with a British Virgin Islands (“BVI”) or Cayman Islands vehicle issuing debt based on contractually “guaranteed” revenues from onshore concerns.

Similarly, shaky structures may underpin equity investments. These mechanisms may not protect investors, or allow for the reclaiming of funds, in the event of a broader crisis – particularly if the authorities prioritise domestic over foreign investors.

Fundamentally, though, the ZEG crisis makes clear how investors need to carry out detailed investigationsinto investments, taking account not only of commercial concerns, but also of other risks that may derive from political, geo-political or regulatory shifts, including those in related sectors. Any failure to do so could result in serious losses.

SVA are specialists in these areas and can give impartial assessments as to levels of exposure.

What to do now?

This trust crisis highlights how the risks facing foreign business in China are also rising. These risks are real, but they are not insuperable.

SVA advise companies to respond to these risks, by:

• Adhering to robust and real world due diligence standards, which examine the risks facing an organisation in detail, and take account of non-commercial issues.
• · Assessing whether investments in shares or bonds in China rest on shaky “work-around” structures which no longer may be viable.
• Reassessing risks in the financial sector, to take account of the changing investment climate, and of the policy priorities of the Chinese government.
• Reappraising the risks of non-payment, and implementing measures to mitigate the impact, such as by buying insurance or using financial derivatives.
• Watching closely for early signs of fraud in companies that have received investment, with attention to questionable payment practices or misuse of documents.
• Considering alternative means to recover funds, such as asset searches outside China, or actions against key executives.

SVA has experience in all of the above and can assist as needed.

SVA

SVA (www.stevevickersassociates.com) is a specialist risk mitigation, corporate intelligence and risk consulting company. The firm serves financial institutions, private equity funds, corporations, high net-worth individuals and insurance companies and underwriters around the world.

SVA has three core lines of business, which are: Business Intelligence and Political Risk; Corporate Investigations; and Special Risk and Security. SVA also has a dedicated crisis management team which, for our retained clients, stands ready to assist companies during crisis situations.

SVA is based in Hong Kong, Singapore, and London and operates globally.