What’s going on with China’s shadow banking system?

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New York

China is in trouble.

The world’s second-largest economy is grappling with growing financial distress, which means big problems for the nation’s nearly $3 trillion shadow banking industry.

Chinese households are spending less, factory production is falling and businesses are investing more slowly than last year. Youth unemployment has jumped so much that Beijing decided to stop releasing the data. Meanwhile, the real estate market is in crisis with home prices dropping and some big developers have defaulted.

What’s happening: Shadow lenders, including trust firms, operate outside of the formal banking system. They’re only lightly regulated and are a hugely important part of the financial sector in China. These institutions facilitate the movement of funds from investors to infrastructure, property and other areas of the economy.

China’s government-backed banks have long maintained low interest rates on bank deposits, enabling these trusts -— which often pay rates between 6% and 8% -— to lure investors with the promise of higher returns.

For years they’ve enjoyed a reputation as safe investment vehicles, with the now discredited notion that they were protected against loss of capital. But now, China’s economic woes have led some trusts to fail and saddled others with the risk of massive financial losses, leaving billions of dollars at the mercy of a slowing economy. The growing risk has stoked fears that a larger financial crisis is looming.

Recent developments have been less than encouraging: Some trusts are already falling, according to Chinese state media. Others may be teetering on the edge. Zhongrong, one of the country’s largest trusts, which managed about $87 billion worth of funds for corporate clients and wealthy individuals as of the end of 2022, missed payments to clients in August.

Experts worry that the fall of these trusts could potentially trigger a domino effect, spreading through the global economy. That’s because shadow banks are not just a problem in China.

“These types of organizations exist throughout the world, especially in Europe. What’s happening in China creates headline risk and contagion risk,” said Phillip Toews of Toews Asset Management. The US has its share of shadow bankers too, according to the IMF.

The key concern, said Towes, is whether Western organizations have loaned to shadow banks and are now vulnerable.

“That can create problems and affect the broader economy or the broader stock market,” he said.

What may come next: The threat is grave enough that there could be a call to action for China’s regulatory bodies to enact measures to rein in the unruly shadow banking sector.

So far, “we’ve seen defaults where the Chinese government is not stepping in,” said Toews. That lack of intervention has led to a wave of protests by angry investors and heightened police presence outside of the offices of Zhongrong. The protests could indicate that the trust’s problems run deeper than previously believed.

“The real interesting question to see is if [these protests] expand and if the government will step in. It doesn’t really matter whether it’s a real bank or a shadow bank, it’s still money that’s effectively vaporizing from the economy and they certainly can’t tolerate a lot of additional money disappearing through shadow bank defaults,” he said.

Global equities sold off 3% in August, largely because of China worries.

Goldman Sachs is increasingly confident that the US economy will stick the soft landing that many thought was nearly impossible to pull off, reports my colleague Matt Egan.

In a research report published Monday night, Goldman Sachs lowered its estimated chance of a US recession over the next 12 months to just 15%.

That’s basically in-line with the historical average chance of a recession on any given year. It’s also down from the Wall Street bank’s prior forecast of 20% and well below its 35% projection in March as the banking crisis erupted.

The report, titled “Soft Landing Summer,” pointed to a series of encouraging economic indicators on inflation and the jobs market that suggest the US economy will avoid the Federal Reserve-fueled recession that many feared.

“We strongly disagree with the notion that a growing drag from the ‘long and variable lags’ of monetary policy will push the economy toward recession,” Jan Hatzius, Goldman’s chief US economist, wrote in the report. “In fact, we think the drag from monetary policy tightening will continue to diminish before vanishing entirely by early 2024.”

Hatzius added that Goldman Sachs is increasingly confident that the Fed is “done” raising interest rates as unemployment rises, wages slow and inflation eases.

Oil prices surge after Saudi Arabia and Russia extend supply cuts

Oil prices hit a new high this year after Saudi Arabia and Russia — the world’s biggest crude exporters — said they would extend output cuts by at least another three months, reports CNN’s Hanna Ziady.

Brent crude, the global benchmark, gained 1.8% to trade above $90 a barrel, while West Texas Intermediate (WTI), the US benchmark, rose by a similar margin to $87 a barrel.

The moves by Saudi Arabia and Russia reinforce efforts by the alliance known as OPEC+ — which includes members of the Organization of the Petroleum Exporting Countries and other producers — to support oil prices by agreeing to deep and prolonged production cuts.

An official source from the Saudi Ministry of Energy told state-run news agency SPA that the kingdom would extend its production cut of 1 million barrels per day until the end of December. The decision would be “reviewed monthly to consider deepening the cut or increasing production,” the source added.

Production cuts by OPEC+, which produces 40% of the world’s crude oil, have helped send oil prices higher in recent months, a development that could have repercussions for inflation and interest rates. Average US gas prices have also drifted higher to $3.81 a gallon, a couple of cents above where they were this time last year.

“The recent upward trajectory in oil prices has laid the groundwork for potentially elevated [consumer price index] figures for August,” Stephen Innes, managing partner at SPI Asset Management, wrote in a note Tuesday.

“These impending increases in oil prices present a fresh challenge for central banks as they continue their diligent efforts to bring inflation levels back in line with their desired targets.”

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