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- Corporate yield spreads over central government bonds have widened, reflecting heightened concerns about a tighter policy environment.
- New rules governing the sale of asset management products indicate regulators want to shrink the shadow finance system outright.
- The gradual approach will remain unchanged but we expect more investment products and vulnerable corporate and local government borrowers to default.
Sentiment in the Chinese bond market has worsened as investors digest the government’s latest message about reducing risk in the financial system. After November’s treasury sell-off, corporate bond prices have fallen; the spread between five-year triple A-rated corporate paper and equivalent Ministry of Finance yields has widened to a three-year high.
The sell-off has spread to riskier assets in the wake of the release of draft rules aimed at bringing order to China’s Rmb75tn ($11tn) universe of asset management products. They were announced on November 17 jointly by the People’s Bank of China and the securities, banking, insurance and foreign exchange regulators.
This signals a more co-ordinated approach to regulation, and onshore markets are losing faith that the government is bluffing. They will remain on edge into 2018, with renewed concerns about domestic inflation and rising interest rates around the world. The PBoC appears willing to provide funding to manage rising market rates, but rules are being tightened across the financial system and credit availability is likely to be more constrained in the coming year.
The latest rules should lead to greater competition for credit and higher financing costs for vulnerable borrowers, such as local government financing vehicles and companies in overcapacity sectors. Rising rates could be a catalyst for defaults, which the authorities have been holding at bay.
Shrinking the system
The new rules are intended to mitigate some of the most potent sources of risk in the financial system, stemming from the sale of items ranging from wealth management products (WMPs) distributed by banks, securities houses and online platforms, through to asset management plans and trust products.
These underpin a vast pool of loans to Chinese corporations and local governments.
The draft rules seek to ban issuers from guaranteeing repayments and forbid multi-layered asset structures and the pooling of funds. Issuers will be forced to set aside more funds for losses and will be limited in how much extra debt their products can take on. They also seek to end the so-called “channel business” of funnelling loans through non-bank financial institutions in exchange for fee income, a key workaround for getting credit to less worthy borrowers.
The laws will not be effective until the end of June 2019, although institutions will not be allowed to increase net sales of products that do not meet the new requirements during the transition period. The rules may be watered down after consultation and the usual internal wrangling.
Nonetheless, their scope and tone suggest a tougher regulatory approach in the wake of the 19th Communist Party Congress. Having slowed the growth of WMP sales and encouraged credit to flow through less risky parts of the shadow finance system, regulators may now try to shrink the system outright.
Years of piecemeal rulemaking by competing regulators nurtured murky interconnections and increasing complexities in the Chinese shadow finance system. The underlying assets may be easily understood loans to property developers or state-owned enterprises. However, by the time they have been dragged through an increasingly tangled regulatory thicket by trusts or issuers of wealth or asset management products, they have been processed and reprocessed to the extent that investors have little understanding of what they are buying. Nor have they needed to; the belief that the government will ultimately make good on any losses has supported Chinese asset prices.
No crash diet
In the rare instances that such products have failed, issuers have found easy scapegoats. In 2012, Huaxia Bank blamed the failure of a WMP on a rogue employee. The bank reportedly paid off aggrieved investors. Rogue employees were also blamed by China Minsheng Bank, which last week was fined Rmb27.5m for the sale of fake WMPs. Again, investors are reported to have been repaid their original investments.
Isolated fines do not go far enough. According to an FTCR survey, WMPs are considered by consumers only slightly less safe than bank deposits, even though they offer returns that are many multiples of deposit rates. Defaults of trust products have been as rare, even though they typically offer annual returns of more than 8 per cent.
The sheer size of outstanding liabilities guarantees cautiousness and gradualism. Since they nearly crashed the system in 2013, the authorities have typically retreated in the face of financial volatility. If the government is serious about tackling risk, however, it will need to show greater appetite for failure. We expect retail investors to see increased losses and the more vulnerable borrowers in the market, who have been allowed to exist on easy credit, to be pushed finally to default.
Of course, Chinese financial institutions tend to see tighter rules as just more regulatory roadblocking and innovate their way round them. Rising bond yields and falling stock prices suggest they are taking the government line somewhat seriously, although it remains to be seen if and how they will circumvent the latest measures.
|FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and Southeast Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on-the-ground research to provide predictive analysis for investors.|