China is deleveraging while the US and Japan pump their Covid-hit economies with liquidity. Image: Getty/iStock

So much for the “PBOC put” that was supposed to lead China to Japan-like ruin.

In recent years, punters expressed fears the People’s Bank of China would go the way of the Bank of Japan and US Federal Reserve. Both the BOJ and Fed have spent the last 20-plus years bailing out markets with liquidity jolts in times of trouble.

That’s been the strategy for the BOJ’s Haruhiko Kuroda in Tokyo now to BOJ teams dating back to the 1990s. The same with Fed leaders – from today’s Jerome Powell on back to the Alan Greenspan era two decades ago.

A central bankers’ job, it’s often said, is to yank away punchbowls before parties get out of hand. A “put” means they’re continuing to refill it in ways that warp market dynamics and investment incentives.

A sober PBOC, though, appears to be yelling “last call.”

In recent weeks, Asian markets buzzed about the specter of PBOC “tapering.” No one expects Governor Yi Gang to hike interest rates anytime soon, or even to pursue a generalized tightening of financial conditions. By merely becoming less generous about punchbowl refills, though, the PBOC is signaling Beijing’s latest cleansing campaign is real.

“This is a restart of deleveraging reform,” says economist Iris Pang at Dutch bank ING. This credibility matters, as events from Tokyo to Washington attest.

“Deleveraging” is a codeword for China Inc’s effort to scrap the credit-and-debt model Beijing has harnessed to great effect since the 2008 Lehman Brothers crisis.

It encompasses moves to rein in China’s US$13 trillion shadow banking monster. It includes steps to curb fintech giants like Ant Group. It comprises Vice Premier Liu He’s “zero tolerance” decree last month concerning fraud and other violations in the bond market.

The central bank, as with any big outwardly facing economy, is the vanguard of any deleveraging effort. And China is proving to be the adult in the room as the BOJ and Fed continue to pump giant waves of liquidity into markets.

The US and Japan and pumping unprecedented liquidity into markets. Image: Facebook

And that is the Everest-sized irony casting a giant shadow over capital markets in the world’s three biggest economies.

The BOJ and the Fed – the central banks of the world’s leading supposedly “capitalist” economies – each control far more market assets than the supposedly “socialist” PBOC.

The worry, longer-term, is that policymakers in Tokyo and Washington are rewarding terrible investor behavior and corporate mediocrity.

Some of the clearest expressions of this risk globally are coming not from dyed-in-the-wool capitalists on Wall Street, but from PBOC officials including Zhou Xiaochuan, who headed China’s central bank from 2002 to 2018.

In September, the globally-respected Zhou urged monetary authorities to plot exits from the “swift and bold” emergency steps taken in the Covid-19 era.

“On the one hand, we firmly support central banks’ monetary policy response to the pandemic,” Zhou said. “On the other hand, we should not ignore or underestimate the side effects of the current monetary policy.”

More recently, PBOC Governor Yi and Guo Shuqing, head of the China Banking and Insurance Regulatory Commission, both warned about moral hazard.

In both cases, markets read the comments as a defense of deleveraging efforts in Asia’s biggest economy.

On-again, off-again deleveraging

In recent weeks, Beijing has displayed a surprising tolerance for defaults by state-owned enterprises. Officials clamped down on fintech giants, including Jack Ma’s Ant, which last month shelved an initial public offering that would’ve been history’s biggest.

This has markets pricing in Chinese deleveraging as rarely before.

There may be some deja vu in play, as investors have heard all this before in the Xi Jinping era. In 2012, Xi came to power pledging greater financial transparency and letting market forces play a “decisive” role in Beijing’s decision-making.

The true test came in 2015, when Xi’s Communist Party let Kaisa Group Holdings become the first mainland property developer to default on dollar bonds. As the Shanghai stock market plunged, Team Xi lost its nerve. Leverage was back in fashion.

Chinese President Xi Jinping has pledged greater financial transparency. Image: AFP

In 2017, Xi’s government moved to curb debt growth anew by cracking down hard on the shadow-banking industry. The reckoning was short-lived, though. The arrival of Washington’s China trade war drove Beijing back into stimulate-at-all-costs mode. That, for the most part, was the imperative in 2018 and 2019.

The Covid-19 crisis required its own aggressive fiscal response in the first half of 2020. The PBOC engineered a series of interest rate cuts and took other liquidity-boosting actions to support both the state and private sectors.

Yet with China having contained the coronavirus and GDP growth reviving, now expected to hit 2% for 2020 – the PBOC and regulators are wisely swinging back toward deleveraging.

Fiscal policy is still very much in growth mode. Beijing and local governments have, through policy banks, issued around $2.5 trillion of debt this year. That’s the most since at least the early 1990s and comparable to the stimulus Japan has thrown at Asia’s No. 2 economy. And it’s driven China’s debt-to-GDP ratio to 277%.

This 2020 debt buildup has Beijing hitting the brakes. As punters read the tea leaves, market rates are ticking higher. Earlier this week, yields on government debt rose to 18-month highs even as inflation pressures drop.

In November, China’s consumer prices fell for the first time in 11 years. That 0.5% year-on-year decline was as unexpected as it was telling.

Domestic price trends would, in theory, call for additional PBOC stimulus. If Asia learned anything from Japan’s lost decades, it’s that deflationary pressures are best addressed early and aggressively.

All signals suggest, though, that the PBOC is staying the course toward reducing credit growth and overall leverage. This imperative has made China’s $17 trillion government bond market one of the most attractive anywhere in yield terms. In fact, Japanese funds looking to avoid turmoil in emerging markets are increasingly veering China’s way.

While Japan’s 10-year debt yields a negligible 0.01%, China’s offers a 3.3% rate, having risen 80-plus basis points since April. The appeal reflects several variables, including the inclusion of Chinese debt in global indexes. A major one is a sense among investors that China is finally tending to microeconomic cracks.

Indications that the PBOC “put” is on hold indefinitely also could instill longer-term trust. Analysts at Citigroup reckon China’s government market will pull in about $100 billion over the next few years – in part thanks to sober PBOC policies.

Trouble in the shadows

The key, though, is building credibility with overseas punters. Along with the PBOC reining in excesses, that means getting control of the shadow-banking system. Last week, Beijing did something highly significant on that front: put out some real numbers on this beast.

One reason Japan’s 1990s bad-loan crisis got so bad was extreme opacity. It was not until the early 2000s when Tokyo’s Financial Services Agency began putting out credible figures on non-performing assets.

Now, the China Banking and Insurance Regulatory Commission, or CBIRC, admits that its shadow banking sector swelled to $12.9 trillion in 2019 – or 86% of GDP.

A bank employee counts stacks of yuan. Image: AFP

By CBIRC’s definition, the shadow sector includes wealth-management fund products, small credit, peer-to-peer lending and so-called entrusted loans. All told, we’re talking at least 29% of China’s total banking assets.

This is, in other words, a “systemic” risk to China’s economic outlook, one with direct bearing on Xi’s designs on establishing the yuan into a global reserve currency.

The aim, says researcher Tang Jianwei at the Bank of Communications’ Financial Research Center, is “not to eradicate shadow banking but to incorporate it into the regulatory system.” The idea being, Tang says, the sector “can be a complement” to China’s financial future if “it is well regulated.”

This, as skeptics will point out, is a very big “if.” One open question is Xi’s tolerance for economy-wide pain.

As analyst Michael Taylor of Moody’s Investors Service notes, any market turmoil related to, say, worries about deteriorating asset quality, could hit the broader financial system. That, in turn, could have implications for trust companies and lenders in general.

All this would be a step in the right direction, of course.

As analyst Rowena Chang of Fitch Ratings puts it: “We view the authorities’ efforts to reduce financial risk as credit positive for China’s financial sector. If the authorities were to loosen credit policies, permitting a significantly larger increase in system leverage than we currently expect, or a continued rise in system leverage in 2021, we would view this as credit negative for the broader financial industry.”

Chang adds that a “significant pick-up in irregular financing activities, such as securities and trust companies’ channel business, could also signal higher financial system risk. However, these scenarios do not form part of our baseline forecast.”

In general, Chang says, Fitch expects a “gradual decline in China’s overall shadow-bank assets in 2020-2021, as regulators focus on curbing irregular financing activities as part of the broader drive to resolve risks in the financial system.”

It’s a work in progress. The good news is that transparency appears to be coming in other ways too. Beijing is stepping up efforts to measure the “social creditworthiness” of companies. While the US blacklists mainland companies, China is endeavoring to “redlist” domestic companies to ensure ethical and international business practices.

Ant Financial’s IPO has been indefinitely postponed. Photo: AFP

This Corporate Social Credit System, or CSCS, would “penalize companies with poor compliance records by reducing their access to the market and subjecting them to public censure via ‘blacklists,’ while rewarding consistently-compliant companies with economic incentives and public praise via ‘redlists,’” consulting firm Trivium China explains in a new report.

China also needs to create a deeper, more globally trusted domestic credit rating system. It’s a necessary ingredient to China Inc playing the global leadership role Xi envisions with ambitious programs like “Made in China 2025” and the giant Greater Bay Area project.

Yet the PBOC acting like the sober adult among major monetary powers drunk on excess is a sign that rumors of the death of Xi’s deleveraging campaign are highly exaggerated. That could augur well for China’s 2021.