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It’s not quite a People’s Bank of China taper, but Beijing’s crackdown on shadow banks is suddenly getting as creative as it could be impactful.
Over the last week, Chinese regulators detailed plans to limit what mainland banks and wealth managers can do with so-called “cash-management products.” It’s a nearly US$1 trillion segment, one that involves investing in assets that must be traded for lower-yielding, higher-quality assets by the end of 2022.
It’s a pivotal sector. While only about $400 billion of these products are currently in circulation, their placement in assets rated lower than AA+ – often supporting riskier borrowers like property developers – is a vital lubricant keeping mainland credit markets liquid and agile.
Yet it is also a source of market froth that authorities want to tame. Beijing is now taking direct aim at these opaque investments by forcing banks and wealth managers to avoid sub-AA+ rated bonds and longer-term debt.
This step could address two of President Xi Jinping’s top 2021 goals: reducing runaway leverage and incentivizing Chinese borrowers to improve credit quality in ways that stabilize the broader economy.
More broadly, it falls under the rubric of bolting prudent risk-management practices onto finance sub-sectors. That strategy shot to global prominence when Beijing halted the eagerly awaited initial public offering (IPO) of Ant Group to emplace an appropriate regulatory framework over the sprawling firm.
The cash products coming under the eye of Beijing are the cornerstone of wealth management offerings – and the wealth-product sector is a constant thorn in the side of regulators. With their role in building up leverage, creating disorienting duration mismatches, offering implicit guarantees against losses and near-absence of transparency, they’re at the root of China’s financial overheating risks.
China’s latest policies “have started slowing the pace of credit growth and cracking down on shadow banking as it seeks to normalize monetary policy and curb potential risks now that the economy’s recovery is gathering pace,” says strategist Bruce Pang at China Renaissance.
Adds Julian Evans-Pritchard at Capital Economics, “The slowdown in credit growth is happening even faster than we had been anticipating a couple of months ago. While the economy has so far weathered the withdrawal in policy support very well, the usual lags mean that weaker credit growth will become a growing headwind to activity over the next few quarters.”
The timing of this new policy is certainly tantalizing, coming just as markets buzz about China Huarong Asset Management possibly getting dropped from the MSCI Inc stock indexes. Thursday marked the 52nd day since the halting of trading in the company’s shares, the result of its failure to release 2020 financial results.
That move alone could upend exchange-traded funds with more than $210 billion of assets that base investments on MSCI. The government-controlled bad-debt manager is the subject of will-they-or-won’t-default speculation that is preoccupying greater-China market confidence.
Beijing’s decision to crack down on wealth management products was telegraphed 17 months ago, but largely ignored. Untold hundreds of billions of dollars have flowed into these instruments from month to month as banks and wealth managers seek fatter returns.
Cash management products routinely offer higher rates than money-market funds and deposits. Yet flows into the sector are about to hit some serious headwinds, reducing the market significantly and straining bank reserves.
New rules require each cash management product to cap leverage at 120%. They will be confined to short-term bank deposits, central bank bills, bond repurchase agreements and openly traded asset-backed debt coming due in no more than 397 days.
Perhaps most importantly, cash management products can’t be used to lend more than 10% of assets to the same bond issuer. The policy shift sent Chinese property management stocks lower this week as punters count the costs of a loss of a key funding source.
Analyst Huang Wenjing at China International Capital Corp says equities could be among the major beneficiaries as investors diversify. At the moment, more than 16% of assets in cash management products are “not compliant” with Beijing’s tweaks to credit-rating and maturity requirements.
The upshot could be increased pressure on property developers already under strain. They will now have even greater trouble accessing the funds needed to repay debt. Hence this week’s drops in shares of China Evergrande Group and CIFI Holdings Group.
One worry: a possible domino effect as assets that form the underlying foundations of other products experience sudden bursts of selling pressure. Analyst Ming Ming at Citic Securities reckons that nearly $390 million of cash management products are currently parked in investments heading toward non-compliance.
Things look healthier in the long run. Forcing cash wealth management circles to invest in higher-quality assets, take on less leverage, limit the length of bets and increase disclosure fits with Xi’s pledge to let market forces play a “decisive” role in China’s financial sector.
This will likely cheer bankers at JPMorgan Chase & Co and Blackrock Inc angling for a sizeable piece of China’s growing wealth asset market. Any success in deleveraging and internationalizing the market would increase the mainland’s appeal.
So would squeezing asset imbalances out the financial system that built up in the post-2008 global crisis stimulus boom. Those credit and debt excesses now collide with economies reopened from the Covid-19 pandemic, a dynamic that’s boosting inflation from China to the US.
Property prices are once again under regulatory glare. Virtually all of China’s top metropolises feature housing price surges as income struggles to recover from the devastation of 2020.
As factory-gate inflation hits 12-year highs, prompting Xi to tolerate a rising exchange rate, the yuan’s nearly 10% rise versus the dollar over the last year reduces imported inflation risks.
So far, China’s bond market has taken the increases in its stride; yields on 10-year government debt are just 3.2%. “The biggest negative factor for the bond market – that monetary policy may tighten because of inflation – has been proved false,” says analyst Chen X at Pacific Securities Co.
Even so, China’s 1950s-sounding Department of Price is ratcheting up efforts to tame surging commodities prices. Also, Xi’s team just approved record capital outflows from Chinese markets.
Earlier this month, Beijing okayed $10 billion held by newly qualified domestic institutional investor, QDII. That was the highest single amount ever approved to head overseas. More broadly, roughly $147 billion of cumulative approvals mean waves of mainland cash are flowing into overseas markets, perhaps acting as a pressure valve of sorts.
Along with reducing upward pressure on assets, the outflows could limit yuan gains without irking the US Treasury Department. In early June, the PBOC also prodded Chinese lenders to increase foreign-currency holdings, a first since 2008.
Still, there’s a limit to how much Xi’s team can hold back the tide. The yuan is rising in part because China’s post-Covid recovery is outpacing the world.
Efforts by Xi and the PBOC to internationalize the yuan are creating organic demand. So is China leading the globe in launching a central bank digital currency, or CBDC.
Yet the yuan could soon give up recent gains as the US Federal Reserve veers toward tapering — or even outright tightening.
Barclays Plc just accelerated its timeline for the Fed stepping back from Covid-era support to as soon as calendar 2021. After this week’s Fed policy meeting, Chairman Jerome Powell acknowledged market chatter about policymakers cutting back on aggressive bond-buying operations.
“You can think of this meeting that we had as the ‘talking about talking about’ meeting,” Powell said, riffing off his 2020 statements that the Fed wasn’t “thinking about thinking about raising rates.”
Any resultant weakening in the yuan will be just fine by the PBOC, so long as it’s orderly. A sudden drop could both undermine confidence and make it harder for Chinese borrowers to repay foreign-currency-denominated debt.
Domestic reforms are far more pressing, particularly those concerning financial goalposts. It’s reasonable for Xi’s government to prod banks and wealth managers to buy debt rated AA+ and higher. But without a credible credit-rating system, what’s the point?
China has long been notoriously slow at spotting signs of corporate stress and has failed to differentiate between sectors and companies within them. And it has also been overly generous with credit scores.
In 2020, as many as 96% of onshore credit ratings were – impossibly – in the investment-grade orbit. China also has a higher proportion of supposedly better-quality credits defaulting relative to lower-rated companies than peers.
This explains why, time and time again, investors are caught flatfooted when major Chinese companies stumble.
In late 2019, Yongcheng Coal & Electricity Holding Group had a AAA rating when it missed bond payments. The same with state-owned carmaker Brilliance Auto Group, when it couldn’t honor its debt.
Questions surrounding why (deep breath) Dagong Global Credit Rating, China Chengxin International Credit Rating and Golden Credit Rating International missed troubles under the surface have yet to be answered.
In April, the PBOC asked for public comment on ways to strengthen supervision of domestic credit raters, improve quality control and foster independent assessments.
As of now, the PBOC is working with the Ministry of Finance, the China Banking and Insurance Regulatory Commission and the China Securities Regulatory Commission to devise unified standards for credit scores and what to do about violators.
Getting this right, and as quickly as possible, is vital to China’s ambitious financial opening process. In 2019, Chinese shares were added to MSCI’s benchmarks, while government bonds are now part of the FTSE Russell. And tsunamis of capital are heading China’s way.
China must get its excessive leverage problem right, too. The good news, says Moody’s Investors Service analyst Lillian Li, is that Beijing is making progress. Overall, she notes, shadow banking assets grew by just $109 billion in the first quarter of 2020.
“That said, over the same period, shadow bank assets were broadly flat as a share of nominal GDP, reflecting China’s rapid economic rebound from the coronavirus pandemic,” adds Li.
The catch is finding a way to rein in the sector without tanking the Chinese economy. One wonders if Xi has done just that with his shadow banking crackdown.