Investment Research General Market Conditions 20 November 2017 Flash Comment China takes more steps to fight financial risks China stepped up the fight against the risks of shadow banking on Friday, announcing tougher rules for asset management companies. The aim is to reduce the off balance sheet loan growth that is sold through wealth management products (WMP) and channelled via asset managers. The rapid growth of WMP has contributed to half the increase in shadow banking over the past five years and has made the funding of Chinese debt much more fragile due to (see Figure 1) the lack of safety net in these shadow banking products. To avoid too much disturbance the new rules will not come into force until June 2019 but they are likely to dampen growth in so-called channelling loans ahead of the deadline. These loans go through the banks and are channelled on to trust funds and other non-bank financial institutions. If the loans turn sour, the losses are born by savers (Chinese households) rather than by the banks. This could cause a risk of a run on these shadow banking products if losses start to increase at some point. It could prove very disruptive and risk setting off a negative spiral of price losses, further redemptions and so on, as is often seen triggering financial crises. The new rules imply the following. Financial institutions are not allowed to use asset management products to invest in commercial banks credit assets (typically loans) or provide channel service for other institutions to bypass regulations. Comment: This is to avoid the abovementioned risk of high-risk loans being moved to trust funds and sold to households through asset management products (WMP). The guidelines also forbid financial institutions to create asset pools to manage funds raised through asset management products. Comment: Pooling assets increases the risk of contagion in the case of a crisis, as was the case with the subprime crisis, when high-quality mortgages suffered from being pooled with lowquality mortgages when funds had to meet redemptions from investors. Financial institutions are required to provision 10% of their management fee income as risk reserves. Comment: This introduces some capital buffer in asset management products that otherwise have very little safety net. Institutions would be punished for providing implicit guarantees on asset management products. Comment: Most Chinese savers perceive that the state guarantees WMP even though it does not. With little sense of the risk in the products, more money goes into this universe and if returns are ultimately not delivered, could trigger a public outcry and demand for the state to cover any losses. Non-financial institutions are prohibited from issuing or selling asset management products. Comment: Another aim is to stop savings products that have grown outside the 'normal' financial system. Chief Analyst Allan von Mehren +45 45 12 80 55 alvo@danskebank.dk Important disclosures and certifications are contained from page 6 of this report. www.danskeresearch.com
The rules unify regulations on asset management products issued by banks, trusts, funds, insurance asset management companies and are issued jointly by regulators across banking, insurance, securities and FX. This is the first sign that regulatory authorities are now working together on regulation. Lack of co-ordination has been a big problem before but this summer the Chinese central bank took on the role of coordinating a new financial oversight body in order to better co-ordinate regulations across the financial system. The new regulation is another sign that China continues its' crackdown on shadow banking, which began last year. It also follows very strong warnings of financial risks from China s central bank governor Zhou Xiaochuan over the past couple of months (see for example Bloomberg, 4 November) and his comments have been a clear warning of tougher regulation coming. It seems clear that the priority given to fighting financial risks has moved very high on the agenda of Xi Jinping, who has also stepped up his warnings this year. At the National Financial Work Conference in July, Xi stated, among other things, that we cannot neglect any risk factors or hidden dangers. The new steps underline that China is well aware of the financial risks of the high leverage and growth in shadow banking and is taking stronger measures to contain these risks. It is likely to have a short-term cost in terms of lower growth but reduces the risk of a bigger downturn at a later stage. It is an indication that China may use the current window of a strong global economy and calm on the Chinese economy to take some short-term pain for long-term gain as also advised by the IMF in its Article IV consultation report in August. It does add some downside risk to growth over the coming year though and underpins our expectation of a slowdown in China in 2018. The continued crackdown on shadow finance is probably behind the recent rise in Chinese bond yields (see Chart 4). Normally, yields fall when signs of slower growth emerge (as has been the case in China lately see, for example, Research China The housing party is over, 14 November). During the spring, we saw the same signs of ministress in the bond markets following a crackdown on shadow finance but the bond selloff paused in the months ahead of the Party Congress in October, as China wanted stability around the Congress. However, the sell-off continuing very shortly after the Congress ended is a further sign that China is continuing to fight financial risks and aims to reduce leverage in high-risk products sold as, or perceived as, safe products. Apart from the sharp growth in shadow banking in recent years, the sharp rise in debt in state-owned enterprises (SOEs) is another element of the danger of financial risks highlighted by Xi Jinping and Zhou Xiaochuan. At the National Financial Work Conference mentioned above, Xi Jinping also said that Deleveraging at the SOEs is of the utmost importance and that officials must get a grip on Zombie enterprises. This is part of the SOE reform agenda and we expect Xi Jinping to use his stronger power to push through more of these reforms in his second term over the next five years. 2 20 November 2017 www.danskeresearch.com
Chart 1. China s shadow banking has grown sharply over the past five years Source: Moody s, Danske Bank Chart 2. Wealth management products are behind a big share of the increase now constituting 20% of debt funding, up from 4% in 2012 Source: Moody s, Danske Bank 3 20 November 2017 www.danskeresearch.com
Chart 3. Very low deposit rates have led Chinese households to put money in wealth management products providing around 4-5% returns Source: Danske Bank, Macrobond Financial Chart 4. China government yields resuming increase after the Congress is a sign of further deleveraging taking place in leveraged funds Source: Danske Bank, Macrobond Financial 4 20 November 2017 www.danskeresearch.com
Figure 1. How banks can channel risky loans through wealth management products Instead of launching lending directly to a company (say a developer), a bank can issue wealth WMP management and use funds products to lend and use to the funds developer to lend to indirectly the developer by indirectly by transferring the funds to a trust transferring company that the then funds lends to the a trust money company to the that then developer. lends If the there money is no to guarantee the developer. on the wealth If there s no management guarantee product, on WMP it can it can be be kept kept off balance off balance sheet. If loans sheet. turn If loans sour turn and the sour trust and fund the goes trust bankrupt, the depositor faces the loss. Two-thirds fund of wealth goes management bankrupt the products depositor have faces no the loss. guarantees 2/3 of WMP has no guarantees. Bank CNY deposit 9% minus fee WMP, 5% return Developer Depositors Trust company Source: Danske Bank 5 20 November 2017 www.danskeresearch.com
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