What about China’s shadow banking sector?
There has been a lot of comment about systemic risks to China from the scale and stability of the financial sector’s off-balance sheet assets. In tandem with lending from non-financial institutions these assets are what is referred to as ‘shadow credit’, and their existence reflects the sector’s desire and ability to avoid tighter regulation and higher reserve requirements on traditional deposit and lending activities.
Precise estimates about the size of the shadow banking sector vary widely, but few doubt that the sector has played a key role in providing debt to the wider Chinese economy.
Concerns about liquidity issues in the shadow banking sector are focused in particular on higher risk funding areas such as asset backed securities and wealth management products (WMPs).
In late November the PBoC moved to address some of these concerns, announcing widespread changes that significantly tighten the standards affecting some USD15 trn of wealth management products. The new rules ban guaranteed return products, prohibit capital pooling across asset management products, limit leverage and force providers to put aside 10% of management fees against potential losses.
How serious are the authorities in dealing with the debt issue?
In 2017, while China’s economy has slowed, it has not slowed as much as many forecast at the start of the year.
Signs of stress have generally been absent. This has led some to believe that China is not tackling the debt with the seriousness it should. We believe this view is mistaken.
First, the improving external demand environment has played an important role in supporting the Chinese economy via better than expected profits and by reducing the disinflationary pressures of excess capacity in manufacturing. With lead indicators for global demand strengthening, we believe that the external environment will continue to support the Chinese economy.
Moreover, there has been significant action to-date in terms of reform and deleveraging. On the supply side of the economy there has been a welcome ratcheting up of environmental standards and the reduction in capacity across heavy polluting industries including steel and iron ore.
We take the recent tightening of regulations regarding WMPs as further proof positive of the authorities’ determination to address the debt issue.
WMPs acted as an important source of funding for shadow banking activities and are now under the strict supervision of the China Banking Regulatory Commission. That the move follows new restrictions on negotiable certificates of deposit and money market funds shows that the deleveraging campaign is broad-based and unlikely to change in the short-term.
Elsewhere, China has already progressed initiatives designed to address the significant debt on SOE balance sheets. Given the large proportion of China’s overall debt in SOEs—and longstanding issues with SOE productivity and profitability—successful reform of the SOEs lies at the very heart of addressing China’s broader debt problems.
These initiatives include new incentive schemes for SOEs to address poor corporate governance and low productivity, as well as a pilot mixed-ownership structure which involves the introduction of private equity capital to reduce debt.
Meanwhile, stringent personal penalties for local government officials caught attempting to circumvent tighter regulations on local government financing vehicles are now helping to slow the breakneck pace of residential construction.
The impact of these policies is already evident. At the end of June, total non-financial debt as a percentage of GDP had increased only marginally from the start of the year.
The housing market is clearly slowing, while measures of money supply, fixed asset investment and new credit growth reveal a marked cooling as liquidity conditions tighten, money market rates increase and bond yields rise.