China’s run of solid economic indicators proved little consolation for its shaky financial markets in April. The dichotomy stems from a shift in the leadership’s focus toward reducing leverage — one that’s set to determine whether growth joins asset prices in heading down. Economists are practically unanimous in saying that reduced debt loads would be good for China’s longer-term health. The big unknown is whether officials can manage that without a dose of short-term pain. As UBS Group AG analysts put it in a note last week: if authorities’ initiatives are “not managed well, it could lead to a rise in credit events, excessive liquidity tightening, faster-than-intended slowdown of credit growth, and greater market volatility.”
What started in the fall of 2016 as a tightening in money-market liquidity has intensified to a broader attack by policy makers on the shadow-banking system, where patchy regulation has allowed investors to make leveraged bets. When President Xi Jinping last week warned top officials to crack down on financial risks, the benchmark equities index at one point gave up gains for the year, while bonds suffered their biggest tumble of 2017.
While past regulatory shifts — especially pricking a stock bubble and letting the yuan depreciate in 2015 — have sometimes spooked international investors, this time around the reaction has been muted. The positive economic backdrop has helped, along with the conviction that Xi and his lieutenants won’t allow turmoil to disrupt a key, once-in-five-years Communist Party leadership gathering this autumn. The imperative of heading off disorderly moves in financial markets is a backdrop to the slew of regulatory initiatives over the past two months. Besides broad increases in money-market rates, the list includes:
The People’s Bank of China incorporated off-balance-sheet wealth-management products in its macroprudential assessment of banks’ risks, putting lenders on notice that shadow banking is facing deeper scrutiny The China Banking Regulatory Commission, under new leadership since February, stepped up scrutiny of entrusted investments — funds that banks farm out to external managers The CBRC issued guidelines to enhance liquidity risks at banks, including all of lenders’ interbank and WMP business in their monitoring Authorities stepped up inquiries about wholesale funding after smaller banks sold a record amount of negotiable certificates of deposit.
For now at least, the economy isn’t expected to take a major hit. For one thing, growth accelerated last quarter to 6.9 percent according to official figures, and the debt hangover is getting easier to service as factory prices snap years of deflation. Some indicators suggest the expansion may be coming off the boil. Caixin Media and Markit Economics’s manufacturing purchasing managers’ index slipped to 50.3 in April — the lowest since September. But while trends in the property market signal a slowdown ahead, China has plenty of infrastructure needs in central and western parts of the nation, and urbanization remains a long-term engine.
In the most recent tussle between market sentiment and economic fundamentals, it was the latter that won out. The economy weathered the 2015 market turmoil, first stabilizing and then perking up as the housing market took off again and the government stepped in with massive doses of infrastructure investment. The latest push to contain financial risks is focused more on speculative bets than on curtailing credit to the “real” economy. The PBOC has kept benchmark lending rates at a record low and the government continues to spend on pipes, rail and bridges. “China’s current economic recovery is likely to be in its early days, and has more legs to run,” said China International Capital Corp. economist Liang Hong. Better policy coordination and ongoing liquidity injections by the PBOC make a credit crunch seem unlikely, she said.
Crucially, the increase in yields on Chinese government bonds (CGBs) has coincided with the emergence of inflation that’s reflected the economy’s quicker growth. Nominal GDP rose 11.8 percent in the first quarter from a year before, according to Bloomberg Intelligence economist Tom Orlik. That helps fuel corporate profits, government revenue and household income, along with making debt easier to service.
Wringing out leverage may make economic sense, but it may not be pretty for equities and higher-yield bonds. “We could see more forced redemptions from high-yield bonds and a flight to quality back to high-grade bonds like CGBs,” Nomura Holdings Inc. analysts including Hong Kong-based Albert Leung wrote in an April 26 note. Any further sell-off in central government bonds offers “an opportunity for long-term investors,” they wrote.
But overshadowing all: the 19th Communist party Congress slated for later this year, when Xi will preside over a reshuffle of leadership positions below him. It’s unlikely that the government will allow the economy to veer off script, said Minyuan Zhao, an associate professor of management at the University of Pennsylvania’s Wharton School. “This is not unlike injecting strong medicine into a patient — make sure you kill the disease before killing the body,” she said of the deleveraging push.