Wednesday, December 20, 2017

Coming Slowdown in the Economy Will Be Measured
By Hong Hao
Global Times
2017/12/20 23:48:39

The tightening of regulatory oversight on China's financial sector and the curbs on shadow banking growth in particular may lead to more tepid performance in the domestic economy and financial markets next year.

Since late 2016 when the macro prudential assessment (MPA) framework was first proposed in the country, funding costs across the board began to rise, as evidenced in the increase both in levels and volatility across key benchmark interest rates, as well as the yields of corporate bonds, government bonds and bonds issued by the China Development Bank. During the recent surge, the CDB bond yield has for the first time surpassed the benchmark lending rate, suggesting some financial institutions' funding costs have in nominal terms exceeded their interest income.

This is reminiscent of the liquidity crisis in June 2013, which was induced by tightening regulations regarding non-standard credit assets. The surge in funding costs during the country's stock market plunge in June 2015 was also spurred by the deleveraging policies targeted at margin loans, umbrella trusts and stock index futures.

The various episodes of interest rate surges represent the authorities' efforts to regulate banks' off-balance-sheet activities. After all, there are tight restrictions for banks to lend in terms of capital reserve requirements and various ratio requirements. But each time, banks, especially smaller ones, have managed to skirt the regulations by increasing layers of complexity, by such means as wealth management products (WMPs), interbank certificate of deposits, passageway investments and entrusted investments. These structures hide off-balance-sheet leverage further and further away from the authorities.

In an effort to stabilize the market after the bubble burst in 2015, the People's Bank of China, the country's central bank, managed to keep market interest rates steady. While stock market volatility finally subsided, low and stable interest rates have been conducive to adding leverage. Consequently, for some small and medium-sized banks, the off-balance-sheet items have grown just as big as those on the balance sheet, and increasingly represent systemic risks and regulatory challenges.

As regulations for shadow banking tighten, China's credit growth has plunged and started to converge with broad money (M2) growth since 2016. Such developments suggest the growth in the size of shadow banking has been curtailed. The new regulations are now targeting the stock of off-balance-sheet credit.

As credit growth slows, its drag on economic growth will gradually emerge, as suggested by recent softening in economic data. And the reduction in off-balance-sheet leverage will inevitably induce forced sales of some of the corresponding underlying assets, pressuring both bond and equity prices. The effects of tightening regulations will be more apparent in the coming 18 months.

As such, 2018 will be another year of coping with liquidity constraints for Chinese traders. As off-balance-sheet deleveraging proceeds, credit growth will continue to decelerate, and market interest rates will stay elevated. Meanwhile, corresponding assets will have to be liquidated. As such, it is still difficult to see a raging bull market ahead.

Contrary to the experiences in 2017, mid and small caps will likely be back in favor. And selective large caps should continue to do well, but the difficulty of picking the right stocks within this group will be increasing.

The Chinese economy, for its part, may slow down, but in a calibrated fashion. The Chinese economy is at the late stages of expansion, and growth is about to moderate. With economic growth less reliant on property and consumption having contributed more than half of the country's GDP growth in recent quarters, the slowdown will likely be measured, with bullish views gradually coming to terms with reality. China's supply-side reform and property de-stocking have unambiguously contributed to the subsequent global upswing since late 2015. The moderation in China's economic cycle will once again be felt by the world, but in a more benign way than some had feared.

Recent economic data has shown weaker growth in money supply and credit, as well as in property investment and industrial profits. The fading momentum in the current economic cycle will likely become more apparent in the coming months. But so far, it has been an orderly slowdown.

The author is managing director and chief China strategist at BOCOM International, the investment banking and brokerage arm of Bank of Communications Co in Hong Kong.

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