24th August 2017

Chinese banks and other lenders have enjoyed years of double-digit credit growth, but in March 2017 the authorities stopped the party, turned the lights on, and took away the alcohol. Abrupt changes in the leadership of the three main regulators (of banks, brokers and insurers) were followed by equally abrupt changes in regulatory style. Draconian new rules were issued and existing rules were enforced much more tightly.

Why this about-face after years of successful growth? Official commentary in 2016 had made it clear that Xi Jinping and other top leaders had become concerned about the rapid growth of debt, which has now passed 250% of GDP – more than Greece ever managed. In particular, recent experience with companies defaulting on their bonds suggested that much of the outstanding corporate debt lacked adequate collateral, and that further insolvencies and defaults could lead to systemic risk.

The last five years have seen very rapid growth in China’s shadow banking system, which regulators perceive as a serious risk to financial stability because they cannot accurately measure the size of off-balance-sheet products, let alone identify the chain of potential liabilities.

For example, entrusted loans arise when banks farm out loans to external fund managers in order to get higher returns. Entrusted loans do not appear on a bank’s balance sheet, but the profits on them are brought to account by the bank.

Another example is wealth management products (WMPs), which are off-balance-sheet products that banks, acting as agents, have sold to customers in search of higher returns. There have been numerous cases where the WMP issuer has defaulted on interest or principal, and the unfortunate investors have discovered to their surprise that the bank which sold them the WMP disclaims all liability. The regulators, however, have usually forced the relevant banks to accept liability.

Banks’ on-balance-sheet risks have also been rising. As an example, small and medium-sized banks have been making increasing use of negotiable certificates of deposit (NCDs) as a source of wholesale funding, with a typical maturity of only three months. These banks lack the broad depositor base of the big four state-owned banks, so they have to look for funds in wholesale markets. Wholesale funding is intrinsically riskier than retail deposits, because retail deposits are sticky, and they are also covered by deposit insurance up to RMB500,000 per account.

NCDs, which were introduced in China in 2013, became increasingly popular because they were a low-cost source of funding – their yields averaged 3.1% in CY16. But they were priced at a spread above the Shanghai Interbank Offered Rate (ShIBOR), so when the authorities raised interest rates this year the average NCD yield jumped to 5.0% in June, and is currently 4.4%.

The regulators wanted to reduce the use of NCDs because they were being bought by the big four banks who, thanks to their deposit base, had a permanent surplus of available funds. These NCDs thus counted as inter-bank assets and liabilities. The risk effect of such NCDs was to channel big banks’ spare cash to little banks, creating instant systemic risk if any of the little banks failed to meet their obligations.

The regulators’ actions had already brought positive results by 30 June 2017, in the form of a reduction in the most problematical assets:

  • Commercial banks’ inter-bank assets fell by 5.6% – the first fall in seven years
  • The volume of wealth management products fell by 2.2% – the first fall in nine years
  • The amount of entrusted loans fell for the first time since 2007.

These developments are positive signs for the reduction of systemic risk, but China is not out of the woods yet. Regulatory intervention will need to continue for several years in order to get systemic risk down to an acceptable level. We do not consider that China is in imminent danger of a financial crisis, but the prevention of a crisis relies on the authorities continually identifying potential problems and containing them. They may yet slip up, and a visible disturbance would be very negative for investor sentiment on China.

Q.E.D.