A "New Era" In Chinese Regulation Means Turmoil For $15 Trillion In China's "Shadows"

The post-Party Congress attempts to deleverage and crack down on the worst abuses in China’s horrific credit bubble - especially the country's $15 trillion in wealth-management products - saw China’s authorities turn their sights on shadow banking and wealth management products (WMPs) specifically. On their way out are "guaranteed returns" and “capital pools”, which had turned the wealth management sector into a Ponzi scheme. In a radical and "shocking" departure from the historic norm, financial institutions will have to offer yields based on the risks and returns of the underlying assets.

As Citic' Ming Ming summarized China's shadow reform to Bloomberg, this is "the most comprehensive and most profound regulatory document ever. This marks the beginning of a new era in financial regulation as it implies the end of a ‘big leap’ in the asset management industry. Going forward, it means more compliance requirements, tighter risk control, and thus slower but better-quality growth."

This might go down like a cup of cold sick with Chinese savers who have become accustomed to circumventing financial repression via these products. However - and this is significant - the new regime doesn’t take effect until the end of June 2019. We can only guess the delay reflects the enormity of the problems discovered by China’s regulators when they finally looked under the hood.

The shadow banking measures, announced after Friday’s close, hit Chinese equities when they opened Monday. However, the sharp fall in the Shanghai Composite miraculously turned around late in the day, closing up 0.3%. Either, “bargain hunters” saw a too-good-to-be-missed opportunity as Bloomberg TV implied, or the “National Team” was ordered off the bench late in the session. We think we know the answer and our sense is that the authorities are increasingly concerned about risk-taking in Chinese equity markets currently. On Friday we highlighted the warning from the state-owned Xinhua news agency that the share price of China’s largest liquor maker, Kweichow Moutai, was rising too fast.

This is Bloomberg's take on the market reaction to the new shadow banking rules.

China’s sweeping new plan to rein in its shadow banking industry rippled through the nation’s stock market on Monday, sending the Shanghai Composite Index to a two-month low. Investors pushed the benchmark gauge down as much as 1.4 percent amid concern that the government’s latest attempt to tighten supervision of $15 trillion in asset-management products will siphon funds from the market. Developers and brokerages paced losses. While analysts applauded the plan as an important step toward curbing risk in China’s financial system, they also warned of turbulence as markets adjust to outflows from popular shadow-banking products.

The government directives, which are set to take effect in 2019, add to signs that President Xi Jinping is willing to sacrifice growth as he tries to put the world’s second-largest economy on a more stable financial footing. “The rules dealt a blow to the market,” said Zhang Gang, a Shanghai-based strategist with Central China Securities Co. “A lot of such products had positions in the equity market, and those that don’t qualify under new rules may choose to exit some small and medium caps.”

In the midst of the sell-off, the major losers in the real estate sector were China Vanke Co. which fell 4.9% on the wild(er) Shenzhen exchange, Poly real Estate which fell 3.2% and Gemdale Corp. which fell 2.6%. Securities dealers tumbled to a five-month low with Citic Securities sliding 3.7% at one point. Meanwhile, trading in China’s government bond market was relatively civilized, with the benchmark 10-year yield rising 1 basis point to 3.97% - remaining on the “right” side of the psychologically important 4.0% level. That said, the benchmark has risen 24 basis point since the end of the Party congress on 24 October 2017. 

This was Reuters’ take on the new shadow banking measures.

The guidelines unified rules covering asset management products issued by banks, trust firms, insurance asset management companies, securities firms, funds and futures companies, the People’s Bank of China (PBOC) said in a joint statement with the banking, insurance, securities and foreign exchange regulators…The new rules aim to close loopholes that allow regulatory arbitrage, reduce leverage levels to curb asset price bubbles and rein in shadow banking activity.

The new rules will set leverage limits for asset management products. They will cap the total assets to net assets ratio at 140 percent for open mutual funds and 200 percent for private funds. Investors will be prohibited from pledging their shares in asset management products as collateral to obtain financing, a practice that would increase leverage. The central bank also said financial institutions must break the practice of providing investors with implicit guarantees against investment losses.

Financial institutions will also be forbidden from creating a “capital pool” to manage funds raised through asset management products. The practice allows banks to roll over the products constantly. The investment losses will be implicitly covered by the new product issuance…Financial institutions will also be forbidden from creating a “capital pool” to manage funds raised through asset management products. The practice allows banks to roll over the products constantly. The investment losses will be implicitly covered by the new product issuance.

While the new shadow banking measures are obviously welcome, we fear that they are coming too late to prevent a catastrophic bursting of China’s debt bubble. As we said in “The Complete Idiot’s Guide To The Biggest Risks In China”.

we have said for the past 3 years, the next global crisis will start in China, and with Xi's role cemented for the next 5 years (if not for life) the smart thing would be to have the Chinese economic hiccup (because recession is clearly a taboo under central planning) as soon as possible, so the economy can recover by 2022.

As ever, it’s the timing of China’s “Minsky moment” which remains elusive. Having said that, we suspect that the Xinhua warning about Kweichow Moutai was a signal that the Chinese leadership is on high alert regarding a spike in equity volatility. As we said on Friday.

In retrospect, perhaps the Xinhua warning was not so strange: after China's debt-fueled stock market bubble burst in 2015, wiping out $5 trillion of value, Chinese policy makers have acted to restrain excessive speculation in equities. “Xinhua is concerned that a runaway rally in a heavyweight like Kweichow will hamper the stability of the overall market,” said Hao Hong, chief strategist at Bocom International Holding Co in Hong Kong.

And while one can wonder why China is suddenly so concerned about even the hint of potential vol spike in the stock market - suggesting that even a modest selloff could have dramatic consequences for the Chinese financial sector - it is certainly strange that whereas even China is acting to restrain the euphoria of its citizens over fears of what happens during the next bubble, in other "developed" countries, the local central bankers, politicians and TV pundits have no problem in forcing retail investors to go all risk assets when the market is at all-time highs.

As for China, it will have truly gone a full "180", if in a few months time instead of arresting sellers as it did in the summer of 2015, Beijing throw stock buyers in prison next.

Below Bloomberg summarises the key takeaways from the new rules followed by the reactions from several analysts and portfolio managers.

  • This adds to evidence that containing financial risks is a priority for President Xi Jinping after he cemented his grip on power at the Communist Party congress in October
  • The rules may bring an end to popular short-term investment products that offer fixed rates of return; returns from new products will fluctuate and more accurately reflect the risks of their underlying assets
  • Uniform guidelines for banks, trusts, insurers, fund managers and brokerages will help prevent regulatory arbitrage
  • The move to end implicit guarantees is welcome, but it could spur outflows and weigh on domestic securities markets
  • Smaller banks are more vulnerable to a loss of off-balance sheet funding than larger ones
  • A grace period through June 30, 2019, will help contain market fallout and give financial institutions time to prepare
  • Watch for follow-through; authorities have clamped down on shadow banking before, only to ease up because they feared an economic slowdown
  • David Loevinger at TCW Group

There’s no let-up post the party congress. They still have their foot on the brake and they will keep it there for a long time. Chinese leaders have realized that disorderly unwinding of financial leverage presents one of the biggest risks to the economy. The importance of this announcement is that the rule is being applied across financial sectors. Similar financial products are treated the same way, regardless of which financial institution offers it and who regulates it. That’s important because regulation arbitraging had been rampant. It looks like a signal that the new financial stability and development committee may mean business in terms of harmonizing financial regulations. You cannot just say there’s no longer guarantees. You have to show people that there’s no longer guarantees. The only way to show it is to force investors to take losses. They have to see it to believe it.

  • Patrick Chovanec at Silvercrest Asset Management

It’s a good move, and much overdue, but depends entirely on the follow-through. There have been plenty of less formal crackdowns before. They’ve broken down because Chinese authorities have been unwilling to face the consequences of truly cutting off questionable credit. The private wealth products are now thoroughly embedded in the heart of China’s financial system and play a key role in rolling over non-performing debt. Investors believe they will be paid regardless of whether the investment performs or not. If investors can lose their money, they will stop funding these sorts of assets. Is China willing to accept what that means?

  • Ming Ming at Citic Securities

It is the most comprehensive and most profound regulatory document ever. This marks the beginning of a new era in financial regulation as it implies the end of a ‘big leap’ in the asset management industry. Going forward, it means more compliance requirements, tighter risk control, and thus slower but better-quality growth.

  • Yang Ling at StarRock Investment Management

Banks, the industry’s big brother with 29 trillion yuan of WMPs, will bear the brunt of the new rules, which foreshadow the disappearance of products with less than three months maturity and those offering a promised rate of return. That means banks can no longer invest in long-term assets by rolling over short-term products to profit from the duration mismatch. To investors, banks’ WMPs will no longer be risk-free.

  • James Stent, author and former director at China Minsheng

What’s important to me is there’s a lot of time given for actual implementation. That is to ensure that as they begin to bring the wealth management products under control, they will not be too disruptive on the economy. They will give people plenty of time to react. I think it is very favorable news. It again shows foreigners all their worries that these are going to bring down the Chinese economy are nonsense. The Chinese have been well aware of the risks. They have been planning this probably for at least a year and a half. Now they are implementing it very slowly and this is good news. I think wealth management products will still be there, but they will change the pricing to reflect the risks.

  • Stephen Jen at Eurizon SLJ Capital

Chinese investors also need to be conditioned to understand that investments have risks, and that corporate bonds should carry higher spreads than what we are seeing now. The real test of whether these implicit government guarantees are indeed lifted will only come when an important corporate defaults. Only time will tell.

  • Becky Liu at Standard Chartered Bank

The rules close many loopholes that had resulted from previously segregated regulatory frameworks. They have turned out to be tighter than a version leaked earlier this year and are likely to lead to slower asset growth in the foreseeable future. They will materially curb asset managers’ ability to increase leverage, both market and structural, in the long-term. In the near term, the bond market’s current defensive tone will likely continue. In the medium term, due to limitations on non-standard products and leverage, demand for standardized products such as bonds and equities will increase, while that for non-standard products will decrease.

  • Jiang Chao at Haitong Securities

The new rules will reverse the asset management industry’s aggressive expansion, leading to a drop in entrusted investments -- which are funds that were farmed out by banks to external money managers. Demand for bond allocation is likely to be curbed, and money will return to lower-risk assets from high-yielding, non-standard assets with poor liquidity.

  • Pan Jie at Orient Securities

Money-market fund yields are likely to replace that of WMPs to become new risk-free rates. The new rules are negative to lower grades and will lead to wider credit spreads. This is because it will now be difficult for new WMPs to invest in such securities.