STORMY WEATHER: A REGULATORY TEMPEST LASHES CHINA´S MARKETS / THE ECONOMIST

Stormy weather

A regulatory tempest lashes China’s markets

But with growth still strong, officials are expected to intensify their battle against debt


IT IS is the kind of company that for years was a safe bet for investors. China City Construction is big, government-owned and focused on building basic infrastructure such as sewers. But the bet, it turns out, was not so safe after all. In November China City missed interest payments on three separate bonds, after failing to refinance its hefty debts. It is one of a growing number of victims of the government’s clean-up of the financial system, or what is known in China as the “regulatory storm”.

The storm has been gathering strength for the better part of a year but its intensity over the past couple of weeks has caught many off-guard. The government wasted little time after an important Communist party meeting in October before taking on some of the riskier parts of the financial system. As a result, China’s risk-free interest rate—ie, the yield on government bonds— has shot up. Overall, it has risen by a percentage point since the start of 2017.

For firms, even those closely tied to the state, the rise in borrowing costs has been even steeper.

The yield on ten-year bonds issued by China Development Bank, a “policy bank” that finances state projects at home and abroad, has soared to nearly 5%, the highest in three years (see chart).



Rising interest rates are partly a sign of strength. An industrial recovery has fuelled a return of inflation after years of sluggish growth, and investors are pricing in rate rises from the central bank. But the jump in yields also reflects a bout of nervousness. The CSI 300 index, which comprises shares in the biggest companies listed in China, fell by 3% on November 23rd, its largest drop in 17 months.

The fear—or the hope, depending on your perspective—is that the government means business when it talks of cutting debt. Going into this year, China’s leaders said their economic priority was to control financial risks. Debt is the biggest of all, having climbed from 160% of GDP to roughly 260% over the past decade. Much of it is held off-balance-sheet by banks. So the government’s efforts have had two aims: to slow the rise in debt and to clarify the full extent of existing liabilities.

Its actions, though welcomed by ratings agencies, are causing market indigestion. The latest worry for investors is the central bank’s proposal on November 17th for an overhaul of wealth-management products (WMPs), deposit-like instruments with relatively high interest rates that are sold by banks. New rules would mean banks could no longer guarantee investors against losses. They would also need to price WMPs according to their current market value and do a better job of matching the duration of their liabilities and assets.

The WMP market was worth nearly 30trn yuan ($4.5trn) at its peak, or more than a third of China’s GDP. The draft rules are likely to cause it to shrink and, in so doing, to leave banks with less free cash to invest in bonds. Zhang Yu of Minsheng Securities, a local brokerage, notes that banks have until mid-2019 before the rules are enforced. But investors are not waiting.

They have already started trimming their bond holdings, pushing yields higher.

Another focus for the government has been internet microlenders, lightly regulated institutions that often charge exorbitant interest rates. On November 21st officials ordered a halt in licence approvals for new online lenders. They have also sounded the alarm about the property market, vowing to stop homebuyers from borrowing funds illegally.

The question is how far the government will go. With the battle against risk so high on the political agenda, few think it will ease. A financial-stability committee, a powerful new body tasked with closing regulatory loopholes, held its inaugural meeting on November 8th. Zhou Xiaochuan, China’s veteran central-bank governor, has spoken on four separate occasions in the past two months about rising financial dangers.

Yet there are signs of a pushback. Banks are said to be lobbying against the most stringent of the proposed WMP rules, arguing that forced asset sales will only cause more serious financial stress. The value of bonds in default in November was 9bn yuan, a single-month record for China.

Officials can afford to allow their regulatory storm to rage on for now. China is still enjoying sunshine: its campaign to curb indebtedness is in its early days and yet to have much negative impact on economic growth. But the market ructions of the past couple of weeks point to rougher weather ahead.