Oliver Dyson

Since the 2008 crisis, sovereign debt from the Emerging Markets has been on a steady rise. From the 146% to 217% increase in public debt across the IIF 21 countries (compared to aggregated GDP), it is clear that developing nations are more indebted today than at any point since the crisis. The same can be said for China. In an article published in November, I talked about the current issue of China’s rising credit binge. Keeping this in mind I thought it would be interesting and worthwhile to keep up with the developments in financial markets since then. This is especially pertinent given the importance of strong Chinese financial markets to the health of the global economy.

If we are just considering the debt pile, the picture still looks bleak for the nation. With an estimated $36trn of debt looming at the end of 2017, policymakers have the task of balancing strong GDP growth with deleveraging, to avoid excessive bubbles and issues for the future. As mentioned in my previous article on the subject, an interest rate hike was to be expected to combat the borrowing expansion, which indeed occurred in mid-December as the People’s Bank of China (PBOC) raised its 7-day and 28-day reverse repurchase agreements rates by 5 basis points. The other main development in the past few months is that the composition of the credit expansion can be pinpointed to a specific sector: shadow banking.

Playing a crucial role in the US 2008 Financial Crisis, the shadow banking system refers to the financial intermediaries who are not subject to regulatory oversight as well as the unregulated activities that are performed. Examples of these institutions credit hedge funds, money market mutual funds and securities lenders. As was the case for the US 10 years ago, economic growth is underpinned by borrowing in this sector, despite the financial risks that are mounting. To put the size of this system in perspective, the outstanding assets owned by Chinese shadow banks at the end of last year stood at $4.3trn, or 4 times the size of the Mexican economy. This came after a growth in their assets by $555bn in 2017, resulting from private companies resorting to other forms of financing following a general crackdown on credit. The issue for policymakers is that if a hard regulatory approach is taken to curb financial risk, a contraction could have serious implications for GDP. Indeed, the PBOC has been quoted as wanting to double GDP per capita by 2020, as well as clean up financial sector risks in the next three years. Can strong growth occur at the same time as reducing financial sector risk?

Earlier this month, regulators released policies that suggest that it can. Some economists argue that through a soft regulatory approach of tightened bond supervision and insurance, financial risks can be brought down to Earth. The three main policies are as follows. First, entrusted loans will face further scrutiny, with banks being ordered to limit their exposure to these products. Entrusted loans are made from one corporation to another with a trustee or agent acting as an intermediary, and they make up the fastest growing sector of shadow banking, according to BMI Research. Second, rules have been imposed aimed at preventing insurance firms from extending loans in the guise of equity investments using buyback agreements, a key component of rising local government debt. Finally, bond trading will face further supervision, with traders having to meet more stringent liquidity requirements. It is worth considering the effect on banks and firms going forward, given that cheap forms of financing are drying up or being cracked down on; it is likely that private investment could slowdown in the coming years. The aforementioned policies have worked in curbing shadow bank activity, however, with lending in the sector down by 90% in January.

In answer to my previous question, President Xi Jinping publicly stated at the end of last year that credit growth must be reigned in by focussing on financial risks, not deleveraging, to prevent any asymmetric shocks to the economy. Indeed, it is important not to end up in a Japanese-style ‘Lost Decade’ resulting from an aggressive policy decision.

Yet another issue facing the Chinese economy that is worth mentioning is the ongoing trade dispute with the USA. President Trump’s ‘America First’ trade policy will ‘hurt the world economy’ and ‘damage the recovering momentum’ of global growth, Beijing stated on Wednesday. This comes as a response to two US Commerce Department reports suggesting tariffs of up to 24% on Chinese products on Tuesday, which will be considered by Trump for a new round of sanctions. New sanctions of this magnitude would result in slower growth for China, while asset prices would likely drop at the news.

Developments in the USA tend to feed through to Chinese markets. This has certainly been the case with last week’s stock market rout, which saw falling equity prices at the news of Fed interest rate hikes after many years of stability. There are many fears that an era of cheap credit and stability are about to close, and this uncertainty is showing in Chinese markets, which have been some of the worst hit globally. The Shanghai stock Index lost 11% of its value over two weeks, while the blue-chip CSI300 index fell by 10%. This has been exacerbated by margin calls, and the ongoing campaign to reduce financial sector risks mentioned previously. Volatility has also risen; the iVx, a widely-used measure of fear in Chinese equities, surged to 33.06 last Friday, the highest in a year, while CSI200 futures saw their volume increase by 50%. This is significant given that these futures are used to short the blue-chip index, indicating a loss in confidence across the board. Many Exchange-Traded Funds have faced trouble as well. Credit Suisse, Nomura, Deutsche Bank and other big names have all closed Volatility-based ETFs after facing up to 80% losses in value last week. This is especially a problem given that ETFs are readily available to retail investors, who have seen a large loss in their portfolios on aggregate, to the tune of $USD 4bn. The full effect of the rout will only be see after the effects ripple through the OTC derivatives market, which will be a further test of the post-crisis regulation structure.

With what some describe as an end to the era of low volatility, the PBOC’s goal of reducing financial risks going forward is looking more difficult to achieve. As I posited in my previous article 3 months ago, the Chinese economy could grow sustainably only if these systemic risks could be curbed. Given the recent developments in global markets, the regulatory system will need to work extra hard so as not to spook the shadow banking sector.