China’s crackdown on shadow banking could seriously upset global markets
Very much the driving force behind the ‘reflation trade’, the global repercussions of further Chinese regulatory and monetary tightening to tame financial risk could become a lot more severe
Amid all the talk of remarkably subdued levels of volatility, signs of potentially severe stress are emerging from one of the most – if not the most – vulnerable areas in global financial markets: China’s unruly shadow banking sector.
The Beijing government’s efforts to discipline its financial system and rein in a huge credit bubble have already led to a deterioration in sentiment in the country’s equity and debt markets.
Since the drive to curb financial leverage intensified in early April, China’s banks have started withdrawing money from so-called entrusted investments – asset or wealth management products that banks outsource to third-party asset managers – which has forced non-bank financial institutions to sell their bond and equity holdings.
The Shanghai Composite Index, which on April 11 reached its highest level since January 2016 – the month during which global stock markets suffered a dramatic sell-off because of heightened fears about China’s economy and policy regime – has fallen more than 5.5 per cent over the past month. Short-term lending rates, meanwhile, have surged since President Xi Jinping told a politburo meeting on April 26 that maintaining financial stability was “strategically important”. The overnight Shanghai interbank offered rate currently stands at its highest level since April 2015.
More worryingly, there are signs that China’s economy is beginning to slow once again. On April 30, the publication of an official purchasing managers’ index survey showed that growth in the manufacturing sector last month fell to a six-month low. A separate survey for China’s services sector also revealed that activity has dropped to its lowest level in six months.
A brutal sell-off across commodity markets is putting China’s manufacturing industry under strain and, more alarmingly for international investors and traders, accentuating the risks posed by Beijing’s efforts to tighten liquidity and rein in shadow bank credit.
While the steep falls in commodity prices – iron ore has dropped below US$60 a tonne for the first time in six months, copper prices are down more than 6 per cent since the end of March, while Brent crude, the international oil benchmark, is back below US$50 a barrel for the first time since late November – stem partly from persistent concerns about global oversupply, the sell-off is inextricably linked to measures to curb financial risk in China.
As ADM ISI, a London-based brokerage, rightly notes, “while oil’s fall owes much to doubts about the efficacy of production cut[s], this is as much or more about the China clampdown on credit and leverage”.
Make no mistake, the global repercussions of Chinese regulators’ efforts to tame financial risk could become a lot more severe in the coming weeks and months.
The whiff of another “January 2016” is in the air.
While Beijing’s regulatory crackdown on shadow finance is long overdue – China’s total debt as a share of gross domestic product has surged to nearly 265 per cent since the global financial crisis, while the value of wealth management products, a key part of shadow banking, has tripled to US$3.8 trillion in just three years, according to Bloomberg – the challenge of gently pricking an unprecedented credit bubble without roiling global markets and severely endangering growth in China is a daunting one.
The stakes could not be higher.
As Pimco, an asset manager, notes, Chinese credit has been the driving force behind the “reflation trade” over the past year or so. “Just as a less hawkish Federal Reserve is the backstop to market volatility, the Chinese growth ‘put’ is ultimately the backstop to [emerging market] and commodity-related credit risk,” Pimco wrote in a blog.
Among all the pressure points in markets – and there are many, ranging from concerns about economic policy under the new US administration to the governance of the ill-managed euro zone – regulatory and monetary tightening in China is the one that investors are the most sensitive to.
The betting is that Xi will prize market stability and economic growth above all else in the run-up to November’s crucial party congress at which he expects to cement his influence.
Yet it is also clear that the political impetus behind recent efforts to discipline China’s shaky financial system is considerable and is likely to intensify further, putting commodity markets under further strain.
For the time being, the fallout from the crackdown is confined to the commodity space. Global equity markets remain buoyant while EM bond and equity mutual funds continue to enjoy strong inflows.
Yet the scope for another major China-induced sell-off has increased considerably over the past month.
Nicholas Spiro is a partner at Lauressa Advisory