Comment on deleveraging China

Executive Summary

China is trying to slow its credit scale and growth by deleveraging, with a focus on the high leverage of SOEs in industries with excess production capacity. To support this, the PBOC, China's Central Bank, has implemented the "half tightened policy" to adjust the monetary markets, creating funding cost increases whilst still keeping financial liquidity stable. Authorities have upgraded their supervision to govern potential operational chaos that may arise from adding leverage and restrict capital outflows. We have seen some effective impact but risk remains.

Deleverage especially for SOEs to slow credit growth

Credit growth has increased rapidly in recent years and many enterprises' leverage is at historical highs. China's capital market is still developing and provides fewer opportunities for equity financing; enterprises mainly rely on indirect financing resulting in relatively high credit ratios which have also increased risks in the shadow banking system. From 2008 to 2016, China's social non-financial enterprises leverage ratio (liabilities/GDP) increased from 114% to 209.5% (BIS). In particular, SOEs' debt increase has grown rapidly to a ratio of 177% (China MOF). However, residents, financial institutions and governments' leverage ratios are relatively much lower, a natural characteristic of China's debt structure.

Our views on China's deleveraging have been that the most effective means of reducing leverage is SOE reform (reigning in borrowing, disposal of non-performing assets and bringing private ownership into state-dominated sectors) and financial reform (to increase the size and scale of equity market financing preferably with more from investment from foreigners). However, in the run up to the 19th Party Congress, de-leveraging has been placed on the back burner somewhat as focus has been primarily upon economic growth and stability (focus has actually been on several targets simultaneously - GDP growth, financial sector stability, and RMB exchange rate stability). Policymakers will only start to address corporate leverage issues after the leadership transition is completed.

Mortgage tightened to counter potential bubbles, but credit risk remains

To counter potential bubbles in the property sector, policymakers have strengthened restrictions on purchases (increasing minimum down payment requirements and interest rates). The market has been cooling with decreases seen in both property prices and sales since Q2 2017, and the ratio of mortgage to newly added loans dropped to 38.9% in May compared to 53.6% year over year. Tightened credit conditions are also making it difficult for developers to finance through entrusted loans, corporate bonds and related property asset management programs.

However, we should consider the opposite result. If these declines and restrictions continue into 2018 and, for example, sales decrease by 30%, the liquidity of real estate enterprises may become increasingly exhausted. Combined with a peak in the maturity of property bonds expected to occur between 2018 and 2021, this may result in an unintended increase in overall credit risk. On the other hand, as stressed above, the key is the extent of enterprises' leverage rather than domestic leverage. As such, efforts to cool the domestic property market will not essentially reduce the broader group of enterprises' leverage.

Interbank boom must be strictly supervised to reduce leverage in Financial Services

During the recent economic slowdown, following reductions in returns on investment, a considerable amount of fund transferring among financial institutions has been directed to capturing arbitrage profits rather than representing injections into the real economy. This has led to increased leverage that has the potential to erode the overall capital adequacy within China's financial system. Through a combination of wholesale borrowing, the issuance of off-balance sheet Wealth Management Products (WMPs) and Negotiable Certificates of Deposits (NCDs), there has been an overall increase in debt levels, replacing traditional deposits, investment bonds and non-standard assets by entrusting external investors (the so called “shadow banking” phenomenon). In particular, major players and small and medium sized banks have expanded balance sheets very quickly, with more than 30% growth year over year. However, capital growth in the Banking sector has not been able to sustain the same pace of expansion, placing pressure on both the operations and leverage positioning of many Banks, similar to the boom experienced in the lead up to the past financial crisis. The 2016 growth rate in Bank overall equity was 13.2% - 3.4 percentage points less than total assets growth (16.6%) with a resultant contraction in capital adequacy ratios by 0.17 percentage points down to 13.28.

To ensure that Banks operate prudently, in conjunction with the half tightened monetary policy, the PBOC has further implemented a stricter Macro Prudential Assessment (MPA) which requires the growth of a Bank's credit and lending (including off-balance sheet WMPs) and interbank debt to be no faster than the targeted benchmark ratio compared with M2. At the same time, the Chinese Banking Regulatory Commission, China's banking regulatory authority, has strengthened its supervision of arbitrage activities in the interbank business (NCDs, entrusted investment).

These measures are showing some impact as the May WMP balance decreased by 5.3% on a relative base, interbank funding cost increased, and the increase of total assets in financial institutions slowed, with some shrinkage in some Banks' balance sheets. May M2 growth dropped at 9.6% year over year, which is an encouraging sign and is mainly due to the reduction of internal leverage within the overall financial system. It is reasonable to conclude that the expansion of investment which is highly associated with interbank, asset management, off-balance sheet and shadow banking activities will be slower, and derived deposits will further decrease.

High leveraged outbound M&A activity is restricted to control capital outflow

China's authorities have paid particular attention to large outbound M&A activities to control capital outflow since the end of 2016. Targeted conglomerates include those who acquire offshore loans with parent company guarantees from the mainland. Regulators have further upgraded supervision over these highly leveraged offshore operations, in particular those undertaken by private enterprises. China's foreign exchange reserve in May increased to 3.05 trillion since dropping below 3 trillion dollars for the first time in January 2017.

In conclusion, to lower down its credit growth, China has accelerated deleveraging both in enterprises and financial institutions. With half tightened monetary policy and upgraded supervision, Banks' rapid expansion has been slowed and enterprises' credit and business operations should become more prudent. This should further be reflected in M2 growth which is expected to be less than 10% under China's New Normal economy.