Wake-up call from China

This article first appeared in The Edge Financial Daily, on November 29, 2017.
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THE pace at which Beijing is announcing deleveraging reforms following last month’s Communist Party Congress is a wake-up call for investors in Chinese markets: risk just got real. Sweeping new rules for the asset management industry, a crackdown on micro loans and losses imposed on the creditors of the state-owned Chongqing Iron & Steel are not yet a “Big Bang” of reforms.

Some of the measures were well flagged and will only kick in in 2019. But they are sending a signal to markets that policymakers are serious about deleveraging, something that has been urged by the International Monetary Fund and rating agencies for years and flagged as a top priority by President Xi Jinping at the party congress.

Debt markets reacted first, with benchmark 10-year borrowing costs hitting three-year highs above 4% and yield spreads between government and corporate debt widening as policymakers appear more tolerant of defaults.

Last week, the debt sell-off spilled over into equities, which saw their worst day in 19 months, and markets have since weakened further.

Surprising pace
“The pace of new regulations” being announced “does look somewhat surprising,” said Alexander Wolf, senior emerging markets economist at Aberdeen Standard Investments. “It might have caught some people off guard.”

But, he said, policymakers were ultimately trying to reduce risks in the system. “So I think that’s positive even if there’s some short-term volatility.”

Two weeks ago, the Chinese central bank and the top regulators for banking, insurance, securities and foreign exchange announced unified rules covering asset management. The aim was to close loopholes that allow regulatory arbitrage, reduce leverage levels, eliminate the implicit guarantees some financial institutions offer against investment losses and rein in shadow banking.

Last week, a top-level Chinese government body issued an urgent notice to provincial governments urging them to suspend regulatory approval for new Internet micro-lenders in a bid to curb household debt, which is currently low but rising rapidly.

In the meantime, creditors of Chongqing Iron & Steel Co took a 70% loss in a debt-to-equity swap restructuring of nearly 40 billion yuan (RM24.87 billion) of debt.

It is not the first time the authorities have tried to get markets to price risk. In March 2014, Shanghai Chaori Solar Energy Science and Technology Co Ltd missed a bond interest payment, marking China’s first domestic bond default. But about six months later, domestic bondholders were bailed out after the default caused a jump in corporate bond yields.

Debt-to-equity swaps are complex operations that are harder to undo than a missed bond payment and analysts say the move signals a clear path for tackling high corporate debt levels, which the Bank for International Settlements estimates at 1.6 times the size of the economy.

“If you own the wrong stuff you’re in trouble because they are not going to bail you out any more,” said Joshua Crabb, head of Asian equities at Old Mutual Global Investors.

Crabb, however, remains bullish on China. Likewise, Aberdeen’s Wolf says China is “too big to ignore” and will look for select opportunities in other sectors aligned to policy priorities, such as consumption and technology, while avoiding the small banks that lose business as corporates deleverage.

A key reason is that, unlike during the 2015 “Black Monday” stock market sell-off, there are fewer reasons to panic. Back then, valuations were 25% higher and China’s capital account was more open, allowing the sell-off to spill over into the foreign exchange market and damage investor confidence.

China has since made it harder to move money overseas — September’s crackdown on cryptocurrencies being the latest move to close an exit route — so policymakers have better hopes of keeping the yuan stable.

“Depreciation fears have somewhat alleviated and policymakers have been doing a great job in terms of managing outflows and changing overall expectations,” said Jean-Charles Sambor, deputy head of emerging market debt at BNP Paribas Asset Management.

He said, however, that the recent announcements warranted a switch to government debt from corporate debt as he expected default rates to rise, while public debt should benefit from being included in MSCI’s widely used bond indexes.

Moving gradually
The other source of comfort for investors is that Chinese policymakers are still keeping an eye on growth — they are likely to keep this year’s target of “around 6.5%” in 2018, according to policy sources.

This means that they will be wary of tightening financial conditions too much to avoid hurting the healthier parts of the economy in the process, analysts say.

“We feel that the regulators are serious about reducing systemic risk,” said one risk manager at a Chinese bank in Guangdong province, who asked not to be named due to the sensitivity of the subject. He added that his bank’s priority switched this year from business expansion to risk management.

“However, the adjustment should be a long-term process since drastic changes within a short period will cause additional risks which will be against the regulators’ purpose.” — Reuters