China
11 October 2011
China has been the economic powerhouse over the past decade, but are the cracks starting to show?
Image: Shutterstock
China might be headed for trouble during a time of global economic uncertainty because of its 鈥渟hadow banking鈥� system - will the country鈥檚 regulators continue down the path of reforms intended to increase market liquidity?
After travelling to China, Nomura analysts Lucy Feng and Donger Wang concluded that China鈥檚 banks are showing signs of strain.
鈥淸The] shadow-banking credit situation has worsened since our June visit鈥e have seen a continued expansion of shadow-banking credit and a decline in its quality since our most recent visit in June this year. We believe the situation is worsening, as shown by the rapid growth, 28.8 per cent year on year and of outstanding trust funds, compared to 15.2 per cent by the end of the first half of this year, as well as a 119.4 per cent year on year surge in new entrusted loans in the first half,鈥� said Feng and Wang in the joint report.
The duo estimates that total shadow-banking credit increased to CNY 10.4 trillion at the end of the first half, up by 10.5 per cent compared to the same period the year previous and representing 20.3 per cent of total bank loans.
One of the more jarring figures is a skyrocketing debt to GDP ratio of above 135 per cent under adverse scenarios, such as a government bail-out amid accumulation systemic risks.
鈥淎lthough China鈥檚 government debt to GDP ratio of 43.6 per cent stood well below the international dividing line of 60 per cent as of end 2010, we are worried that it may climb substantially if the boom-bust of shadow-banking credit forces the government to assume not only central and local government debt but also underground credit in a deleveraging environment,鈥� write Feng and Wang.
News headlines have recently highlighted the growth of SME bankruptcy, particularly in Wenzhou, a city in the south-eastern Zhejiang province known for entrepreneurism and private lending, while public discourse focuses on the urgent necessity to bail out a large number of SMEs amid a backdrop of appreciating local currencies, rising labour costs, softening economic conditions and, in particular, tight liquidity.
鈥淕iven tight liquidity conditions and a tougher operating environment, many entrepreneurs in Wenzhou have suddenly 鈥渄isappeared鈥� as a result of breaks in their financing chain. It seems that the situation is becoming even worse now, as more entrepreneurs seem to have run away because they cannot pay back the money that they owe,鈥� report Feng and Wang.
According to Nomura鈥檚 economics team, China鈥檚 CPI inflation will remain elevated at 6.3 per cent year on year and 5.4 per cent in the third and fourth quarters this year respectively, while the forecast for real GDP growth (accounting for inflation) is at 9.4 per cent in the fourth quarter.
鈥淎s such, we think there should be limited room for monetary policy loosening on the interest-rate front before the first quarter of 2012. In our view, any directional changes in China鈥檚 monetary policy would require either real GDP growth to slow significantly to below nine per cent year on year, or CPI inflation to ease to between four and five per cent to mitigate the negative real deposit interest rate,鈥� they write.
So, while global growth hopes have been pinned on China鈥檚 juggernaut economy, news that its balance sheet could take a big hit from the shadow banking system in an era of central banks with limited policy tools is sure to hit global stock markets. This, past the damage already inflicted by a worsening eurozone debt crisis and while regulators continue to navigate the OTC markets.
Shadow banking, also known as market-based financing, is on the radar of supranational regulators, notably the Financial Stability Board (FSB), which is setting up working groups to recommend regulation of activities associated with credit intermediation outside the official banking system.
And China鈥檚 securities regulator is also paying attention considering developments within the country.
Speaking at the Pan-Asian Regulatory Summit in Singapore at the end of September, Dr Eddy Fong, chairman of the 麻豆传媒 and Futures Commission (SFC), the capital markets regulator, stated that for Asia to have an impact on the shaping global regulatory reforms, Asian nations must continue to actively engage their counterparts in the West through participation in various standard setting bodies and international organisations, such as the FSB.
The SFC declined requests for an interview, however, experts have stated that international regulations are not likely to have a material impact on China鈥檚 regulators any time soon.
Still, with liquidity concerns running high in an uneven, uncertain global economic recovery, the natural question arises 鈥� will market reforms intended to increase market liquidity continue down the development path or might heightened fears of introducing new mechanisms stall it?
Legal eagles
Development of the securities lending markets is slow but observers are seeing sign posts of advancement from the China 麻豆传媒 Regulatory Commission (CSRC).
Patrick Phua, partner at law firm Mallesons, says that since China鈥檚 State Council approved a package of measures for securities lending and futures index and margin trading in January 2010, progress has been made.
鈥淲hat is really encouraging is that reform is taking place and the direction is clear, regulators are still progressing down the path of convergence with overseas market practice. They are adopting best practices from overseas jurisdictions and lessons from the 2008 market turmoil. But the progress has taken time,鈥� says Phua, currently based in Beijing.
After a hiatus of nearly two years with little movement, a recent consultation draft from CSRC indicates that the two-year government-run pilot programme will be extended to allow a larger pool of brokerages access to securities lending practices, as well as making entry thresholds lower.
But there is still some way to go towards providing depth to the market. Phua explains that securities brokerages do not have a substantial amount of proprietary inventory for lending, and, combined with existing barriers to participants outside of the securities brokerages, the government-run pilot programme has been 鈥渁 controlled experiment鈥�.
In March 2011, Martin Chen, vice president of Corporate Trust department at the Chinatrust Commercial Bank (CTCB) provided an overview of the securities lending market in China and the pilot programme which began approving brokers between the end of March and December 2010. In total 25 pilot-run brokers with 2200 branches can operate margin trading and short selling business in China, accounting for more than 50 per cent of the total number of branches of all securities firms in China.
There are currently 50 eligible stocks in Shanghai Stock Exchange and another 40 eligible stocks in Shenzhen Stock Exchange, while eligible collateral includes cash, government bonds, ETFs, listed fund and bonds and listed shares, each with varying levels of haircuts.
In addition, short selling fees are high - at 10.35 per cent per annum compared to margin trading at 8.35 per cent, while initial margin stands at 150 per cent and maintenance margin is 130 per cent.
Moreover, there is an anticipated learning curve as short selling is a relatively new concept for China.
Some headway is being made on this front - Global Times reports that at the end of September this year, the government provided training for 75 securities companies on margin trading and short selling. Something that Phua thinks is a sign of things to come, although any development will remain sensitive to the macroenvironment.
Phua notes that Chinese regulators viewed complex financial products with strong disfavour after the Lehman crash, and the fact that a host of European regulators are imposing short selling bans during the current eurozone debt crisis may affect ongoing reforms.
鈥淚t is unfortunate that just when the second phase of the securities lending pilot is starting, we are running into what could be the second phase of market turmoil,鈥� says Phua. 鈥淎t the same time, Chinese regulators are commendable, in that they recognise the benefits of securities lending and short selling but are intent on a conservative approach to implementation.鈥�
Although disputed among officials, a timeline of five years for easing of capital controls has been put forward by the regulator, State Administration of Foreign Exchange (SAFE). Whatever the timeline may end up being, there is wide spread consensus among international experts and analysts that China intends to internationalise the RMB.
鈥淛ust greater partial convertibility would result in an explosion of cross-border activity,鈥� says Phua. 鈥淭he impact on the global economy cannot be underestimated.鈥�
It begs the question 鈥� once the flood has come through, does it make sense to erect any one section of the dyke?
鈥淎lthough it is just a matter of time before other restrictions come down, many things are dependent on macroeconomic and political developments, both globally and within China,鈥� Phua notes.
Tie Cheng Yang, a partner in the Beijing office of law firm Clifford Chance says he expects that the securities lending market will continue to be liberalised, noting the regulator encourages financial innovation, albeit that, in China, every financial innovation is originated by the regulators and not by market players.
鈥淔or foreign institutions, in order to get access to domestic securities lending business, they may have to set up a securities company in China first. In the future, CSRC may permit domestic securities companies to provide securities lending business to [Qualified Foreign Institutional Investors] QFIIs,鈥� says Yang. 鈥淪o far, only big domestic-funded securities companies are licensed for the pilot stage 鈥� this may be expanded to all securities companies in China, including securities companies with foreign investment.鈥�
Seclending rumblings
There are, however, some rumblings of what those securities companies might look like. After a consultation with large funds, the Chinese regulator is considering implementing a non-profit securities finance company that would act as a third party securities lending provider between institutional investors and borrowers. The idea just might be the beginnings of a third party lending environment with a dedicated pool of securities, solving some of the issues associated with a thin market, albeit with a 鈥渇irewall鈥� between securities brokerages and a non-profit securities finance company.
It is highly unlikely, says a source familiar with the situation, that the scheme would include retail investors, however, which comprise some two-thirds of the market.
鈥淭he retail investor is critical to the Chinese stock market and regulators in China are very conservative, the last thing regulators want is to introduce innovation that blows up badly, like a securities finance company that becomes insolvent,鈥� the source notes.
Hong Kong favouritism?
Hong Kong generally gets preferential treatment from China. And the tie that binds is getting stronger, through the Mainland Hong Kong Closer Economic Partnership Arrangement (CEPA). At the moment, however, there is no preferential proposal put forward for Hong Kong companies to engage in securities lending.
鈥淭here isn鈥檛 anything in place that allows [Hong Kong] companies to come in and participate in securities lending or securities finance arena, so there is no agreement to assist Hong Kong companies right now,鈥� an analyst familiar with both markets says.
In fact, dual-listed shares between mainland China and Hong Kong do not have a mechanism for arbitrage, as attempts to allow the practice saw the mainland premium instantly drop, while QFIIs, such as BlackRock and Amundi, have quotas limiting investment in China鈥檚 equity markets.
鈥淎ll things said and done with respect of any offshore market development in securities lending, the reality is there isn鈥檛 a functioning model just yet,鈥� the analyst says.
After travelling to China, Nomura analysts Lucy Feng and Donger Wang concluded that China鈥檚 banks are showing signs of strain.
鈥淸The] shadow-banking credit situation has worsened since our June visit鈥e have seen a continued expansion of shadow-banking credit and a decline in its quality since our most recent visit in June this year. We believe the situation is worsening, as shown by the rapid growth, 28.8 per cent year on year and of outstanding trust funds, compared to 15.2 per cent by the end of the first half of this year, as well as a 119.4 per cent year on year surge in new entrusted loans in the first half,鈥� said Feng and Wang in the joint report.
The duo estimates that total shadow-banking credit increased to CNY 10.4 trillion at the end of the first half, up by 10.5 per cent compared to the same period the year previous and representing 20.3 per cent of total bank loans.
One of the more jarring figures is a skyrocketing debt to GDP ratio of above 135 per cent under adverse scenarios, such as a government bail-out amid accumulation systemic risks.
鈥淎lthough China鈥檚 government debt to GDP ratio of 43.6 per cent stood well below the international dividing line of 60 per cent as of end 2010, we are worried that it may climb substantially if the boom-bust of shadow-banking credit forces the government to assume not only central and local government debt but also underground credit in a deleveraging environment,鈥� write Feng and Wang.
News headlines have recently highlighted the growth of SME bankruptcy, particularly in Wenzhou, a city in the south-eastern Zhejiang province known for entrepreneurism and private lending, while public discourse focuses on the urgent necessity to bail out a large number of SMEs amid a backdrop of appreciating local currencies, rising labour costs, softening economic conditions and, in particular, tight liquidity.
鈥淕iven tight liquidity conditions and a tougher operating environment, many entrepreneurs in Wenzhou have suddenly 鈥渄isappeared鈥� as a result of breaks in their financing chain. It seems that the situation is becoming even worse now, as more entrepreneurs seem to have run away because they cannot pay back the money that they owe,鈥� report Feng and Wang.
According to Nomura鈥檚 economics team, China鈥檚 CPI inflation will remain elevated at 6.3 per cent year on year and 5.4 per cent in the third and fourth quarters this year respectively, while the forecast for real GDP growth (accounting for inflation) is at 9.4 per cent in the fourth quarter.
鈥淎s such, we think there should be limited room for monetary policy loosening on the interest-rate front before the first quarter of 2012. In our view, any directional changes in China鈥檚 monetary policy would require either real GDP growth to slow significantly to below nine per cent year on year, or CPI inflation to ease to between four and five per cent to mitigate the negative real deposit interest rate,鈥� they write.
So, while global growth hopes have been pinned on China鈥檚 juggernaut economy, news that its balance sheet could take a big hit from the shadow banking system in an era of central banks with limited policy tools is sure to hit global stock markets. This, past the damage already inflicted by a worsening eurozone debt crisis and while regulators continue to navigate the OTC markets.
Shadow banking, also known as market-based financing, is on the radar of supranational regulators, notably the Financial Stability Board (FSB), which is setting up working groups to recommend regulation of activities associated with credit intermediation outside the official banking system.
And China鈥檚 securities regulator is also paying attention considering developments within the country.
Speaking at the Pan-Asian Regulatory Summit in Singapore at the end of September, Dr Eddy Fong, chairman of the 麻豆传媒 and Futures Commission (SFC), the capital markets regulator, stated that for Asia to have an impact on the shaping global regulatory reforms, Asian nations must continue to actively engage their counterparts in the West through participation in various standard setting bodies and international organisations, such as the FSB.
The SFC declined requests for an interview, however, experts have stated that international regulations are not likely to have a material impact on China鈥檚 regulators any time soon.
Still, with liquidity concerns running high in an uneven, uncertain global economic recovery, the natural question arises 鈥� will market reforms intended to increase market liquidity continue down the development path or might heightened fears of introducing new mechanisms stall it?
Legal eagles
Development of the securities lending markets is slow but observers are seeing sign posts of advancement from the China 麻豆传媒 Regulatory Commission (CSRC).
Patrick Phua, partner at law firm Mallesons, says that since China鈥檚 State Council approved a package of measures for securities lending and futures index and margin trading in January 2010, progress has been made.
鈥淲hat is really encouraging is that reform is taking place and the direction is clear, regulators are still progressing down the path of convergence with overseas market practice. They are adopting best practices from overseas jurisdictions and lessons from the 2008 market turmoil. But the progress has taken time,鈥� says Phua, currently based in Beijing.
After a hiatus of nearly two years with little movement, a recent consultation draft from CSRC indicates that the two-year government-run pilot programme will be extended to allow a larger pool of brokerages access to securities lending practices, as well as making entry thresholds lower.
But there is still some way to go towards providing depth to the market. Phua explains that securities brokerages do not have a substantial amount of proprietary inventory for lending, and, combined with existing barriers to participants outside of the securities brokerages, the government-run pilot programme has been 鈥渁 controlled experiment鈥�.
In March 2011, Martin Chen, vice president of Corporate Trust department at the Chinatrust Commercial Bank (CTCB) provided an overview of the securities lending market in China and the pilot programme which began approving brokers between the end of March and December 2010. In total 25 pilot-run brokers with 2200 branches can operate margin trading and short selling business in China, accounting for more than 50 per cent of the total number of branches of all securities firms in China.
There are currently 50 eligible stocks in Shanghai Stock Exchange and another 40 eligible stocks in Shenzhen Stock Exchange, while eligible collateral includes cash, government bonds, ETFs, listed fund and bonds and listed shares, each with varying levels of haircuts.
In addition, short selling fees are high - at 10.35 per cent per annum compared to margin trading at 8.35 per cent, while initial margin stands at 150 per cent and maintenance margin is 130 per cent.
Moreover, there is an anticipated learning curve as short selling is a relatively new concept for China.
Some headway is being made on this front - Global Times reports that at the end of September this year, the government provided training for 75 securities companies on margin trading and short selling. Something that Phua thinks is a sign of things to come, although any development will remain sensitive to the macroenvironment.
Phua notes that Chinese regulators viewed complex financial products with strong disfavour after the Lehman crash, and the fact that a host of European regulators are imposing short selling bans during the current eurozone debt crisis may affect ongoing reforms.
鈥淚t is unfortunate that just when the second phase of the securities lending pilot is starting, we are running into what could be the second phase of market turmoil,鈥� says Phua. 鈥淎t the same time, Chinese regulators are commendable, in that they recognise the benefits of securities lending and short selling but are intent on a conservative approach to implementation.鈥�
Although disputed among officials, a timeline of five years for easing of capital controls has been put forward by the regulator, State Administration of Foreign Exchange (SAFE). Whatever the timeline may end up being, there is wide spread consensus among international experts and analysts that China intends to internationalise the RMB.
鈥淛ust greater partial convertibility would result in an explosion of cross-border activity,鈥� says Phua. 鈥淭he impact on the global economy cannot be underestimated.鈥�
It begs the question 鈥� once the flood has come through, does it make sense to erect any one section of the dyke?
鈥淎lthough it is just a matter of time before other restrictions come down, many things are dependent on macroeconomic and political developments, both globally and within China,鈥� Phua notes.
Tie Cheng Yang, a partner in the Beijing office of law firm Clifford Chance says he expects that the securities lending market will continue to be liberalised, noting the regulator encourages financial innovation, albeit that, in China, every financial innovation is originated by the regulators and not by market players.
鈥淔or foreign institutions, in order to get access to domestic securities lending business, they may have to set up a securities company in China first. In the future, CSRC may permit domestic securities companies to provide securities lending business to [Qualified Foreign Institutional Investors] QFIIs,鈥� says Yang. 鈥淪o far, only big domestic-funded securities companies are licensed for the pilot stage 鈥� this may be expanded to all securities companies in China, including securities companies with foreign investment.鈥�
Seclending rumblings
There are, however, some rumblings of what those securities companies might look like. After a consultation with large funds, the Chinese regulator is considering implementing a non-profit securities finance company that would act as a third party securities lending provider between institutional investors and borrowers. The idea just might be the beginnings of a third party lending environment with a dedicated pool of securities, solving some of the issues associated with a thin market, albeit with a 鈥渇irewall鈥� between securities brokerages and a non-profit securities finance company.
It is highly unlikely, says a source familiar with the situation, that the scheme would include retail investors, however, which comprise some two-thirds of the market.
鈥淭he retail investor is critical to the Chinese stock market and regulators in China are very conservative, the last thing regulators want is to introduce innovation that blows up badly, like a securities finance company that becomes insolvent,鈥� the source notes.
Hong Kong favouritism?
Hong Kong generally gets preferential treatment from China. And the tie that binds is getting stronger, through the Mainland Hong Kong Closer Economic Partnership Arrangement (CEPA). At the moment, however, there is no preferential proposal put forward for Hong Kong companies to engage in securities lending.
鈥淭here isn鈥檛 anything in place that allows [Hong Kong] companies to come in and participate in securities lending or securities finance arena, so there is no agreement to assist Hong Kong companies right now,鈥� an analyst familiar with both markets says.
In fact, dual-listed shares between mainland China and Hong Kong do not have a mechanism for arbitrage, as attempts to allow the practice saw the mainland premium instantly drop, while QFIIs, such as BlackRock and Amundi, have quotas limiting investment in China鈥檚 equity markets.
鈥淎ll things said and done with respect of any offshore market development in securities lending, the reality is there isn鈥檛 a functioning model just yet,鈥� the analyst says.
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