China’s $9trn moral hazard grows too big to ignore

Bloomberg

China may be about to embark on its most ambitious — and perilous — campaign to convince investors that they shouldn’t depend on a bailout when markets go south.
In a rare show of cooperation, the nation’s main financial regulators are drafting new rules for asset-management products that aim to make clear the investments don’t have government guarantees, people familiar with the matter told Bloomberg News on Tuesday. The products, which promise higher returns than bank deposits but are viewed by many investors as a form of risk-free savings, have become an integral part of the Chinese financial system after swelling in recent years to almost $9 trillion as of June 30.
Policy makers face a difficult balancing act. If they fail to dispel the notion of an implicit government guarantee, riskier investments could proliferate and pose an even greater threat to the financial system when China faces its next bout of market turmoil. But if authorities act too forcefully now, they risk triggering a stampede away from products that have become a key funding source for banks.
“Rolling this back is China’s biggest financial challenge,” David Loevinger, a former China specialist at the U.S. Treasury who’s now an analyst TCW Group Inc. in Los Angeles, which oversees about $191 billion, said by e-mail. “But seeing is believing. Saying investors won’t get bailed out is important, but you have to show them you mean it.”
For President Xi Jinping’s government, it’s a particularly sensitive time to be shaking up an industry that manages assets worth more than three-quarters of China’s gross domestic product. Policy makers have been placing an emphasis on financial stability as the ruling Communist Party prepares for a twice-a-decade leadership reshuffle later this year. They also need to grapple with a host of other risks, from a potential trade war with America to political upheavals in Europe and North Korea’s nuclear program.
History suggests Beijing may have a hard time following through on reforms. One of the biggest tests of the implicit guarantee on trusts — sold to wealthy individuals — came in 2014 when a product called Credit Equals Gold No. 1 lacked the funds to repay investors. The trust, which was sold to clients of state-run Industrial & Commercial Bank of China Ltd., was eventually bailed out by unidentified buyers after the episode roiled markets around the world. When Chinese equities crashed in the summer of 2015, the government went to extreme lengths to protect individual investors from losses, allowing hundreds of companies to halt trading in their shares and banning major stockholders from selling. State-run funds also spent billions to prop up the market, which has rallied more than 20 percent from its low at the start of 2016.
The investments said to be under consideration by regulators play a much bigger role in China’s financial system than the stock market. The draft rules would apply to new products issued by banks, insurers, brokerages and other financial institutions, said the people, who asked not to be identified because the discussions are private.
China’s asset-management products totaled about 60 trillion yuan ($8.7 trillion) as of June 30, according to a recent estimate by an official at the China Securities Regulatory Commission. Off-balance sheet wealth-management products issued by banks, which are backed mostly by bonds and loans, amounted to 26 trillion yuan at the end of December, according to the central bank.
Trust firms had 15.3 trillion yuan of products outstanding at the end of June, according to the CSRC official. Specialized asset management products, issued mostly to institutional investors by China’s mutual fund companies, were worth 16.5 trillion yuan, and brokerage firms had issued 14.8 trillion yuan. Most of them are purchased with the expectation of a fixed return.
So far, that assumption has proven correct. Even though more than 70 percent of WMPs lack principal guarantees, banks have almost always delivered the marketed return. Among more than 181,000 products that matured in 2015, just 44 suffered a loss, according to official data. When products struggle to repay, banks often resolve the problem by tapping into their own assets, the People’s Bank of China said in its quarterly monetary policy report on Friday.

MARKET REACTION
“The belief in repayment, even though it’s often a misperception, has given investors the confidence to roll over the products again and again as they are regarded as quasi-deposits, said Hou Wei, a Hong Kong-based analyst at Sanford C Bernstein & Co.
Under the new draft rules, which would only apply to new products, financial institutions are banned from issuing any products that guarantee principal or interest, people familiar with the matter said. The draft is still being discussed and is subject to changes, the people said. China Insurance Regulatory Commission Vice Chairman Chen Wenhui confirmed in a briefing on Wednesday that regulators have been designing an overall supervision framework for asset management products.
The PBOC, the CSRC and the banking regulator didn’t respond to requests for comment. Chinese markets have taken news of the regulatory discussions in stride. The Shanghai Composite Index rose 0.2 percent and the yuan was little changed on Wednesday. While government bond yields rose slightly on Tuesday, they’re still below this year’s high reached during the first week of February. Noah Holdings Ltd., a US-listed distributor of WMPs in China, climbed 1.3 percent in New York trading.
For TCW’s Loevinger, the real test for gauging whether China is committed to tackling its moral hazard problem may only come when an asset-management product faces losses. “This will ultimately require having more investors getting their fingers burnt,” he said.