China’s credit crackdown is starting to bite and we won’t be spared

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Should we be bracing for a coming China crash?

Figures released on Monday clearly show that the Chinese economy is losing momentum as tighter financial conditions – including higher money market interest rates and tougher regulatory rules – begin to bite.

In July, industrial production and retail sales showed the weakest increases since February, while investment grew at its slowest pace since December.

Meanwhile, housing sales rose at a 2 per cent annual clip in July, down from the breath-taking 21 per cent pace in the first six months of the year, while housing starts dropped 3 per cent year-on-year – the first fall since September.

Their waning interest is spreading to other property markets, with Chinese investors increasingly turning their backs on Australia.

The economic slowdown was largely expected, as Beijing stepped up its efforts to rein in rampant credit growth, which has pushed Chinese corporate debt levels to a worrying 169 per cent of GDP.

Chinese leaders have become increasingly concerned that the country’s debt-fuelled growth model is fuelling financial risks, while having a diminishing effect on growth.

China’s huge steel industry, however, defied the slowdown, cranking up output to a record 72 million tonnes in July, in order to benefit from soaring domestic prices.

Steel prices have soared in expectation of a looming reduction in supply,after Beijing ordered steel producers in four northern provinces to cut output in the northern winter months to reduce chronic air pollution.

But despite the clear evidence that economic activity is slowing, China’s central bank – which has increasingly taken on the mantle as the country’s main financial regulator – announced that would introduce tighter rules on how banks classify a major source of wholesale funding – negotiable certificates of deposits (NCDs).

This is an important development because small and medium-sized Chinese banks have become increasingly reliant on these financial instruments to raise funds as their traditional deposit base has dried up. In the past year, the number of NCDs on issue has surged almost 60 per cent to 8.4 trillion yuan ($1.6 trillion).

Small and mid-sized Chinese banks “channel” much of the money raised from issuing NCDs into non-bank financial institutions – such as wealth management companies – which then provide loans to riskier corporate borrowers, or to make big speculative bets in commodities, such as iron ore.

And this has been an important source of funding for many cash-strapped borrowers, who are unable to borrow from the big state-owned banks, and which have to pay prohibitive rates to borrow in the country’s corporate bond market.

They’ve been able to avoid default by borrowing high-cost money from China’s “shadow banking” sector.

But the new rules will mean that instead of classifying NCDs as bonds, small and mid-sized banks will have to include them in their tally of borrowings from other banks.

This is expected to leave dozens of smaller Chinese lenders in breach of the rule which says that borrowings from other banks can only amount to one-third of their total liabilities, and will leave them with an invidious choice.

Either they’ll have to call in some of their investments, or they’ll have to find alternative sources of funding.

Some analysts argue there are good reasons to expect that China will be moderate in its clamp-down on credit growth.

After all, China is about to hold a key Communist Party meeting that will select its next generation of leaders.

They argue that although Chinese President Xi Jinping is keen to promote greater stability in financial system, he won’t want to see a major slow-down in economic activity.

Another reason is that the clamp down in credit growth is far much more moderate than in previous Chinese tightening cycles in 2010 and 2013, which makes it more likely that the Chinese economic slowdown will be less pronounced.

Growth in total social financing – a broad measure of credit and liquidity in the Chinese economy – has only slowed by around 3 percentage points since its early 2016 peak.

By contrast, at this point in previous tightening cycles, credit growth had already slowed by nearly 6 percentage points.

But, as the Reserve Bank of Australia points out in its latest statement, total social financing figures “do not capture some of the credit extended through channel investments, so they are likely to understate the slowing in the growth of financial activity.”

As the Reserve Bank points out, the “uncertainty about how the authorities will negotiate the difficult trade-off between growth and the build-up of leverage in the Chinese economy” will inevitably have a major bearing on Australia’s economic performance.

The statement warns that if Beijing clamps down too hard on the shadow banking sector, as well as tightening the regulatory regime, this “could lead to tighter-than-expected financial conditions and result in growth being weaker than expected”.

And this will have a major impact on commodity prices, and Australia’s export earnings.

As activity in China’s industrial and manufacturing sectors brakes sharply, the growth in demand for steel, as well as iron ore and coking coal, could be lower than expected.

by Karen Maley
Financial Review

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