As he puts the finishing touches on his second federal budget, Treasurer Scott Morrison may well be offering silent thanks to Beijing’s reflationary policies for delivering the sharpest jump in Australia’s national income for years.
But he’d be prudent to keep a close watch on China’s latest clamp-down on its huge shadow banking sector, which could be critically important for Australia’s medium-term growth prospects.
In particular, Morrison should be keeping a close eye on the actions of China’s energetic new top banking regulator, Guo Shuqing, who took up his new post in late February.
After all, Chinese banks, who have been hit by a flurry of new policy documents from the China Banking Regulatory Commission in recent weeks, are becoming increasingly wary that not only is Chinese bank regulation about to get a lot tougher, it’s also likely to be enforced more rigorously.
Their fears were exacerbated when the highly-regarded Chinese media group Caixin reported that at an internal government meeting on April 21, Guo pledged to “administer the strongest medicine” in response what he described as “chaos” in the banking system.
This combination of regulatory concerns and tighter market liquidity has pushed short-term borrowing costs in China to their highest level in two years. The Shanghai interbank overnight rate, or Shibor, has climbed above 2.8 per cent – the highest level since April 2015, when Beijing was trying to take some heat out of the country’s share market bubble – while the cost of borrowing for three months has now reached 4.3 per cent, up from 2.8 per cent only six months ago.
China’s major share and bond markets have also wilted as investors have realised that this spike in short-term rates is far from accidental. In the past two weeks, the Shanghai Composite has fallen more than 4 per cent, while the yield on 10-year bonds has climbed above 3.5 per cent for the first time since the 2015 devaluation.
Guo is targeting short-term borrowing costs for two reasons. In the first place, Chinese banks have become increasingly reliant on borrowing in these wholesale markets, with their claims against other financial institutions rising threefold since 2013 to more than $5 trillion.
Higher short-term money market rates pushes up funding costs for small and mid-size banks, which are major lenders to the smaller privately-owned property developers in regional areas. Beijing is trying to rebalance its lop-sided property market, at a time when home prices in the big Chinese cities have surged, while developers are still holding large inventories of unsold homes in smaller cities.
At the same time, borrowing costs for the large, debt-laden state owned enterprises – which account for two-thirds of China’s massive corporate debt – will remain unchanged, because these are priced off official borrowing and lending rates which are set by the Chinese central bank.
More importantly, however, higher short term market rates will discourage excessive levels of leverage in wealth management products (WMPs) – those opaque high yield financial products that are sold to retail investors.WMPs are becoming increasingly popular, with around 29 trillion yuan ($5.6 trillion), or around 40 per cent of GDP now invested in these products.
The problem is that WMPs have been taking on increasing financial risk, with some borrowing heavily in the short-term money market and investing the proceeds on highly leveraged bets on assets such as bonds, or commodity futures in order to boost the yields they offer.
Even more worrying, some WMPs have borrowed money to invest in other WMPs – similar to what happened in the subprime derivative market before the financial crisis – while others have use assets bought with short-term funds as collateral for yet more borrowing, multiplying the leverage in the Chinese financial system.
But there are growing concerns that China’s latest – and more vigorous – attempt to rein in its over-leveraged financial system could slow Chinese economic activity and curb the country’s voracious demand for commodities.
Already, prices for copper and iron ore have fallen from their highs set earlier this year, with iron ore – a key source of profits for both BHP Billiton and Rio Tinto – dropping more than 20 per cent in six weeks.
If this pattern continues, it’s likely to mean a far bleaker backdrop for next year’s budget.
By Karen Maley