Modern economies rely on complex financial systems to support growth and prosperity. At an earlier stage of development, China succeeded despite an immature financial system, as state-led investments in sectors such as infrastructure were high return. Today’s requirements are more complicated and risks are apparent. China’s financial reform goals include improving efficiency (return on investment) and reducing systemic risk while attempting to preserve state influence. China has made strides, but long-standing tasks remain unfinished even while new ones emerge and the cost of retiring old liabilities swells.

To gauge the state of financial system reform, we construct a quarterly incremental capital output ratio (QuICOR) as an acid test for efficiency; then we discuss the policies giving rise to this picture. The indicator tells us how much investment occurs relative to one unit of output growth: a lower ratio is better, with 3.5 being best practice internationally, according to International Monetary Fund (IMF) guidance. To supplement this analysis, we look at other indicators including total credit growth rates, the ratio of stock and bond financing to less direct channels, interbank lending rates, return of household savings, and foreign bond holdings.

Quarterly Assessment and Outlook

In the Third Plenum Decisions in 2013, the Party committed to “opening the financial industry wider”; developing a “multilayered” capital market, including equities and bonds; and promoting direct financing for Chinese companies. The leadership also recognized the need to allocate capital more efficiently through interest rate liberalization and the “convertibility of cross-border capital and financial transactions.” Achieving these aims is critical to give market forces a greater role in resource allocation, encourage competition, properly fund emerging sectors, and alleviate systemic financial risks. Our Dashboard financial indicators suggest only halting financial progress this review period. To gauge financial efficiency, our primary indicator tracks how much investment capital is needed to deliver growth.

This quarter our indicator remains high: nearly 7 renminbi of investment are needed to generate 1 unit of GDP growth. Beijing is aware of the problem; it pursued a focused campaign to deleverage the financial sector in 2017, the effects of which are visible. For example, shadow bank borrowing costs were elevated relative to standard banks, reflecting government success in pushing proper risk pricing (even if that spread narrowed somewhat in the review period). But other indicators show the limits of substantial reform. The share of domestic bonds held by foreign investors, a gauge of financial openness, remained low at 1.7%. This casts doubt on whether equity investors will crowd into China’s A-share market when the MSCI Emerging Market Index adds China’s domestic large-cap shares this June.

We expect deleveraging to continue under the new economic leadership team but to rely more on regulation and fiscal temperance than monetary tightening as the economy slows. This shift has begun. Following the March National People’s Congress (NPC), the newly elevated Financial and Economic Affairs Commission declared that deleveraging would focus on state-owned enterprises and local governments in 2018. In early April, newly appointed People’s Bank of China (PBoC) Governor Yi Gang pledged to permit foreign firms to hold majority stakes in key financial services segments “within months,” a meaningful step toward openness if implemented.

This Quarter’s Numbers

Data this quarter suggest policy has not improved China’s financial efficiency yet, even though deleveraging is making headway toward better risk pricing. We evaluate how much investment capital is required to deliver one unit of economic output. The indicator, a capital output ratio (QuICOR), remains high and showed no meaningful improvement in the fourth quarter. The ratio came down slightly to 6.96 from 6.99 (6.98 based on preliminary data used in our previous update, since revised). This continued a modest downward trend from a peak of 7.21 in 3Q2016, but improvement is not sufficient to be decisive or curtail downside risks.

Our indicator is a proxy for financial sustainability. At nearly 7 to 1, the ratio of investment (as measured by gross capital formation stock) to the marginal increase in GDP is double what the International Monetary Fund (IMF) considers best practice (around 3.5). This indicates misallocation of capital. These conditions are brought about by government interest rate controls. As shown in Return on Savings, Chinese savers do not receive market-driven returns on bank deposits. Banks are thereby able to maintain lower lending rates for the government and corporate sectors, so capital allocation is shaped by policy design as much as by the market. Beijing’s control, including via bank ownership, confers the power to mitigate credit misallocation risks in the short run, but low efficiency means mounting debt and severe risks should market-oriented conditions be introduced.

As deleveraging was pursued in the review period, headline credit growth fell. Growth in total social financing (TSF), China’s unique financing measure, slowed to 12% year-on-year (yoy) from 13.2% in 3Q2017. This is positive and on the surface indicates a step in the right financial policy direction. Yet this did not improve our primary indicator: TSF remained well above nominal GDP, and credit is still expanding. Bank lending, a subcomponent of TSF, grew one percentage point faster than TSF, at 13%. Government is forcing banks to return off-balance sheet loans, chasing high returns back to their traditional lending balance sheets. This is a policy success, but it means that truly new bank lending is much less than the reported 13% growth.

Our Interbank Lending Rates indicator shows funding costs for nonbank financial institutions (NBFIs, or shadow banks) fell modestly to 3.31% in 4Q2017 from 3.39% in 3Q2017. Funding costs for normal banks were stable at 2.88%, so the spread between these groups – an indication of whether markets are permitted to price risk rationally – narrowed to 42 from 51 basis points (bps). We flagged last quarter’s widening spread as a sign of financial system progress; thus, conversely, we see this narrowing as counterproductive. Still, that the spread remains at all is a sign of progress after years of these two sets of institutions enjoying the same cost of capital despite their vastly different risk profiles. Some analysts point to the narrowing spread as a sign that financial deleveraging efforts are losing steam. A more hopeful interpretation is that deleveraging shifted from monetary policy to regulatory and fiscal tightening. We consider this in the policy discussion section.

Our data on Return on Savings shows Yu’e Bao money market fund returns (a more market-oriented, private deposit option) fell 7 bps to 3.96% in 4Q2017. There was no change in the official household savings deposit rate, which remained at 1.5%. This gap is a proxy for financial repression, because most Chinese citizens were limited to the low, plain vanilla bank rates, while better-off households were able to take advantage of higher rate offerings such as Yu’e Bao. Those higher Yu’e Bao rates were possible thanks to higher returns on NBFI securities, as discussed earlier. This means that as the spread between traditional bank and NBFI lending rates narrowed, so too has the bank/Yu’e Bao spread. More reform will produce wider pricing of risk in these rates.

Though it was a 2013 Third Plenum goal, foreign participation in China’s financial markets is low (see Foreign Held Bonds). Our indicators show that foreign investors hold just 1.7% of domestic bonds, less than 2014 levels! Greater inflows have not materialized despite the Bond Connect program rolled out in July 2017, which expanded access for foreign investors. Total bonds held by overseas investors in the Shanghai Clearing House and China Central Depository & Clearing Corporation increased to RMB 1.07 trillion in 4Q2017 from RMB 992 billion in 3Q2017, keeping the share basically constant at 1.7%, from 1.6% last quarter.

This raises the question of whether the inclusion of China’s large cap A-share stocks into the MSCI Emerging Markets (EM) Index in June 2018 will attract much foreign equity investment. China will initially be weighed in at 0.73% of the index, and funds designed to track the MSCI are supposed to mirror that weighting. Estimates are that this would mean something on the order of $15 billion in new funds entering China’s stock markets. This assumes that just 5% of China’s market capitalization is open to foreign investors. If that were normalized to 100% (as for Taiwan, South Korea, other Asian emerging markets, and even for Chinese firms traded in Hong Kong), the implied inflow potential is huge – 20x greater. But for now, the low level of foreign bond holdings despite the market being more open to foreign investors suggests it may take time before foreigners are more than a footnote in China’s $9 trillion stock market.

Broader structural reforms are needed to improve capital allocation, make risk manageable, free up capital flows, improve data credibility and corporate governance, and reduce policy opacity.

Policy Analysis

China’s March NPC communicated more deleveraging to come, under a new economic team and revised regulatory structure. The government’s annual work report dropped a target for money supply (M2) growth and set one for “stable macro leverage.” Just after the Congress, the Communist Party’s Financial and Economic Affairs Commission, newly elevated from its status as a “leadership small group,” announced that deleveraging would continue but with a focus on state-owned enterprises and local governments. President Xi said government would “strive to achieve a stable and gradual decline in the macro leverage ratio” this year. That will require more efficient capital allocation and slower debt accumulation, which would show in our QulCOR indicator. In the short term, these policies would mean slower growth and higher risk of financial market disruptions. This is why Beijing remains intent on gradualism and tighter regulation, instead of a more robust monetary squeeze.

The NPC announced long-planned regulatory changes, including a merger of the China Banking and Insurance Regulatory Commissions (CBRC and CIRC), which gives the PBoC more authority over banking and financial policy. Liu He, Xi Jinping’s top economic advisor, was named vice-premier and put in charge of financial regulation, while technocrat Yi Gang was put in charge of the central bank (PBoC). Guo Shuqing was appointed Party Secretary of the PBoC, somewhat muddling the message about who is in charge of monetary policy. Whether these shifts will facilitate reform remains to be seen.

The deleveraging campaign shifted from monetary to regulatory controls. Policymakers issued guidelines curtailing the wealth management product market and other off–balance sheet financing activities, as well as restricting smaller city commercial banks. Major documents included the draft Unified Asset Management Regulation (November 17), Commercial Bank Liquidity Risk Management Regulation (December 6), and a Notice on Regulating Bank-Trust Businesses (December 12).

Of these, the most significant was the Unified Asset Management Regulation. A draft was announced jointly by all major financial regulatory bodies in November, and the final policy was issued on April 27 2018, just as this Dashboard edition went public. The regulation is the first concerted effort to regulate the massive RMB 110 trillion ($18 trillion) asset management industry. It was spearheaded by the new Financial Stability and Development Commission (FSDC), an institution created during the National Financial Work Conference in 2017 and run by Liu He. The regulation bans the use of asset management products as collateral, requires diversification and tighter risk control of underlying assets, and forbids the implicit guarantee of wealth management products.

The draft received strong industry pushback. An unusually high number of comments (around 2000) were registered during the public consultation period, with industry flagging concerns over liquidity and solvency given a proposed tight June 2019 implementation deadline. The final regulations extend this implementation timeframe to the end of 2020.

The PBoC announced in April that it would allow majority ownership for foreign financial services firms, including banking, insurance, and asset management “within months.” This accelerated a November 2017 commitment to lift and ultimately abolish shareholding limits in many financial services sectors in three to five years (see our Winter 2018 Investment cluster). On the surface, these promises signal increased foreign investment opportunities and are meant to encourage the kinds of inflows Beijing badly needs to balance outflow pressures hardwired into its growing economy. They would be meaningful steps toward the stated 2013 Third Plenum objective of further opening China’s financial industry if implemented faithfully.

But regulatory changes alone are insufficient to incentivize foreign financial investment. Broader structural reforms are needed to improve capital allocation, make risk manageable, free up capital flows, improve data credibility and corporate governance, and reduce policy opacity. As our data suggest, opening the door to investment will not guarantee flows if underlying concerns are not addressed.

This leads to our answer to the ultimate China question: finance drives growth, and growth is paramount, but is China’s financial system sustainable? Our answer is that if market conditions are introduced, it is not. And even with the present degree of financial system control and cross-border capital flow limitation, the risks are rising as choices between growth and deleveraging come due. By keeping the system under the Communist Party’s wing, a reckoning can be staved off for some time (how long exactly depends in part on global conditions outside of Beijing’s control, and forecasters’ ability to predict). But President Xi has pledged to open up China’s financial system so China can play an international role. Current dynamics are not sustainable under that eventuality.

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