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

The amount of national output (GDP) growth resulting from capital stock investment in China remains dangerously low: at nearly 7-to-1, not enough investment translates into real economy demand. At least the ratio is moving in the right direction, however slightly, which is a result of the deleveraging effort now in its sixth quarter. Nevertheless, at this level of capital inefficiency, damage is continuing to accrue. Financial conditions force businesses back to bank loans instead of more direct bond and equity financing (though this may have bottomed out and turned this quarter). Foreign holdings of Chinese bonds remained less than 2%, up from the second quarter but still proof of a very low level of real financial globalization for the world’s second-largest economy.

Policy signals emphasized continuity this quarter, rather than stepped-up reforms. Deleveraging continued, as reflected in higher interbank market borrowing rates and wider funding cost spreads between strong and riskier borrowers. As a result of higher corporate borrowing costs, the household share of new borrowing is rising. The central bank cut reserve requirement ratios (RRR) for some banks, but with implementation delayed many months, sending a mixed message. An increased pace of stock market initial public offering (IPO) approvals may positively impact capital-raising conditions in the quarters ahead.

Financial efficiency remains far from normal, and the improvement was insufficient to mitigate risks.

This Quarter’s Numbers

China’s capital output ratio (QuICOR) is very high, reflecting low investment efficiency. The ratio was 6.98 on a four-quarter moving average (4qma) basis in the third quarter, down slightly from 7.04 previously (revised from preliminary data we used last quarter). This continued a gradual downward trend since a peak of 7.22 in 3Q2016. But these are not good numbers: financial efficiency remains far from normal, and the improvement was insufficient to mitigate risks. China’s broad measure of all types of financing – total social financing (TSF) – grew at 13% year-on-year (yoy) in the quarter, well above nominal GDP. Thus, in an important sense, credit conditions are still expanding. However, this number overstates credit activity because it includes old loans moving back onto bank balance sheets from other institutions (where they had been temporarily exchanged in questionable investment schemes) in response to regulatory scrutiny (see Growth in Credit). This does not reflect new activity. Bank asset growth – a more accurate reflection of financial conditions than frothy credit numbers – slowed to 10.9%, the lowest level since 2013.

Deleveraging continued. The People’s Bank of China (PBoC) tightened credit conditions through its “open market operations,” driving rate divergence in the interbank market, where smaller, ostensibly riskier financial institutions borrow from bigger banks at a premium (see Interbank Lending Rates). This is a positive sign from a reform perspective. Average borrowing costs for riskier “shadow banks” were 3.39% (seven-day rates – see chart for details; previously 3.34%), while for safer regular banks, rates held at 2.88% (previously 2.89%). This is what risk pricing for speculative, less-guaranteed players should look like. At the same time, one must acknowledge that these needed reforms create near-term risks to growth by reducing the lending that fuels it, which is a potential challenge as well.

While Beijing recognizes the need to deepen stock and bond markets, the Direct Financing Ratio remains low. For most (private) companies, it is still difficult to raise money by listing or issuing bonds. On the 4qma basis we use to filter out seasonal and other short-term anomalies, these finance categories fell to 11.1% of new financing (TSF) in 3Q2017, from 15.9% previously and higher shares still in the 11 quarters previous to that. On a single-quarter basis, we did see an uptick this period in net new bond financing and a flat to slightly higher result for IPO money; these trends may lift this indicator as early as next quarter. On the other hand, TSF as a whole is rising strongly, which pushes in the other direction (toward a lower direct financing share). The factors at work – especially on the debt (bond) side – are complicated. The bank deleveraging campaign should in theory push up direct financing; however, in the idiosyncratic case of China, bank leverage was the source of demand for direct finance, and thus the dynamics at work are muddled.

Third-quarter data show just how modest foreign participation in China’s bond market is (see Foreign Held Bonds), despite Beijing’s recent commitment to further open financial services to foreign competition (a fourth-quarter announcement, after our review for this edition). Foreign investors held 1.6% of total bonds in China at the end of 3Q2017, up from 1.4% in the previous quarter. While low, this is near the top of the five-year range. We expect the share to increase – assuming Beijing continues to prioritize deleveraging and financial risk reduction over the risks from slowing GDP growth. China is under pressure to keep rates high to support deleveraging, and also to prevent capital outflow driven by rate hikes elsewhere. Chinese rates in fact rose faster than U.S. rates in 2017 despite U.S. hikes. This tends to incentivize foreign holdings. The cumulative value of bonds held by foreign institutions in the Central Depository and Clearing Corporation (CDCC) and the Shanghai Clearing House (SCH) grew by 11.5% and 32.8% this quarter, respectively, from the low base.

In our inaugural 2Q2017 Dashboard, our Return on Savings indicator relied on a wealth management products (WMPs) yield curve data stream from the Chinese Academy of Social Sciences (CASS), which was suddenly discontinued without explanation. We replace it with the quarterly average yield for Yu’e Bao, a RMB 1.56 trillion money market fund that is the most popular retail investment product in China and the biggest money market fund in the world. Yu’e Bao represents the low-risk end of WMPs in China. Both the official one-year savings deposit interest rate (1.5%) and the Yu’e Bao average return (4.03%) were unchanged in 3Q2017 from 2Q2017. The gap between the two can be said to reflect the level of financial repression imposed on savers in China’s financial system. The low official rate, which banks are legally required to follow, encourages savers to seek higher-return alternatives such as Yu’e Bao. Yu’e Bao in turn is able to offer higher rates by investing in bank negotiable certificates of deposit (NCDs), yields on which have been elevated by the PBoC’s deleveraging campaign. So the bank savings/alternative money market rate gap is today effectively a byproduct of deleveraging as well.

Policy Analysis: 3Q2017

Financial policy reinforced the focus on deleveraging and systemic risk, with the PBoC squeezing the interbank market in particular. In mid-July, credible domestic financial media reported that the central bank criticized 40 financial institutions for violations such as not vetting interbank accounts. Institutions singled out included regional branches of the Agricultural Bank of China (ABC), China Construction Bank (CCB), Bank of China (BOC), and prominent joint-stock Minsheng Bank. These branches were given three- to six-month holding periods to improve compliance before they could resume their interbank businesses.

On August 11, the PBoC said it would include NCDs, an important source of funding for smaller banks, in calculations of total interbank borrowing used in quarterly macro-prudential assessments for banks with more than RMB 500 million in assets effective 1Q2018. The China Securities Regulatory Commission (CSRC) announced later in August that, effective October 1, fund management companies could not place more than 10% of their shares in a single bank, and that it would include NCDs in its calculations. The result will be higher costs and lower profits for smaller banks that rely on NCDs, consistent with the more pronounced risk spread showing up in our indicator.

An RRR cut announced by the PBoC on September 30 was a small, token gesture that did not significantly dilute deleveraging efforts. The cut, which takes effect in early 2018, was crafted to push more loans to small businesses. Banks that lend more to small businesses will receive a 1.5 percentage point RRR cut, while for all other banks the cut will be just 0.5 percentage points. Most of China’s commercial banks will be eligible only for the lower number. By our calculations, the cut has freed up only 0.2% of deposits as of February 2018.

The CSRC permitted an increased number of companies to issue IPOs in the review period: 343 IPOs were issued for the year through 3Q2017, up from 137 in the same period in 2016 (although the bulk of this new equity was listed at the start of the year). Regulators have improved the IPO vetting process and reduced a backlog of IPO applications through 2017 into the third quarter. Chinese media reported that 20% of IPO applications were rejected through 3Q2017, versus just 2% in 2016 – an indication of growing activity. As noted in our State-owned Enterprise (SOE) section, the dominance of private firms in this year’s new listings is even reducing the share of revenue captured by listed SOEs in some industries.

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