February 15, 2019/Fitch Ratings
China’s shadow financing is likely to decline for a second year consecutive year in 2019, albeit more gradually than in 2018, as the authorities balance reining in excessive leverage and supporting economic growth, says Fitch Ratings. The regulatory crackdown on shadow banking should, if maintained, support the long-term stability of the financial system and reduce risks for asset managers, but is likely to continue to create funding challenges across the economy in the near term, particularly for private-sector enterprises.
Fitch estimates China’s shadow banking assets shrank to just below 60% of nominal GDP in 2018 from a peak of around 70% in 2017, and we expect a further drop to around 50% of GDP this year. Leverage outside banks is rising at a noticeably slower pace, and contagion risks between banks and non-bank financial institutions (NBFIs) are also falling with the drop in shadow banking activity, although they still remain relatively high.
The crackdown has focused on credit activities that allow banks to shift lending off of their balance sheets to avoid regulatory supervision. The use of “shadow-banking arrangements” to disguise banks’ non-standard lending activities in 2013-2017 led to a sharp rise in system leverage and increased interconnectedness between banks and shadow banks. New measures have, for example, made it much more difficult for asset managers to engage in “channel business”, whereby they act as intermediaries channelling bank funds to high-yielding credit-type assets. Regulatory scrutiny on peer-to-peer lending (P2P) has also increased significantly.
The liquidity squeeze caused by these measures has eased the last six months as the authorities have shifted towards selective monetary easing, cutting targeted required reserve ratio and relaxing asset management rules, for example. However, there remains a strong regulatory commitment to contain riskier types of leverage, suggesting most of the restrictions that have curbed shadow financing will remain in place.
Funding conditions are likely to stay relatively tight, particularly for private-sector enterprises that lack strong access to bank lending. The capital positions of Chinese banks are, in any case, under pressure, which will limit their ability to boost lending and bring off-balance-sheet exposures back onto their balance sheets. The offshore funding market also remains challenging, and issuance costs could rise further if the Federal Reserve resumes monetary tightening later in the year.
For asset managers, tighter regulation – particularly on channel activities – will help reduce the disproportionate risks incurred when they charge low fees for passive management, but are exposed to potentially substantial contingent liabilities. Channel business should, in theory, be low risk for securities firms because banks – as the investors – should bear the underlying risks. However, the legal framework is untested and it is possible that credit intermediaries could be held accountable for investor losses.
The regulatory changes will influence asset managers’ business mix, shifting them away from the low-margin channel business and towards wider-margin, actively-managed asset portfolios. Assets relating to channel business made up around 70% of securities and trust companies’ assets under management as of end-3Q18.