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China's new shadow banking rules signal fresh push to clamp down systemic risk

China's latest rules on so-called cash wealth management products, or cash WMPs, signal renewed efforts by regulators to reduce risk in the shadow banking system, a major funding source for weak or highly leveraged companies that are unable to secure loans from traditional banks.

The rules, announced June 11, have banned banks and wealth management companies from using money raised by cash WMPs to invest in stocks, convertible bonds, asset-backed securities and low-rated corporate bonds, according to the China Banking and Insurance Regulatory Commission, or CBIRC. Those products will also be subjected to a maximum leverage ratio of 120%.

Additionally, financial institutions will need to conduct stress tests and invest at least 5% of the net value of their cash WMP funds in low-risk assets such as government bonds and central bank bills.

"China's latest policies have started slowing the pace of credit growth and cracking down on shadow banking as it seeks to normalize monetary policy and curb potential risks now that the economy's recovery is gathering pace," said Bruce Pang, Hong Kong-based head of macro and strategy research at China Renaissance.

Beijing's yearslong efforts to contain risks in the shadow banking sector were sidelined last year due to the pandemic. As China's economy is recovering more quickly relative to other nations, analysts say it now has room to revive its push to target systemic risk, even at the expense of some loan-led growth. Apart from the cash WMP rules, the government said earlier banks will have until end-2021 to comply with a set of stricter asset management rules that will force them to off-load assets with long maturities, cut ties with intermediaries, and stop pooling money from different wealth products to invest or to repay loans.

Off balance sheet

As of end-March, the outstanding balance of cash management products in China totaled 7.34 trillion yuan, according to China Banking Wealth Management Registration and Depository Center. It represented about 29% of the nation's entire wealth management market of 25.03 trillion yuan, which was up 7.02% from a year earlier.

WMPs in China are sold by financial institutions as savings or investment products and do not appear on their balance sheet, making it part of the shadow banking system where the scale of risk is largely unclear to the regulators. Those products are also often marketed with returns much higher than deposit rates, pushing them to invest in risky assets as well as extend loans to highly leveraged companies, especially property developers, that are often shunned by the formal banking system.

WMPs have also grown more complex in recent years, which concerns regulators in terms of assessing and containing systemic risk. Those products sometimes involve multiple layers of securitization or investment intermediaries. There were also cases where larger banks packaged loans as WMPs and sold them to smaller lenders that needed fresh funds.

While the rules came into effect immediately for new issuances, financial institutions have been given time till December 2022 to rectify existing products.

"We expect a large part of the assets will mature by the [18-month] deadline. Thus, there should be no material impact on existing products. But we expect future product yields will be lower, given the change in investment assets. The rules are also likely to reduce demands for capital replenishment bonds in the market," said Iris Tan, senior equity analyst at Morningstar.

Level playing field

China Renaissance's Pang said the stricter rules will give money market funds, a direct competitor to cash WMPs, a more level playing field.

"We also expect the yields of cash wealth management products to be trimmed, considering the stricter and more explicit regulatory limits now in terms of credit quality, liquidity, maturity, concentration and leverage," Pang said.

He added that the yield for cash WMPs is currently around 50 basis points higher than money market funds, compared with a gap of about 75 basis points around the time when the draft rules first came out in December 2019. He expects the gap to narrow further.

China was the first major global economy to recover from the COVID-19 pandemic, though its businesses were also the first to suffer from lockdowns and other measures to curb the virus. The economy started its recovery in the second quarter of 2020 and the pace of growth surged to 18.3% year over year in the January-to-March period. The country aims for its GDP to grow by more than 6% this year and has restarted reforms to its financial sector, including tighter rules for the financial operations of its tech giants.

"Regulators could follow this trend more closely from now on to examine the structure of the wealth management products and regulate the transparency of the structure," said Iris Pang, Hong Kong-based chief economist Greater China at ING Bank.

As of June 16, US$1 was equivalent to 6.40 yuan.