• The government’s plan to shake up Chinese monetary policy making was derailed by the stock market crash and policy missteps. 
  • Stock market reform is now on ice, while concern is building over the bond market and the government has destroyed the village of renminbi internationalisation in order to save it. The 1Q16 pro-growth tilt has resulted in further backsliding in some key reform areas. 
  • This is not all bad news: the government has curbed the growth of shadow finance, while the central bank’s interest rate reforms have reduced the need for large-scale policy adjustments.
  • A recent People’s Daily essay calling for greater emphasis on reform increases the likelihood of attempts to revisit the framework, though its ambitions have been scaled down.

In November 2014, FT Confidential Research identified an emergent framework for Chinese monetary policy. This was based on the idea that the era of consistent net inflows was drawing to a close (see chart), particularly as the Federal Reserve moved towards monetary policy normalisation.

The framework envisioned greater capital market liberalisation and increased portfolio flows of renminbi on and offshore to ensure that the domestic system had enough liquidity. Shadow finance was to be constrained, while China’s role in – and interdependence with – the global economy was to grow. So much for good intentions. Progress on reforms has been erratic at best. Rather than remaking the domestic financial system, the government’s credibility has collapsed over the past 18 months following disastrous policy missteps. 

There is a chance that the reform agenda gets back on track, particularly in the wake of a recent People’s Daily essay from an unidentified senior figure criticising the first quarter return to the old stimulus playbook. The essay’s 11,000 characters were short on specifics, but this is unsurprising: these are extremely challenging reforms made riskier by years of relative inaction by the government. 

As such, the outlook remains highly uncertain as the economy slows and officials squabble. 

The stock market

The plan: Strong stock markets. These would help financial system deleveraging by providing state firms with an alternative funding channel, reducing their reliance on bank loans. They would also drive cross-border renminbi flows – starting with a direct channel between Hong Kong and Shanghai – boost state-owned enterprise reform and draw funds away from the shadow finance system. 

The reality: The rise and fall of the stock markets over 2014 and 2015 is a case study in bureaucratic mismanagement. The China Securities Regulatory Commission has signalled that appetite for reform has cooled in the wake of the market’s collapse. The government has pledged a new registration system for initial public offerings (IPOs) but has also played down talk of an imminent launch. It has also shelved plans to introduce a new strategic emerging industries board on the Shanghai Stock Exchange, with references removed from the draft outline of the 13th Five-Year Plan. This board had been expected to become a testing ground for the new IPO system. Similarly, a mutual market access programme between Shenzhen and Hong Kong is mooted but no firm release date has been announced. 

Next steps: The government still needs a robust stock market, because state firms need financing and the number of alternatives has been depleted by the events of recent months. As such, the government will most likely look to maintain the uneasy status quo in the markets following last year’s botched – and costly – support efforts. A-share markets continue to fulfil their financing role, although most is being done through private equity placements (see chart).

The bond market

The plan: Cautious, gradual and sequenced reforms. The bond market was to attract both domestic liquidity from the shadow finance system and offshore funds, but only after the government accelerated bond market reform, particularly the nurturing of a market-based default mechanism to better prepare the market for a more internationalised role. 

The reality: The bond market became a major beneficiary of the stock market collapse last year, with issuance rising sharply (see chart). The government was already moving to open the market, but this process was accelerated by the stock market collapse. The People’s Bank of China (PBoC) began opening up the interbank bond market, letting in overseas investors, including central banks and sovereign wealth funds, and scrapping the former quota system. This has been a significant step, but the timing was forced on the PBoC by the massive increase in capital outflows. Domestic investors picked up on the government’s reform signals, just as they had with the stock market in 2H14, and rushed in (see chart), driving yields down to multi-year lows.

Next steps: The government is trying to avoid a sharp bond market sell-off without reinforcing the moral hazard that allows unworthy borrowers to stagger on. Deep and liquid bond markets are needed as part of the disintermediation of the banks and to better transmit monetary policy signals through the system, but these largely speculative inflows have distorted price signals and retarded the development of a true market-based default mechanism. Furthermore, the shift in monetary policy stance in 1Q16 has increased risks associated with these markets

The banks

The plan: Improve credit allocation by reducing the dominant role of banks in the financial system. In exchange, banks were to receive other policy support, such as allowing them to move into new sectors, including investment banking and brokerage. 

The reality: As elsewhere, the stock market disrupted everything. If anything, the role of commercial banks in the financial system was strengthened by the 1Q16 monetary policy shift, including plans for a Rmb1tn ($153bn) debt-for-equity swap and a non-performing loan (NPL) asset-backed securities programme. Directly taking stakes in clients unable to pay loans is a near-total departure from the government’s original reform intentions. 

Next steps: The People’s Daily essay criticised debt-for-equity swaps, but we do not think earlier reform plans can be revived in the short term. This is not the climate for expanding the scope of banks’ business, with NPL growth a continued concern for authorities. However, and particularly in the wake of the essay, disposals may become more market-oriented, including regulatory efforts to get a better read on how banks are categorising impaired loans. 

Liquidity management tools

The plan: Move to price-based monetary tools for managing system liquidity, creating a new market benchmark to replace the PBoC’s one-year deposit and lending rates and reducing the reliance on reserve requirement ratio (RRR) adjustments. 

The reality: The stock market crash has not disrupted everything. Since early 2015, the central bank has been increasingly deploying its new liquidity management tools, including the Standing Lending Facility (SLF), Medium-term Lending Facility (MLF) and Pledged Supplementary Lending (PSL), to generate liquidity and manage market rates. At the end of April, the combined outstanding value of MLF and PSL was a record Rmb2.89tn (see chart). The central bank’s monetary policy framework is changing from the use of traditional, broad-based quantitative instruments to more targeted and diversified tools, helping promote interest rate liberalisation while establishing an interest rate corridor (see chart). Nevertheless, the central bank had no choice amid last year’s chaos but to cut interest rates and the RRR twice in two months, even though lower interest rates threatened to cause downward pressure on the renminbi and fuel capital outflows.

Next steps: The process is incomplete: the market still watches for announcements about policy rate moves far more than it does changes in the MLF rate. Until the PBoC more clearly articulates which of these rates it considers its new market benchmarks, attention will remain on its traditional levers. 

Shadow finance

The plan: Curb the build-up of shadow finance assets while containing systemic risk. 

The reality: The crackdown on the shadow finance system has succeeded in that the growth of China’s trust sector, the largest segment of shadow finance, continues to slow. Growth in trust assets managed by 68 trust companies slowed to 16.6 per cent year-on-year in 4Q15, the slowest pace since 2011 (see chart). This was mainly achieved by a crackdown on umbrella trusts last year, an investment fad that faded with the stock market boom. Shadow finance funds underpinned the excesses of the stock market boom, and were at least partly responsible for the recent bond market rally.

Next steps: Regulators are addressing concerns of growing shadow finance risks – the absence of defaults in this area is a worry more than a comfort, particularly given surging bank NPLs and bond defaults. The banking regulator announced rules to curb the growth of trust companies and the way that loan beneficiary rights are transferred off bank balance sheets. 

Renminbi internationalisation

The plan: Develop offshore pools of renminbi and increase flows of the currency on and offshore. This would help manage system liquidity, increase China’s role in the global financial system (at the expense of the US dollar) and burnish the credentials of the Communist Party. 

The reality: Offshore pools of renminbi did not grow as quickly as intended. Instead, the stock market crash, and last August’s renminbi devaluation, triggered worldwide concerns about the stability of China’s financial system and a surge in capital outflows. The government responded by clamping down on offshore renminbi trading. Renminbi cross-border trade settlement has fallen since 3Q15 (see chart), as have the combined offshore renminbi deposits of Hong Kong and Taiwan. The government attempted to counter this by broadening foreign institutional access to onshore renminbi bonds, but investors have not responded (see chart). Fake invoicing is also back, this time to facilitate outflows, while even official outward-bound cross-border channels are being limited: the Qualified Domestic Institutional Investor (QDII) programme is effectively frozen.

Next steps: A stated goal of the 13th Five-Year Plan is full renminbi convertibility on the capital account by the end of 2020. This may prove the most difficult challenge of all for China’s financial reformers: a relatively closed system has allowed the government to drag its heels and helped insulate the economy, first from the global financial crisis and then from Beijing’s own policy missteps. The crackdown on outflows – both official and illegal – seen since last August highlights the government’s sensitivity and makes a reboot of the capital account liberalisation process that much more uncertain.

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and Southeast Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on-the-ground research to provide predictive analysis for investors.
Copyright The Financial Times Limited 2018. All rights reserved.

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