China’s Credit Engine Is Running Out of Gas

  • Policy makers pledge neutral stance to counter financial risks
  • HSBC sees tighter regulations, rising rates, liquidity squeeze

PBOC Plugs Gaps Amid Capital Outflow Pressure

The People’s Bank of China faces a reckoning after revving its credit engine for years.

Three conditions suggest traditional financing and shadow banking are due to cool: Restrictions on property markets are poised to start weighing on mortgage issuance; bond market turbulence has spurred widespread cancellation of new corporate issues; and banks face more curbs on selling wealth-management products amid a regulatory tightening.

With economic expansion on pace to meet the government’s objective and inflation pressure rising, leaders are signaling tighter monetary policy as they seek to reduce risks. The PBOC also cut language from its last quarterly statement saying it would reduce lending costs.

"China’s credit engine is running out of gas," said Frederic Neumann, co-head of Asian economic research at HSBC Holdings Plc in Hong Kong. "Regulatory tightening, higher interest rates and a liquidity squeeze will likely weigh on credit growth in coming months."

President Xi Jinping and his top economic lieutenants last month pledged prudent and neutral monetary policy and proactive fiscal support for 2017 along with sharper focus on avoiding financial risks and asset bubbles. Meanwhile, the PBOC has been allowing a steady increase in money-market rates to squeeze leverage in the bond market, prompting firms to cancel or postpone bond selling of more than 100 billion yuan ($14 billion).

Read More: China Inc. Struggle to Sell Bonds Poses Quandary for Economy

The PBOC is also managing the money supply in new ways as it moves policy away from the lending rate benchmark and keeps required-reserve ratios for banks on hold. On Tuesday it reported unprecedented injections into banks as its Medium-term Lending Facility’s balance jumped to 721.5 billion yuan in December, the most since data releases began in 2014. The total outstanding for the operations was a record 3.46 trillion yuan.

With policy moving toward selective tightening, "official endorsements from the top leadership tend to consolidate these positions, at least in the near term," said Song Yu, the Beijing-based chief China economist at Beijing Gao Hua Securities Co., the mainland joint-venture partner of Goldman Sachs Group Inc., wrote in a recent report.

Tighter policy also better positions the PBOC to keep the yuan stable after its steepest annual plunge against the dollar in more than two decades. That pressure won’t abate soon with the Federal Reserve resuming interest rate increases and the European Central Bank and Bank of Japan no longer adding to their monetary easing.

Read More: PBOC Shifts to Selective Tightening to Curb Financial Risks

New regulations aimed at shadow banking activity are also set to weigh on credit creation. Starting this quarter, the PBOC is including wealth management products held off bank balance sheets in its framework for assessing risks and credit expansion for lenders. Citigroup Inc. estimated in October that the new rules will apply to 13 trillion yuan of assets.

That means banks must rein in their credit growth to comply with capital adequacy requirements, reducing funding in the financial system.

In that environment, funding levels in markets will be a key risk for 2017, and a neutral monetary policy stance could complicate financing for smaller companies, according to Ming Ming, head of fixed-income research at Citic Securities Co. in Beijing and a former PBOC official.

Funding challenges remain a problem for small businesses, with nearly 60 percent reporting shortfalls in December, the National Bureau of Statistics said in a statement Sunday.

"Imbalances will worsen," Ming said. "There will be liquidity shortages at certain time points, such as quarter-end and ahead of long holidays."

Money Ratio

Those new rules for wealth products are also poised to affect how much economic mileage China gets from the creation of new credit. This so-called money multiplier, a ratio of the money supply to total bank reserves, stood at 5.24 in November, just shy of the 5.29 record in August, according to PBOC data compiled by Bloomberg.

That means each yuan the central bank pumps into the economy generates more than 4 yuan through the process of loans generating new deposits, that then create further loans.

A reversal in that multiplier would mean tighter financial conditions and looser fiscal policy, resulting in slower economic growth, said HSBC’s Neumann. "China’s economic growth remains highly credit intensive," so even a marginal tightening would have a disproportionate effect, he said. Construction and broader economic activity may start feeling a drag by the second quarter, prompting more fiscal support to aid growth. 

To be sure, credit still flows freely. The broadest measure of new lending jumped in November by the most since March, boosted by borrowing for home loans and resurgent shadow banking. If growth looks weak, policy makers can still step on the gas with credit.

And new credit so far isn’t reflecting the tightening bias of policy, according to Wang Tao, head of China economic research at UBS Group AG in Hong Kong.

Aggregate financing, China’s broadest measure of new lending, rose to 1.74 trillion yuan in November, the most in eight months, boosted by borrowing for home loans and a resurgence of shadow-banking activity. The jump was double the prior month’s rise. December’s data are likely to be released next week.

While the PBOC is adopting a more conservative monetary policy, it’s also being cautious to avoid over-tightening, Shen Jianguang, chief Asia economist at Mizuho Securities Asia Ltd. in Hong Kong, wrote in a report.

With tightened liquidity conditions in the inter-bank market since mid-December, new yuan loans likely saw only a moderate increase last month, Shen said, "with measures to ensure credit is directed to the real economy rather than the mortgage market."

— With assistance by Yinan Zhao

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