Within the space of three weeks in December 2016, market driven interest rates spiked higher on rumors of futures trading stoppages, potential defaults and liquidity shortages–precipitating huge withdrawals from funds and wealth management products. Fortunately, following policy intervention, interest rates have stabilized–albeit at higher levels than previously. This brief episode highlights the fundamental weakness of China’s leveraged financial system and the risks facing investors in 2017.
Despite widespread expectations that China’s economy would suffer a hard landing in 2016, the country achieved an annual growth rate of 6.7%, which was in-line with the government’s 6.5% to 7% target range. Supportive monetary policies and the growth of liberalized financial markets were critical components in achieving this growth rate with private sector credit hitting record highs (Fig 1a). In particular, wealth management products (Fig 1b) and trust products saw large inflows as investors were attracted by the higher returns on offer, relative to traditional asset classes.
Risky and opaque investments such as wealth management products and trust products have historically relied on high yield investments and significant leverage to generate attractive returns. However, as economic growth stabilized in the second half of 2016, the need for fiscal and monetary policy stimulus faded, whilst at the same time, the combination of on-shore Renminbi (CNY) depreciation and capital outflows had already tightened liquidity conditions (Fig 2a). In tandem, to further discourage leverage, the People’s Bank of China (PBoC) gradually switched from offering short liquidity (7-day) to longer tenors (14-day and 28-day) which were offered at higher interest rates (Fig 2b).
These actions raised funding costs and generated increased market volatility. With leverage trades now generating negative returns, investors who were spooked by mark-to-market losses started to withdraw funds from wealth management products, trust products and funds. The global back-up in bond yields sparked by the Federal Reserve rate hike and the U.S. presidential elections also negatively affected Chinese investor sentiment, triggering a vicious cycle as investor withdrawals triggered forced selling, which pushed interest rates higher and in turn encouraged further investor withdrawals.
Panic peaked in mid-December as rumors of failed trades, potential bond defaults, liquidity shortages and funds breaking-the-buck swirled around the market. At their peak, overnight Shanghai Stock Exchange repo yields hit a high of 33% while policy bank bills jumped by over 160bps to 4% (Fig 3). Fortunately, recognizing the danger of a liquidity crisis, the PBoC increased liquidity injections and encouraged the large commercial banks to re-start lending–these actions quelled both panic selling and calmed investors.
Although normal market operations have resumed, Chinese interest rates remain elevated and investor confidence continues to be muted. With the government’s focus on preserving stability and avoiding risks ahead of the key 19th National Congress of the Communist Party of China, the PBoC is likely to maintain relatively tight momentary conditions this year–as evidenced by the recent open market operations rate hikes–to encourage further deleveraging, support the Renminbi and minimize capital outflows.
For investors, we believe that higher and more volatile interest rates in 2017 will reduce the effectiveness of leverage, while the government’s lower tolerance for risk and reform should reduce the attractiveness of higher risk investments.