On 27 April 2018, China authorities announced major new asset management rules aimed at tightening shadow banking activities and reducing the systemic risks in order to develop a healthier domestic capital market. Fortunately, thanks to a long grace period for the new rules and the central bank’s commitment to stability in the financial sector, we expect the industry to adjust to the new rules and transition in an orderly manner.
China’s shadow banking is a by-product of the past financial regulation. Historically, interest rates were fixed and financial regulations were narrowly focused on the booking entry instead of economic substance. Shadow banking activities sought to circumvent these restrictions and came in many different forms including wealth management products, asset management plans, trust products, etc. – collectively known as “asset management products” (AMPs). AMPs have become a significant source of systemic risk for China because of their size, complexity, interconnection, opaqueness and moral hazard problem. For investors keen to know more about shadow banking activities in China, the Bank for International Settlements published a detailed paper on this subject .
In November 2017, the government announced the establishment of the Financial Stability and Development Committee (FSDC). Headed by the vice-premier of China, the new “super” regulator aims to reduce opportunities for financial institutions to arbitrage the rules made by different regulators by aligning the regulations among different sub-sectors of the financial industry. Approximately five months after its establishment, the regulators published “guiding opinion on regulating the asset management business of financial institutions” to regulate AMPs issued by different types of financial institutions. AMPs may still exist in the future, but “new AMPs” have to comply with the following key rules and regulations.
It will take time for investors to get familiar with new fund-like AMPs with periodically disclosed NAVs and without guarantees. AMPs unwinding their investment positions to get in-line with the new regulations could generate significant volatility and outflows in the near future. Mutual funds, especially money market funds, could become more competitive in the new, level-playing field, as the new rules are similar to the risk management framework of mutual funds. Meanwhile, direct participation of retail investors to the capital markets is also likely to increase.
According to the new regulations, banks are required to have independent dedicated subsidiaries to run AMPs, which will, in the long term, increase competition in the asset management sector and reduce banks’ reliance on third party asset managers. Surging structured deposits and retail certificates of deposits with yields higher than traditional deposits will likely become a common way for banks to capture outflows from AMPs in the interim.
The combination of hawkish PBoC monetary policy and the new regulations has tightened liquidity, pushed up domestic bond yields and steepened the yield curve, but we believe most of the impacts are priced in and there should not be further substantial technical impacts on yield levels from the new rules in the near future. Weak companies, who previously relied on AMPs as their main fund sources, are facing incrementally more challenges to refinance their debts. The increased frequency of credit events has dampened risk sentiment and widened credit spreads.
Fortunately, the central bank remains committed to maintain stability in the banking system, as demonstrated by the reduction in the reserve ratio requirement in April and other measures to mitigate liquidity seasonality as well as to control systemic risk. Assuming an orderly transition, in the long term, the new rules should help build a healthier financial environment in China, with better transparency and stronger regulatory oversight. These developments underpin our constructive view on the financial industry of China.
 Ehlers, Kong and Zhu (February 12, 2018), “Mapping shadow banking in China: structure and dynamics”, BIS working papers No. 701 (link: https://www.bis.org/publ/work701.pdf)
 PBOC statement: http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3529603/index.html
 Soo (May 15, 2018), “Ant Financial reduces same-day withdrawals from its money market fund to manage liquidity risk”, South China Morning Post (link: http://www.scmp.com/tech/enterprises/article/2146155/ant-financial-reduces-same-day-withdrawals-its-money-market-fund)
 Leng and Lee (April 18, 2018), “China cuts deposit reserve rate for first time in 26 months to unleash cash”, South China Morning Post (link: http://www.scmp.com/news/china/economy/article/2142146/chinas-central-bank-cuts-reserve-requirement-lenders-free-funds)