Chinese regulators to increase scrutiny of the shadow banking sector

These new measures are likely to be negative for corporate bonds.

According to BMI Research, financial risks remain prevalent within the Chinese economy, and policymakers are expected to attempt to rein in these risks through a gradual tightening in monetary policy while stepping up regulations and scrutiny of the shadow banking sector. These efforts are likely to be negative for corporate bonds, and any policy missteps could result in a liquidity crisis and a significant spike in yields, similar to that experienced in 2013.

Here's more from BMI Research:

The recovery in China's economic activity, which took hold in H216, continued into Q117, and with the official real GDP growth picking up to 6.9% y-o-y and outperforming the government's 2017 growth target of 6.5%, it creates room for policymakers to attempt to rein in financial risks and ensure stability ahead of the 19th National Party Congress in H217.

It was reported by Xinhua News that Chinese President Xi Jinping stated during the meeting of the Politburo of the Communist Party of China held in late-April that authorities must ensure that there will not be a systemic financial fallout even as the country faces challenges in overhauling the economy.

With Xi reiterating what was presented in the government's work report presented by Premier Li Keqiang on March 5, this sends a strong signal that the Chinese government is committed to reducing the economy's addiction on credit over the coming quarters.

Raising Interest Rates On Targeted Tools Still The Way To Go
In terms of monetary policy, this suggests that the People's Bank of China (PBoC) will continue to adopt a gradual tightening bias. We expect the central bank to raise interest rates on its targeted tools such as its medium-term lending facilities (MLF) and open-market operations (OMO) instruments.

Indeed, the central bank has already raised interest rates on these instruments three times since the start of 2017, with the benchmark 1-year lending rate still holding steady at 4.35%. It will continue to attempt to strike a balance between reining in excessive short-term borrowing and ensuring that there is sufficient liquidity in the financial system to support economic activity. The central bank will therefore also rely on longer- erm policy tools to inject liquidity over short-term operations.

In addition, we expect Chinese regulators to clamp down on poor practices in the shadow banking sector, which is still growing rapidly when compared to that of bank loans. According to the China Banking Regulatory Commission (CBRC)'s Q1 economic and financial condition analysis announcement, bank-issued wealth management products (WMPs) grew by 18.6% y-o-y at the end of March (slowing from 53.4% y-o-y in the same period last year), compared with 12.3% y-o-y for bank loans.

Since Guo Shuqing, who is known for his significant experience in the financial sector, took over as the chairman of the CBRC in February, the CBRC has issued a number of measures (most of them not made public) to banks to contain financial risks. For example, Document 6 released by the CBRC on April 10 highlighted increased scrutiny of the management of WMPs by improving disclosure to investors, controlling the amount of leverage used, and restricting banks from investing in WMPs. The CBRC is also drafting a regulation on WMPs that will instruct banks to invest those funds obtained from selling WMPs into more transparent assets to reduce risks.

Negative Implications For The Bond Market
A tighter monetary policy environment and fresh regulations to rein in the shadow banking sector are likely to be negative for corporate bonds. An increase in money market rates will make it more costly for Chinese banks to borrow cheaply to purchase bonds and WMPs, which are also largely invested in bonds and money market instruments.

With China's financial system being highly interconnected, the risk for the bond market is that policy missteps by the Chinese government to reduce leverage caused by tougher than expected moves could lead to a severe cash crunch in the banking system, similar to that experienced in 2013, resulting in a significant spike in yields.