While financial markets have been celebrating the results of the French presidential election with a global risk on rally, Chinese markets have been going through a correction over the last week or so. Before the tiny move up today–on April 25 the Shanghai Composite index climbed 0.16%–Chinese markets had tumbled to erase $315 billion in stock market value in just six days. Bond yields had climbed to the highest level in nearly two years. (Bond prices fall when yields climb.) The Shanghai Composite was down 5% from the 15-month high it set on April 11 and the index’s retreat on Monday April 24 of 1.4% was the biggest drop since December 12 and the first decline of 1% or more in the last 80 trading days. That was the longest stretch without a 1% loss since 1992.
You don’t have to look into your crystal ball to figure out why Chinese financial assets have suddenly gone into reverse. Chinese regulators are staging one of their periodic crackdowns on financial leverage. This time the target has been “entrusted investments,” money that Chinese banks farm out to external asset managers. Unlike banks, where regulators have kept a tight rein on leveraged investments recently, these external managers have been relatively free to make leveraged bets in an effort to produce the higher returns demanded by the bank customers who have invested in wealth management products sponsored by banks. Wealth management products pay more than bank deposit accounts–hence their appeal–but that encourages the external managers of this cash to leverage their bets so that they can deliver these higher returns net of their fees.
It’s estimated that these “entrusted investments” are responsible for $1.7 trillion in cash flows into Chinese financial markets.
And now regulators are putting the pressure on banks to rein in their use of these external managers. The China Banking Regulatory Commission has asked lenders to reported the scale of their “entrusted investments” and while not banning “entrusted investments” regulators have asked banks to rectify any irregularities involving high leverage, regulatory arbitrage or multiple layers of investment structures by November 30. Banks are to deliver a report on their “entrusted investments” by June 12.
As is typical when regulators turn up their scrutiny of an investment product, banks have been pulling funds from those products. For example, HFT Investment Management, which managed $27.5 billion last year, told Bloomberg that it had seen an outflow of funds.
No one is sure where the money that is coming out of “entrusted investments” will go or how banks that have promised higher returns to buyers of wealth management products will meet that commitment.
So far, though, the markets are confident that this correction isn’t going to turn into anything major. The thinking goes that the People’s Bank of China will let markets fall just enough to get banks’ attention but then it will step in to supply enough liquidity to reduce volatility.
