“It is necessary sometimes to take one step backward to take two steps forward.” – Vladimir Lenin
“I don’t mind going back to daylight saving time. With inflation, the hour will be the only thing I’ve saved all year.” – Victor Borge, Danish-American Comedian
A Chinese parliamentary document released this week unveiled a major revamp of China’s central government. As part of the overhaul China will merge its banking and insurance regulators to create the Banking and Insurance Regulatory and Management Commission. Two new ministries to oversee the protection of natural resources – the Ministry of Natural Resources – and ecology and environment – the Ministry of Ecology and Environment – will also be set up.
The merger of the banking and insurance regulators will be accompanied by the transfer of authority to draft and issue banking and insurance regulations to the People’s Bank of China (PBoC). The overhaul of the financial regulatory infrastructure comes at a time when Mr Zhou Xiaochuan, governor of the PBoC, is expected to retire after 15 years at the helm of the Chinese central bank. The Chinese banking system has grown by an order of magnitude since Mr Xiaochuan’s appointment as governor in 2002. At the end of 2017, Chinese banking assets amounted to RMB 252 trillion and China’s total debt reached 257 per cent of GDP.
During the Communist Party of China’s 19th National Congress last year, Mr Xi Jinping identified containing financial risks as one of the government’s priorities for the next three years. In November last year, not long after the National Congress, Chinese financial authorities took the first step towards a more unified approach to regulating the financial sector by unveiling new draft regulatory standards for the issuance of asset management products by all types of financial institutions.
The new guidelines will bring the Chinese asset management industry under a single regulatory regime for the very first time and are aimed at closing the many regulatory loopholes that exist in the current setting. Under the new rules, any financial institution issuing asset management products will face a number of new regulatory constraints. Most notably, financial institutions will be unable to pool assets raised through “wealth management products” or roll over these products indefinitely. The ability to pool assets and roll over products indefinitely provided a loophole that allowed investment losses in legacy wealth management products to be covered through the issuance of new products – resulting in a pyramiding of financial risk within the system. The new rules will now expose investors in wealth management products to a greater possibility of incurring losses. While the rules do increase the risk of suffering losses on investors, they are a much needed step toward reducing the systemic risk wealth management products pose to the Chinese financial system.
The authorities, in recognition of the potential disruption a wholesale change in regulations can cause, have proposed a transition period till 30 June, 2019, for existing asset management products to become compliant with the rules under the new regulatory regime.
The plans announced in this week’s parliamentary release are one more step towards bringing the Chinese financial sector under a unified regulatory regime. The transfer of authority to draft and issue banking and insurance regulations to the PBoC, in particular, is a bold move. Under the proposed set up the Banking and Insurance Regulatory and Management Commission will effectively become the PBoC’s oversight and enforcement agency.
In the current setting the PBoC is one of four financial regulators in China. Given the unprecedented growth of the Chinese financial system, a disjointed approach to managing the financial sector is no longer feasible and should have been done away with many years ago. The increased authority of the PBoC and the existence of only one oversight and enforcement agency, we believe, should lead to a more proactive approach to controlling the risks within the financial system. The days of unlicensed peer-to-peer lending – the Chinese equivalent of US wildcat banking in the nineteenth century – are, in our opinion, over. And the toughening of financial regulation that started in 2017 is a theme that, we think, will continue over the course of 2018 and quite possibly 2019.
Mr Xiaochuan’s, during his reign as governor of the PBoC, went to great lengths at reforming and liberalising the Chinese financial system. His contributions, albeit very gradual, were instrumental in the transition of the renminbi from a fixed to a managed float exchange rate, the growth of private sector banks, and the liberalisation of interest rates. The reforms, however, have come at a cost: a banking system that is unparalleled both in terms of scale and complexity. We therefore think that the Chinese government, and by extension the PBoC, will put any plans to further liberalise the system on hold in favour of defusing financial risks.
The Chinese government’s geopolitical ambitions and the success of the Belt and Road Initiative will at a point greatly depend on the PBoC’s ability to transition to a liberalised capital account, which in turn will require the renminbi to be switched from a managed to a floating exchange rate. The opening up of the capital account, and by extension the ambitions of the Chinese leadership, cannot be achieved with an unstable financial system. The Chinese have no choice but to increase control over the financial system in order to diffuse systemic risks.
Mr Zhou’s successor is more likely to be a conservator as opposed to a reformer.
Investment Perspective
The Chinese leadership under Mr Xi’s reign has increasingly come to emphasise the importance of social wellness. So much so that social wellness now sits near the top of the Chinese government’s priorities – the creation of an “ecological civilisation” has been added to the government’s goals as part of the most recent round of amendments to the Chinese constitution.
With the focus on the environment it might seem that the Chinese leadership is attaching less importance to economic growth. With the government announcing target economic growth of “around 6.5%” at the start of this year’s National People’s Congress, however, such an assertion would be far from the truth. In addition to a continued commitment to strong economic growth, the government also highlighted cutting production capacities as one of the goals for 2018.
If we take the Chinese government’s stated goals at face value then we think the world may be entering a profoundly different economic environment to the disinflationary one we have lived through over the last three decades. Consider the scenario that the Chinese government is proposing:
- Chinese credit growth will be regulated to the extent that certain types of corporate borrowers may no longer have access to any form of additional credit;
- Production capacities of industrial commodities, such as steel and coal, will be reduced and there will be negligible amounts of new capacity additions;
- Industries and households will be weaned off coal and other polluting fuels and shifted to more environmentally friendly yet more expensive alternatives such as natural gas;
- Government officials will not only be judged on the absolute level of economic growth achieved but also on the environmental cost of that growth; and
- Chinese growth will continue to be above economic potential despite environmental and financial constraints.
At the same time the world is at the cusp of an infrastructure spending boom. China is moving full steam ahead with the Belt and Road Initiative and the US government is concurrently pushing for congressional approval for a USD 1.5 trillion infrastructure investment plan.
A world with growing demand for industrial commodities combined with lower Chinese capacities is bullish for industrial commodities. Once we throw the fact that the developed world has all but lost its industrial manufacturing capabilities and is unlikely to be able to make up for lost Chinese capacities into the mix, we find ourselves considering the possibility of a wildly bullish outlook for industrial commodities over the medium-term.
Coupling this outlook with the fact that US financial institutions hold over USD 2 trillion in excess reserves, and that US companies’ attitudes toward capital spending are more positive than they have been in a decade, we find ourselves considering the possibility that commodities may well serve as a better hedge for equity market risk than US Treasuries at this stage.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.