Eric Hu, Ye Bingnan and Steve Wang: The Money Tracks

2017-04-27 IMI

This is an excerpt from China’s Rising Certainty at an Uncertain Time – A Cross-market and Cross-asset View by BOCI Macro and Strategy Research. Eric Hu, BOCI Macro & Strategy Research Ye Bingnan, BOCI Macro & Strategy Research Steve Wang, Senior Research Fellow of IMI, BOCI Macro & Strategy Research Shift towards Neutral and Prudent Policy As the economy rebounds with commodity inflation on stimulus momentum while the housing bubble risks increase significantly, the policymakers are shifting the monetary policy from “prudence with easing bias” towards neutrality and prudence with strict tightening over the property sector. The Central Economic Work Conference (CEWC) held last December has laid out the economic policy framework for 2017. The top leaders reiterated the need to control bubbles with prudent monetary policy, enhanced regulations and supply-side reforms next year. The CEWC stated that “housing is for residential use, not speculation” and emphasised the government should employ multifaceted policies involving financing, land, fiscal investment and legislation to curb housing bubbles as well as wild volatility in property prices. The CEWC also put more emphasis on preventing and controlling financial risks in 2017 as mounting financial risks are one of the prominent problems in the economy. Top leaders said the government will enhance financial regulations and resolve some key risk areas to prevent systemic risks. They also called for in-depth studies and active yet prudent promotion of reform in the financial regulatory system, indicating the current regulatory framework is likely to continue for a while. The PBOC warned against increasing bubble risks, economic structural imbalance and inflation expectations given the relatively-eased monetary policy in the past few yearsin its latest monetary policy report. The central bank also pointed out the external restraint in terms of RMB exchange rate stability on the domestic monetary policy. Considering the dynamic changes in economic and financial conditions, the PBOC has vowed to make monetary policy more prudent and neutral to better balance the targets of stabilising growth, restructuring economy, curbing bubbles, and preventing systemic risks. The central bank will maintain moderate liquidity supply to keep the money supply growth at reasonable levels. It will enhance MPA regulations to step up monitoring of financing activities, especially banks’ off-balance-sheet activities, to restrain excessive expansion in broad credits. We expect the central bank to mildly tighten liquidity through window guidance in order to moderately control broad credit growth this year.The central bank has pledged to put systemic risk prevention high on its agenda this year. It will enhance regulations to restrain financial institutions’ aggressive asset expansion and curb financing flows into speculative activities in the property market and financial system. The PBOC has emphasised its continued financing support for the underdeveloped sectors including agriculture, shantytown renovation, water conservancy projects, underground utility tunnels, and impoverished region developments. The premier’s report at the NPC meeting this March confirmed the prudent & neutral monetary policy in 2017. The target YoY growth rates of M2 supply and social financing balance are both set at 12%, although the two variables can hardly achieve the same growth in theory as the direct social financing has no impact on M2 creation while forex flows only influence M2 supply growth. The central government has urged to maintain relatively stable liquidity situation and reasonably guide market interest rates this year. We believe the M2 growth target will become increasingly “soft” as it becomes less measurable and controllable by the central bank as well as less correlated to the macro-economic targets with rapid financial innovation and financial system restructuring. The actual M2 growth was noticeably lower than the target of 13% in 2016, but financing conditions were relatively easy. The public will doubt the suitability, adequacy and effectiveness of M2 supply as an intermediate target for the monetary policy. The PBOC has indicated it will gradually shift the monetary policy framework to a price-based one, with the more important role of interest rate transmission mechanism. Yet, the central bank has also been concerned about the effectiveness of interest rate policy given the severe problem of soft-budget constraint in the real sector and incentive mechanism drawbacks in the financial system. Therefore, the central bank is seeking to control broad credit expansion more precisely by tightening macro-prudential assessment (MPA) regulations and allowing larger liquidity gap (making banks more reliable on the central bank to meet excess reserve demand). The central government is paying more attention to financing expansion or fund flows unrelated to the real sector and requires the financial system to better serve the real economy. The cabinet said the financial systemic risk is manageable, but warned against increasing risks on non-performing assets, bond defaults, shadow banking and internet financing activities. The authorities vowed to steadily push forward the reform of financial system regulations and to enhance financial discipline to reduce potential risks. Tightened Regulations over Shadow Banking System The PBOC released the draft regulation on the asset management business of all financial institutions (banks, brokers, mutual funds, private funds, insurers, and trusts) last month, indicating the central bank’s increasingly-tightened macro-prudential regulations over the shadow-banking system to curb the rapid expansion of broad credits. The new rule requires all asset management business to be off-balance-sheet and have no guaranteed return. The asset managers should not use own capital to repay investors in the asset management products. Currently, about 1/6 of banks’ wealth management products (WMP) are on the balance sheet and have guaranteed returns. Banks have to treat these products as deposits or fully convert them into off-balance-sheet risky products. The new rule will ban investments in non-standard bank credit assets, which are not openly traded in the interbank market or security exchange market. The new regulation will forbid asset managers from financing illiquid long-term investments by rolling over short-term assets or pooling investment funds. In fact, the banking regulator has already announced a similar rule to restrict the funding pool, but it is quite difficult for financial institutions to strictly follow this rule in reality. According to the new regulation, asset managers should charge risk provision at 10% of management fee income and up to 1% of AUM. Trust companies were already required to set aside provision. This proposal will level the playing field for all asset managers. The draft recommends leverage (total assets/net assets) to be capped at 140% for mutual funds and 200% for hedge funds. The leverage shall not exceed 300% for fixed-income products, or 100% for equity products. Such limits on leverage already existed for mutual funds. The new rule will extend such ceilings to cover hedge funds and trust companies. The draft regulation indicates that the central bank’s increasing regulatory controls over the asset management business from the macro-prudential perspective. The central bank has also signalled to tighten the macro-prudential assessment (MPA) regulations over the shadow-banking system in future to restrain broad credit expansion. Once the tightened regulations become effective, financial institutions’ asset management fee income may slow and the leverage in the financial system be restrained. Open-market Refinancing Rate Hikes as Signals for Policy Fine-tuning instead of Significant Tightening The PBOC further raised its open-market reverse repo rates and medium-term lending facility rates by 10bps on 16 March, in response to the additional policy rate hike by 25bps by the US Fed. The central bank said the refinancing rate hike reflects dynamic changes in the money market liquidity condition as the economy and inflation rebound with rapid broad credit expansion and overheating property markets, while the US policy rates and yield curve continue to climb. The PBOC said the increase of open-market refinancing rates is mainly driven by the market supply and demand factors. The central bank denied a fundamental shift of monetary policy towards tightening by adding that policy rate adjustment generally means changes in base lending and deposit rates in China. It is natural to see a gradual increase of open-market refinancing rates as the central bank pointed out that reflation caused a decline of real-term interest rates in China. We believe the refinancing rate hikes are also important signal from the central bank to warn financial institutions against their rapid broad credit expansion and increasing bubble risks. Soon after the refinancing rate hikes, a few cities launched further tightening policies for their property markets to control the soaring housing prices. We expect the tightening policies over the property sector to last for some time and at least until the NPC meeting in 2018. With economic growth stabilising and industrial deflation ended, the policymakers shift their attention to bubble & financial risk controls. The market interest rates have already responded to the fundamental dynamics, and the central bank prefers to see higher funding costs to control financial institutions’ leverage increase and stabilise renminbi exchange rate. Yet, we do not think the policymakers will raise the base lending and deposit rates to tighten the financing condition this year as the consumer inflation is still moderate while the high debt burden will restrain the room for base rate hikes.

In terms of impact of monetary policy on asset prices, we reiterate our view that stocks tend to outperform bonds at the early stage of reflation and interest rate up-cycles. The shift of monetary policy is still smooth currently and the economic recovery momentum may last in the short term, boosting market sentiment about the fundamental prospect. Meanwhile, property market tightening may guide some fund flows into the stock market. China is likely to continue to see YoY growth of M2 supply at above 10% this year. Huge incremental money is expected to support the asset performance as the growth opportunity in the real sector is still restrained by some uncertainty in the economic restructuring and transition process. With the property market speculation strictly restrained this year, some investors may pay more attention to the stock market. Large Southbound Net Inflows Continue in 2017 We have noted still-strong mainland investor appetite for HK-listed stocks via mainland-HK southbound trading YTD. Month to 17 March, southbound trading reported a net inflow of RMB14.9bn. In February, southbound trading reported a net inflow of RMB32.4bn, which exceeded net inflow of RMB17.1bn for January and RMB21.9bn in December, RMB17.0bn in November and RMB3.6bn in October, but still lower than RMB51.4bn in September (the largest monthly net inflow since the launch of the SH-HK stock connect in November 2014). Better still, southbound trading has reported a net inflow in each of the last 15 months. As of 17 March, the aggregate volume of mainland-HK southbound trades came to RMB378.9bn, compared to RMB212.9bn for northbound trades. Insurance Fund Entry via Stock Links Bodes Well for HK Market The China Insurance Regulatory Commission (CIRC) issued on 8 September 2016 the “Regulatory Guidelines on Insurance Funds to Participate in Shanghai-Hong Kong Stock Connect”, which officially allows domestic insurance companies to invest in Hong Kong stocks via the Shanghai-Hong Kong Stock Connect programme. Before the announcement of the guidelines, mainland insurance funds had been able to invest in overseas markets through the Qualified Domestic Institutional Investor (QDII) programme, overseas subsidiaries and mutual investment funds, which require regulatory approval. However, prior to the announcement of the latest guidelines, the CIRC had not made it clear whether insurance companies could invest in Hong Kong stocks via the SH-HK Stock Connect. As of end-2016, the total assets of China’s insurance industry had reached RMB15.1trn, of which about RMB339bn (2.3% of total) had been invested in overseas markets. According to the CIRC, insurance companies’ overseas investments can amount to 15% of total assets as of the previous year. Thus, in theory, RMB2.26trn of insurance funds can be invested in overseas markets, including HK. We have noted still-strong mainland investor appetite for HK-listed stocks via mainland-HK southbound trading YTD. Month to 17 March, southbound trading reported a net inflow of RMB14.9bn. In February, southbound trading reported a net inflow of RMB32.4bn, which exceeded the net inflow of RMB17.1bn for January and RMB21.9bn for December, RMB17.0bn for November and RMB3.6bn for October, but still lower than the RMB51.4bn for September (the largest monthly net inflow since the launch of the SH-HK Stock Connect in November 2014). Better still, southbound trading has reported a net inflow in each of the last 15 months. As of 17 March, the aggregate volume of mainland-HK southbound trades came to RMB378.9bn, compared to RMB212.9bn for northbound trades. Investment behaviour data in 2016 show that, in general, southbound investors focus on high-yield blue-chip stocks, indicating that mainland institutional investors (e.g. mutual funds) make up the majority of them. We note that the six large Chinese commercial banks and HSBC (5 HK) are among the top 10 actively-traded stocks for mainland-HK southbound link. Meanwhile, investment behaviour data year to 17 March 2017 show that southbound investors started to pay attention to some undervalued auto, insurance and property stocks. Looking ahead, along with the steady development of the mainland-HK stock connect programmes, we believe mainland Chinese investors will gradually step up in trading HK-listed stocks and eventually become the major players in the HK market over the medium to long run.

Disclaimer: This article is for information only and does not constitute investment advice. Neither BOCI Macro and Strategy Research nor the authors themselves are responsible for any losses.

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Eric Hu, Ye Bingnan and Steve Wang: The Money Tracks

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