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Chinese Stocks Sink Over Fears Regulators Will Curb Wealth Management Schemes

China’s burgeoning problem with its ponzi-like wealth management product or WMP, industry, is nothing new: we presented a comprehensive summary one year ago in “The 8 Trillion Black Swan: Is China’s Shadow Banking System About To Collapse?”

For those unfamiliar, the outstanding value of WMPs, widely expected to be a major source of future systemic risk for Beijing, rose to 23.5 trillion yuan, or 35% of China’s gross domestic product, at the end of 2015 from 7.1 trillion yuan three years earlier. Much of the growth came in open WMPs, which are extra appealing to investors because they can be redeemed at any time, and thus provide another major duration risk which as we recently saw with commercial real estate funds in the UK, can turn sour overnight. Mid-tier banks such as China Merchants Bank Co. and China Everbright Bank Co. are especially dependent on the products for funding.

However, while these products provide a constant threat of imminent failure, so far the government has refused to take any steps to curbs them for one simple reason: they remains some of the most aggressive buyers of Chinese risk assets.

However, that may have changed overnight when China’s Banking Regulatory Commission drafted new rules curbing the nation’s multi-trillion market for wealth management products, which was not taken well by the local stock market, leading to a plunge in stocks in early Chinese trading, before rebounding at the close of trading. China’s ChiNext index of smaller companies sank as much as 5.5%.

Ironically, this took place just hours after we warned that China’s stock volatility – just like in the US – has plunged to near record lows.

From over 110, short-term volatility in China’s major stock market – Shanghai Composite – has collapsed to single-digits this week. This is among the least volatile period in the index’s history, despite increased uncertainty around stimulus and economic transition. China’s $6.2 trillion equity market was until recently best known for its violent price swings.

As Bloomberg observes, the market’s material response to the news showed what was at stake for China’s watchdogs as they attempt to reduce risk in the financial system while avoiding going too far and provoking another crash in the $6.4 trillion stock market. The Shanghai Composite is down 15%this year, among the world’s worst performers.

Many banks have been investing in WMPs to funnel money into the stock market,” said Francis Cheung, head of China and Hong Kong strategy at CLSA Ltd. in Hong Kong. “It’s non-transparent, so I understand why regulators would try to act. But if this causes too much correction, then they will get worried. The No. 1 priority is to maintain a relatively stable stock market.”

Indeed it is, and not just in China but around the globe.

The CBRC’s proposed crackdown on the $3.5 trillion WMP market was first reported by the 21st Century Business Herald, which said that all lenders may face caps on the investment of proceeds in stocks. Draft rules state that cash from “mass market” wealth products can only be invested in money or bond markets, not domestically-listed shares, a person with direct knowledge of the matter told Bloomberg. The rules are pending feedback from banks, the person said.

There’s an obvious trend of regulators wanting to strengthen market monitoring and lower the use of leverage in financial markets to control risks,” said Dai Ming, a fund manager at Hengsheng Asset Management Co. “Under such circumstances, ChiNext is especially vulnerable, given its high valuations.”

This is not the first time China has tried to tackle the local “shadow investing” industry. In fact, China has been tightening rules on WMPs since late 2014, however it has been mostly unsuccessful. The products are a key reason behind the growth in the shadow-banking industry, which Moody’s Investors Service estimates is worth more than 50 trillion yuan, and have been used by some financial institutions as a way to extend funds to risky borrowers and evade capital requirements. WMPs are sold by banks but often stay off their balance sheets. China’s securities regulator has already restricted the use of leverage by structured asset management plans, and was said to warn brokerages to do better due diligence when raising money for companies.

Adding to concerns, the Shenzhen Stock Exchange will demand better disclosure and limit speculation on stocks in popular industries such as virtual reality and artificial intelligence, according to a statement in the Securities Daily Tuesday.

“China will curb asset bubbles”, the official Xinhua News Agency reported the same day, citing a government statement after a Politburo meeting chaired by President Xi Jinping.

Somehow we doubt it, but on Wednesday, that all added up to a bad day for stock investors. The ChiNext Index of small-company shares sank by the most since June 13, the Shanghai Composite Index fell 1.9 percent and the Shenzhen Composite Index lost 4.5 percent.

And just like in the US, any time sellers emerge, so does volume: according to Bloomberg data, trading volume in Shanghai surged to the highest since April, while a gauge of 10-day price swings doubled. The Shanghai gauge trades at 12.8 times projected 12-month earnings, compared with more than 31 times for the ChiNext.

It goes without saying, that if the “crackdown” on WMPs leads to ongoing selling in Chinese stocks, the local regulator will promptly scrap the rules which as of last night are proposed to include the following:

  • Restrictions would be placed on banks with less than 5 billion yuan ($750 million) of net capital or fewer than three years of experience with wealth-management products, the person said. They would be required to invest the proceeds of any WMPs they issue in less-risky assets, such as government bonds and bank deposits, the person added.
  • Proceeds from “mass market” WMPs cannot be invested in securities funds that aren’t focused on money markets or bond markets, said the person, who asked not to be identified as he is not authorized to speak publicly
  • Private bank clients with net financial assets of more than 6m yuan and high-net worth individuals with more than 1m yuan of financial assets, as well as institutional investors, will be excluded from “mass market” category
  • Proceeds from such WMPs cannot be invested directly or indirectly in domestically listed companies’ shares or beneficiary rights
  • Banks with more than 5 billion yuan of net capital that comply with other regulatory requirements will be allowed to conduct “comprehensive” WMP business and also invest proceeds in equities and non-standard assets, in addition to low-risk assets such as government bonds, bank deposits, central bank bills
  • Banks can only apply for “comprehensive” license after running WMP business for more than three years
  • Banks will be required to set aside risk reserves from their net income until the buffer reaches 1 percent of the value of their outstanding WMPs
  • Banks will be banned from issuing WMPs with different tranches
  • The rules are pending banks’ feedback and may be subject to change

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