The Daily Update - China's reforming shadow

On Friday the People’s Bank of China announced further technical fine tuning on the renminbi fixing mechanism; with the inclusion of a ‘counter-cyclical factor’. The reason for this additional tweak is off the back of continued dollar weakness, the DXY (dollar) Index has fallen almost 4.5% so far this year (at time of writing). If the dollar does weaken, the counter-cyclical factor should in fact limit daily renminbi volatility and according to China Foreign Exchange Trade System (CFETS) could lessen ‘herd effects’; in effect speculative bets against the renminbi. This does not come as a surprise to us as the CFETS basket model which we monitor has not followed the previous prescription; and the offshore renminbi has actually strengthened since Moody’s downgraded the country one notch to A1.  Currently it is not clear what this ‘counter-cyclical factor’ is, however as always we will be monitoring the changes and incorporating them into our models as they evolve.

As China celebrates its last day (of three days) of the ‘Dragon Boat Day’ holidays we expect markets will be relatively quiet. However, it seems market commentators have once again overreacted, claiming that China’s USD9.4tn shadow banking business is on the verge of collapse as the government purge continues. The problem stems from a number of off-balance-sheet lending/borrowing practices involving some smaller banks and insurance businesses. Earlier this year in February, the country’s regulator recognised that these practises were on the rise and are thus becoming a threat to the country’s financial system, so it moved to tighten liquidity within the market, and launched a further set of regulations which should prevent the use of these borrowed funds to invest in China's bond market.

After witnessing the GFC almost decade ago, China has taken the necessary steps towards ‘the harshest crackdown on financial risks in history’ and the country is willing to let certain local and provincial banks go, whilst avoiding financial turmoil. Deleveraging is only ever a good thing for an economy, however it is not something that can happen over night, and yes it is always painful to witness defaults and bankruptcies, but in the shorter term a fine balance needs to be struck between structural reform and financial market collapse in order to avoid longer-term financial system damage. As China’s total government debt stands at 50% of GDP, there is still sufficient space for the government to ease any potential concerns over the country’s sovereign debt and as Moody’s say, ‘robust capitalisation levels and relatively high, albeit declining, loan-loss provisions mitigate Banking Sector Risk for the sovereign.’

We do not currently invest in any Chinese banks, we chose to instead invest in single A rated China Cinda, which is state-owned asset management company (AMC); thus strategically important and well supported, if necessary, by the Chinese government. As China’s economy drives through this stage of reform and rebalancing, we expect Cinda along with other AMCs will play a vital role in providing financial assistance to companies within the industrial and financial sectors. In fact in relation to this, in its latest report, rating agency Moody’s has stated that ‘the extensive experience accumulated by Cinda and its three major AMC peers will come in handy’, adding ‘We expect these AMCs to play an important role in assisting the restructuring of both the corporate and financial sectors.’ China Cinda 4.25% 2025 bonds trade 3.8 notches cheap and have an expected return around 6.5%, and have tightened 45bps so far this year to yield 3.85%.

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