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China's New Year Rule Flurry May Reduce Broader Systemic Risks

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China started the new year with a flurry of rules that may tighten financing for less-creditworthy borrowers, as policy makers prioritize efforts to limit broader risks to the financial system.

Over the first few days of 2018, the nation’s top regulators announced rules governing banks’ involvement in entrusted lending, barred insurance firms from extending loans in the guise of equity investment and tightened supervision on leveraged bond trading.

China is growing more confident in economic growth, giving leaders increased opportunities to clean up the most risky corners of the financial system. Closing regulatory loopholes and thereby slowing the pace of credit growth may enable policy makers to reduce systemic dangers, as the new rules make it more difficult for riskier firms to borrow, curb local infrastructure investment and limit a key funding source for some banks.

(Related: China’s Boom or Bust Market Seen Tempered by 401(k)-Style Funds)

“The new financial regulations are targeting shadow lending, and will eventually curb broad credit growth,” according to Morgan Stanley’s chief China economist Robin Xing. Property and infrastructure investment would be affected most by the tighter regulation, Xing said, adding that he consequently expects a slight growth deceleration this year.

Here are the key regulation changes proposed over the last few days and their possible impact:

Entrusted Loans

The China Banking Regulatory Commission ordered banks to ensure they aren’t exposed to risks from their entrusted loans business, according to rules released over the weekend. The lenders should also cap their credit-risk exposure to any one client, according to a separate draft regulation.

Entrusted loans, by which companies provide finance to each other with banks acting as intermediaries, are a key source of funding for firms that have difficulty accessing regular loans. Larger state-owned companies with easier access to cheaper credit may sometimes lend on to smaller firms and profit from the difference in interest.

The expansion in the use of entrusted loans had already slowed amid last year’s deleveraging campaign. This renewed tightening will further curb such arrangements, potentially leading to funding difficulties for those dependent on them.

“Smaller firms relying on entrusted loans for financing would come under pressure,” said Richard Cao, a Shenzhen-based analyst at Guotai Junan Securities Co. “However, that’s what the regulators have to do to pull the borrowers back into legitimate financing channels.”

Insurance Firms

China’s insurance regulator issued rules preventing insurance firms from extending loans in the guise of equity investments using buyback agreements, in an attempt to control local government debt. Insurance stocks fell after the announcement on Friday.

Insurers have been participating in public-private partnerships, a key way of funding infrastructure. With a tighter grip on buyback agreements, firms are more likely not to support less economically viable constructions, such as subways in some cities. The new rule comes after the Ministry of Finance banned local governments from guaranteeing returns for private investors in such projects or backing a project’s debt.

“Policy makers have been worried about the hidden risks in local government debt,” said Sylvia Sheng, Hong Kong-based China economist at Bank of America Merrill Lynch. The PPP tightening “would pose additional headwinds to infrastructure investment growth this year.”

Bond Trading

The People’s Bank of China, China Securities Regulatory Commission, CBRC and CIRC have stepped up supervision of leveraged bond trading, ordering traders to meet liquidity requirements in their deals.

The central bank has also tightened requirements for banks to sell negotiable certificates of deposit, a key funding source for medium-sized and smaller banks, according to a report in the Securities Times. That indicates the size of that market won’t increase this year, Sun Binbin, a fixed-income analyst at Tianfeng Securities in Wuhan wrote in a note.

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