16.07.2015, 09:09
Fitch: China Equity Sell-off Highlights Reform Challenges, Risks
OREANDA-NEWS. The recent volatility in China's equity markets should not pose a systemic risk to China's real economy or financial system, says Fitch Ratings. That said, the sharp fall in stock prices - and the authorities' reaction - highlights the relatively under-developed nature of the equity market. Policy intervention also raises questions about the pace of future financial reforms. This in turn underscores potentially significant operational risks for some financial institutions, especially brokers, which have exposure to - and operate in - the equity market.
Yesterday's report that GDP rose 7% year-on-year in 2Q15 - unchanged on 1Q - supports Fitch's view that the real economic impact of equity market volatility will be minimal. The GDP number was in line with the agency's forecast which did not factor in any boost from high equity valuations.
Furthermore, Fitch does not expect the equity market correction to have a major impact on Chinese banks' balance sheets or pose a systemic risk to the banking sector. Banks are not allowed to lend directly to customers for margin lending. Moreover, equity allocation represents only a small portion of their investment portfolios - direct investment in equities made up less than 1% of bank assets at end-2014. Banks have indirect equity exposure through issuance and investments in wealth management products (WMPs), however overall exposure is likely to have remained small relative to assets.
Banks also have exposure through lending to securities firms. The rapid evolution of the market and related volatility has highlighted several challenges for brokers - characteristics typical of a sub-investment-grade operating environment. Risk management and governance challenges are highlighted by the aggressive increase in margin lending alongside the rapid rise in equity valuations earlier in the year, as well as the subsequent sharp fall and the authorities' response.
Chinese brokers have sharply increased financial leverage, driven by increasingly exuberant demand for margin finance for equity trading since 2013. Top-tier brokers' gross leverage (excluding money accounts held for customers) had risen to 3.9x by end-2014 from 2.4x in 2013 and 1.6x in 2012. This figure likely rose further in 1H15. The leverage is not particularly high by international standards, but is notable considering the pace of leverage build-up, the high market volatility and inherently higher operational risk in China's developing capital markets.
Access to liquidity is also a weak link in Chinese brokers' credit profile - another point highlighted by the equity sell-off. Nearly half of listed stocks in China were suspended during the recent volatility, which has a direct effect on brokers' liquidity and raises refinancing risk. Brokers are reliant on wholesale funding, and are therefore exposed in the event of suddenly reduced market liquidity on stock exchanges. Notably, Chinese brokers - unlike banks - do not always have access to lenders of last resort, and become more reliant on interbank funding in times of stress. Some large brokers have been given access to a central bank liquidity facility.
More broadly, the policy response to intervene in the equity market raises questions about the pace of future market-oriented reforms in the financial sector. It could indicate that government is shifting positions to prioritise growth over reform, and also underscores the underlying issue of moral hazard in China's capital markets. By implementing policies to back-stop equity prices, government is reinforcing an expectation that the state will protect against any downside. This runs contrary to stated strategic policy intentions to develop equity and fixed-income markets that are governed by market mechanisms.
Some of the policies, such as where banks have been encouraged to provide interbank financing to support margin lending, also highlight the policy and social stability role that they are expected to play. This does reinforce expectations for extremely high state support for the banking system, while also raising the risks of contingent liabilities to financial institutions.
From a systemic level, too, recent volatility and the moratorium on new IPOs raises questions about the potential for the equity market to act as a source of new capital to address the high level of leverage in the economy.
It is important to highlight that there may be risks related to the equity market sell-off that are not yet visible or exposed. There are several key unknowns, including grey market leverage through WMPs, small trust/finance companies and even some banks. There is no official data on the scale of grey market margin finance by brokers, though some estimates place this at up to CNY1.5trn. Fitch has also previously highlighted the potential for loan proceeds from banks to be used to invest in the stock market.
Some of the risks that have built up from the growth in margin financing could also appear in other areas of the financial system, though it remains to be seen where contagion could most likely spread.
Yesterday's report that GDP rose 7% year-on-year in 2Q15 - unchanged on 1Q - supports Fitch's view that the real economic impact of equity market volatility will be minimal. The GDP number was in line with the agency's forecast which did not factor in any boost from high equity valuations.
Furthermore, Fitch does not expect the equity market correction to have a major impact on Chinese banks' balance sheets or pose a systemic risk to the banking sector. Banks are not allowed to lend directly to customers for margin lending. Moreover, equity allocation represents only a small portion of their investment portfolios - direct investment in equities made up less than 1% of bank assets at end-2014. Banks have indirect equity exposure through issuance and investments in wealth management products (WMPs), however overall exposure is likely to have remained small relative to assets.
Banks also have exposure through lending to securities firms. The rapid evolution of the market and related volatility has highlighted several challenges for brokers - characteristics typical of a sub-investment-grade operating environment. Risk management and governance challenges are highlighted by the aggressive increase in margin lending alongside the rapid rise in equity valuations earlier in the year, as well as the subsequent sharp fall and the authorities' response.
Chinese brokers have sharply increased financial leverage, driven by increasingly exuberant demand for margin finance for equity trading since 2013. Top-tier brokers' gross leverage (excluding money accounts held for customers) had risen to 3.9x by end-2014 from 2.4x in 2013 and 1.6x in 2012. This figure likely rose further in 1H15. The leverage is not particularly high by international standards, but is notable considering the pace of leverage build-up, the high market volatility and inherently higher operational risk in China's developing capital markets.
Access to liquidity is also a weak link in Chinese brokers' credit profile - another point highlighted by the equity sell-off. Nearly half of listed stocks in China were suspended during the recent volatility, which has a direct effect on brokers' liquidity and raises refinancing risk. Brokers are reliant on wholesale funding, and are therefore exposed in the event of suddenly reduced market liquidity on stock exchanges. Notably, Chinese brokers - unlike banks - do not always have access to lenders of last resort, and become more reliant on interbank funding in times of stress. Some large brokers have been given access to a central bank liquidity facility.
More broadly, the policy response to intervene in the equity market raises questions about the pace of future market-oriented reforms in the financial sector. It could indicate that government is shifting positions to prioritise growth over reform, and also underscores the underlying issue of moral hazard in China's capital markets. By implementing policies to back-stop equity prices, government is reinforcing an expectation that the state will protect against any downside. This runs contrary to stated strategic policy intentions to develop equity and fixed-income markets that are governed by market mechanisms.
Some of the policies, such as where banks have been encouraged to provide interbank financing to support margin lending, also highlight the policy and social stability role that they are expected to play. This does reinforce expectations for extremely high state support for the banking system, while also raising the risks of contingent liabilities to financial institutions.
From a systemic level, too, recent volatility and the moratorium on new IPOs raises questions about the potential for the equity market to act as a source of new capital to address the high level of leverage in the economy.
It is important to highlight that there may be risks related to the equity market sell-off that are not yet visible or exposed. There are several key unknowns, including grey market leverage through WMPs, small trust/finance companies and even some banks. There is no official data on the scale of grey market margin finance by brokers, though some estimates place this at up to CNY1.5trn. Fitch has also previously highlighted the potential for loan proceeds from banks to be used to invest in the stock market.
Some of the risks that have built up from the growth in margin financing could also appear in other areas of the financial system, though it remains to be seen where contagion could most likely spread.
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