Moody's: China's shadow banking sector affected by tighter liquidity conditions, stricter regulatory scrutiny 

Moody's Investors Service says that liquidity conditions in China's financial system appear to be tightening.

"We expect that a combination of tighter liquidity conditions and stricter regulatory scrutiny on the banks' off-balance-sheet activities will curb the banks' incentives to engage in regulatory arbitrage and gradually dampen the fast-growing component of shadow banking activities," says Michael Taylor, a Moody's Managing Director and Chief Credit Officer for Asia Pacific.

On the other hand, demand from shadow bank borrowers will be relatively inelastic to higher interest rates, given the continuing financing needs in sectors such as property, local government financing vehicles and overcapacity industries.

Moody's also says that the composition of credit flows are undergoing important shifts, even while economy-wide leverage continues to increase.

In recent months, credit flows have been sustained by bank lending and "core" shadow banking. Mortgage loans have continued to contribute a rising share of headline bank lending, while in Q4 2016, the growth rate of trust loans registered its first significant increase since mid-2014.

The up-tick in trust lending could be due to tighter regulations around non-core shadow banking components — notably assets funded by wealth management products (WMPs) — and tighter financing conditions in the domestic bond market for some borrowers. The share of "direct" financing flows — principally corporate bonds — experienced a decline in the final quarter of 2016.

Moody's analysis is contained in its latest Quarterly China Shadow Banking Monitor. The publication draws on publicly available data sources to provide an overview of trends and developments in this important component of the Chinese financial system.

On the issue of liquidity, Moody's publication explains that even before the shift in the People's Bank of China's monetary policy stance signaled at the December 2016 Economic Work Conference, a variety of market indicators — interbank and certificate of deposit (CD) rates and the spread between WMP yields and one year deposit rates — implied tighter liquidity conditions.

In addition, spreads in the corporate bond market are widening across the maturity spectrum, most likely reflecting investors' greater perception of default risk.

"And, there are indications that the shadow banks are increasingly exposed to China's property sector," says George Xu, a Moody's Associate Analyst, and the report's main author.

Moody's says that the share of WMP assets invested in the property and construction sectors increased in the first half of 2016, and this trend is likely to have continued during 2H 2016.

Moreover, Q3 2016 saw a net increase of trust assets allocated to the real estate sector in absolute terms; the rise was more than double the aggregate increase in the first two quarters, which could reflect tighter financing conditions for some borrowers in this sector, who are increasingly resorting to shadow bank financing.

Moody's points out that mid- and small-sized banks demonstrate the greatest interconnection with the shadow banking sector. They are active investors in shadow banking products, including other banks' WMPs and the trust and asset management schemes of non-bank financial institutions.

Moody's also says that interbank activity has increasingly served to help banks pursue profits and expand assets, rather than being a tool for liquidity management. A high and growing reliance on wholesale funding — including aggressive issuance of interbank CDs — exposes the banks to possible liquidity shocks, especially if systemic liquidity conditions tighten further.