China commits to tighten financial regulatory oversight

The current fragmented framework makes it more difficult for regulators to monitor banks.

Fitch Ratings reports that Chinese officials emphasised their commitment to tighter regulation to contain financial risks at the National Financial Works Conference (NFWC), which tends to set the tone for financial policy over the next five years. This could signal rising potential for a more decisive shift in policy focus away from hitting high growth targets, but there is still uncertainty over whether the drive to address risks will continue to take priority if the economy slows, says Fitch Ratings.

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The main policy announcement to come out of the conference was the creation of a cabinet-level regulatory committee that will coordinate the efforts of the four main financial regulators. The current fragmented framework makes it more difficult for regulators to monitor banks and non-bank financial institutions (NBFIs), and to fully address the contagion risks from increased cross-holding of complex financial products.

A more unified approach could enhance regulatory oversight and help to limit contagion risks. This would be positive for the long-term stability of China's financial system and economy. That said, the decision falls short of some speculation that the regulators might be fully merged.

Financial stability was clearly prioritised in the NFWC statement, which said China should create "an austere regulatory atmosphere". It also took a strong tone on accountability for debt excesses, with local officials now to be held liable for risks created during their tenure even after they have left office. This focus is consistent with other recent statements by officials, as well as new guidelines to enhance bank supervision and the facilitation of higher market interest rates by the PBOC to squeeze out speculative activity in the shadow banking sector.

The authorities' belief that economic conditions remain resilient has provided them with the confidence to address financial risks. Recent GDP data showed the economy expanded by 6.9% yoy in 2Q17, the same as in the previous quarter, and growth now looks set to comfortably meet the authorities' 2017 target of "around 6.5%". That confidence could be tested in the second half of the year, as tighter credit conditions feed through the economy, particularly into the housing market.

Tightening is likely to become more targeted as the authorities try to limit the impact on economic growth. The policy approach has already been cautious in this respect, with recent data showing early signs that credit is migrating back onto banks' balance sheets and away from riskier forms of shadow bank financing, but not that credit growth has slowed in overall terms. Meanwhile, targets for credit and GDP growth remain high, and we expect leverage across the economy to continue to rise in the short term.

Nevertheless, the liquidity squeeze in the first half of the year affected bond market access for almost all corporates, and the authorities are unlikely to be comfortable adding to those difficulties as the economy slows. The NFWC statement emphasised corporate deleveraging, but suggests that further tightening is likely to be selective, aimed at zombie companies and sectors with overcapacity.

The authorities will be wary of triggering a liquidity crunch through regulatory tightening, which makes an abrupt clampdown on shadow banking activities unlikely. The NFWC statement said the prevention of system stress is deemed as "a never-ending task" and raised the possibility of increased support for small and mid-sized financial institutions.

This is likely to refer mainly to the city commercial banks and rural banks, which have been hit hardest by recent regulatory measures, given that they have larger exposure to shadow banking activities, generally weaker loss-absorption capacities and thinner liquidity profiles compared to larger banks.