Moody's Investors Service says that liquidity in China's financial system is increasingly tightening, as stricter regulatory measures seek to constrain the growth of leverage in the country.

"At the same time, the interconnectedness between mid and small-sized banks and the shadow banking sector continues to grow, increasing the risk that funding structures could become fragile if confronted with a negative liquidity shock," says Michael Taylor, a Moody's Managing Director.

In particular, tighter systemic liquidity could crystalize the risks inherent in the more complex and opaque funding structures used by smaller banks. These banks are vulnerable to the withdrawal of wholesale funding, which they have used to finance their investments in the trust and asset management schemes of non-bank financial intermediaries to boost profitability, as well as to circumvent capital restrictions on lending.

"The Chinese authorities recognize the risks in the shadow banking sector and are seeking to address them through a new set of regulatory guidelines, highlighting that preventing financial risks has become one of the government's top priorities this year," says George Xu, a Moody's Associate Analyst.

"However, there are indications that regulatory measures to curb systemwide leverage show unintended consequences; specifically, in reviving 'core' shadow banking activities that had previously been constrained by regulation," adds Xu.

Moody's explains that because of government efforts to constrain the growth of leverage, borrowers in sectors such as property, local government financing vehicles and overcapacity industries with high financing needs face reduced access to traditional bank loans and the primary bond market.

As a result, there are increasing signs that these borrowers are turning to shadow banks as an alternative funding source, which drives in particular, demand for trust loans and entrusted loans.

Moody's analysis is contained in its latest "Quarterly China Shadow Banking Monitor," and is co-authored by Taylor and Xu. 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 wealth management products (WMPs), Moody's says that the pace of growth of WMPs has begun to slow, as regulatory oversight is enhanced. Previously the fastest growing shadow banking component over the past several years, the slowdown in the growth of the banks' outstanding WMPs became more apparent in Q1 2017.

The slowdown followed the inclusion of the off-balance sheet WMP business into the Macro Prudential Assessment framework introduced by China's central bank.

However, there have been delays in publishing official data which would shed more light on the impact of increasingly stringent regulations on bond holdings by WMPs (40% of total WMP assets at end-H1 2016) and the share of interbank investors (15% at end-H1 2016) in the banks' WMP business. If this data remains unavailable, the transparency of the shadow banking sector would worsen.

Moody's Quarterly China Shadow Banking Monitor notes that China's largest money-market fund, Yu'e Bao, became the biggest such fund globally in dollar terms during Q1 2017, with assets under management jumping to USD165 billion at end-Q1 2017.

A net increase in the fund's investments in interbank negotiable certificates of deposit (NCD) was one of the main driving factors behind the asset expansion, amid tighter liquidity conditions and elevated NCD rates.