Fitch: China Making Progress in Shrinking Shadow Banking 

China's shadow-banking sector has shrunk in response to the regulatory clampdown launched in early 2017, which could address certain risks to the financial system if it continues over the medium term, says Fitch Ratings. Declining shadow-banking activity could create potential liquidity shortages, but the recently announced targeted cut to the required reserve ratio (RRR) illustrates that the authorities will use policy tools to guard against a significant impact on prioritised sectors.

System-wide inter-bank assets had fallen by 13.8% yoy as of end-August 2017, while interbank liabilities were down by 1.6%, according to data from the China Banking Regulatory Commission (CBRC). This was the first drop in both interbank assets and liabilities since 2010. The decline was sharpest among joint-stock commercial banks, which had been more aggressive in interbank activities. Their inter-bank assets were down by 45% at end-August 2017 from the start of the year. Entrusted loans fell for the first time since 2008 over the same period. Meanwhile, growth in wealth management products (WMPs) continued to slow, with the interbank WMP balance falling by CNY2.2 trillion from January to August 2017. Fitch estimates the outstanding WMP balance has declined by around 10% so far in 2017.

Shadow banking remains a key source of risk to financial stability following years of rapid growth that has increased the interconnectedness of the system and made some banks vulnerable to strains on funding and liquidity. Outstanding WMP balances, for example, reached roughly 40% of GDP at end-2016, having grown by over 40% per year on average since 2013.

The CBRC reiterated its commitment to tackling these risks in late September, emphasising its role in identifying threats and implementing necessary mitigating measures. The regulatory tone was strong, stating that any failure by the regulators to spot and handle risks in a timely manner would be viewed as a dereliction of duty.

Shadow banking therefore appears likely to continue to face greater regulatory scrutiny, at least while the authorities remain comfortable with economic growth. Fitch expects the economy to start slowing in 3Q17, but the deceleration is likely to be gradual, with GDP forecast to grow by 6.3% in 2018, down from 6.7% in 2017.

Liquidity shortages triggered by a deceleration in shadow-banking activity are a potential risk to the growth outlook, but the People's Bank of China's (PBOC) has highlighted that it will continue to use its various monetary policy instruments to keep liquidity stable and maintain its "prudent and neutral" policy stance. One example of targeted support to prevent tighter liquidity from having adverse effects on the real economy is the PBOC announcement on 29 September of a cut to the RRR for banks that meet criteria on lending to rural and micro enterprises.

The RRR cut is likely to encourage banks to support inclusive finance, which is an important component of the authorities' reform agenda. A bank's RRR will be lowered by 50bp if loans to support inclusive finance exceed 1.5% of its total loan balance or its new lending in the previous year. Most banks are likely to reach this 1.5% threshold and be qualified for 50bp cut, but only some will hit the 10% threshold required for a larger 150bp. The adjustments will not be effective until 1 January 2018, but the impact on lending to rural and micro enterprises is likely to come through sooner as banks position themselves to qualify for the cuts. This would alleviate pressure on borrowing costs for targeted sectors, while maintaining a grip on banking sector risks.