Sober Look

China’s Wealth Management Products, a Q&A

We’ve had a number of questions regarding the growth and the risks surrounding China’s Wealth Management Products (WMPs). Here is an overview in a Q&A format.

Q: What are the reasons for the continuing demand and proliferation of WMPs in China?

1. China’s bank deposit rates have been extremely low over the past decade and until recently have been artificially capped by the nation’s central bank, the PBoC. The reason for these low rates is Beijing’s effort to make sure that the banking system has access to cheap financing in order to stimulate credit growth.

Source: Tradingeconomics, PBoC

These days, awash with deposits, many banks pay even less than the latest rate set by the PBoC. Here is one example showing why China’s depositors have been desperate for yield.

Source: Bank of China (one of the 5 biggest state-owned commercial banks in China)

2. Another reason for the explosion in WMPs in China is the rapid growth in money supply, with limited options to deploy all the new cash. The chart below shows China’s  broad money supply (M2), now 15 times the size it was at the end of 1999. That’s a great deal of liquidity sloshing around.

3. More money poured into WMOs last year after the massive “correction” in China’s stock market, as investors looked for other sources of yield.

Q. What rates do banks offer to their WMP customers?
A. In 2015 the typical WMP product yield ranged between 4.5% and 5%.

Q. What is the typical WMP term?
A. According to HSBC, “more than 90% of China’s fixed duration WMPs are shorter than a year”.

Source: HSBC


Q. How do WMPs generate returns?
A. These days most are invested in corporate bonds although some also invest in private loans. The most popular type of bond in WMPs’ asset portfolios is a AA corporate (domestic agency ratings of course) with a 4-5 year maturity.

Q. What is the yield on such bonds currently and is it sufficient to pay the WMP rates?
A. Here is the RMB AA corporate yield curve. With a little help from leverage (usually via the repo market) and/or a big duration mismatch, WMPs generate the necessary yield.

Source: HSBC

Q. Has the WMP growth impacted corporate bond yields in China?
A. Yes. Since early 2014, China’s corporate bond yields have been steadily declining. A great deal of this is the result of China’s WMP demand.

Source: S&P


Q. Who manages WMPs?
A. While banks actively market these products, these days the management is outsourced to brokers (and other non-bank entities) with asset management/trading desks. Banks used to manage WMPs but due to regulatory and resource constraints have shifted the process to third parties.

Q. What sort of arrangements do banks have with WMP managers?
A. WMP managers operate like hedge funds, retaining 20-30% of the upside above the “guaranteed” contractual return of 4.5% – 5% (this is on top of the management fees).

Q. What type of risks are inherent in this market?
A. Given the hedge-fund style upside, this can be an extremely profitable business, encouraging higher leverage as rates decline. Since this activity is concentrated outside of the banking system, it is not yet regulated, resulting in rapid growth in China’s “shadow banking”. In fact this is one of the key reasons the PBoC has been so reluctant to lower the target interest rate, focusing on the reserve ratio (RRR) instead. Lower rates will encourage further “reach for yield” and increase leverage in the system.

An even greater systemic risk in the WMP market is the asset-liability mismatch – one of the key problems that precipitated the financial crisis in the United States (funding illiquid mortgage bonds with asset-backed commercial paper or repo). The chart below shows the amount of WMP placed vs. what is actually reported at year-end by banks. Many WMPs are timed to mature before the bank reporting date (“window dressing”). Most WMPs of course mature several times a year and the industry relies on the WMP customers to roll (on a net basis) their maturing WMPs. Moreover the market’s tremendous growth has banks and managers believing that rolling would not be an issue. If some investors pull their money out, there will always be plenty of new ones wanting to come in. Sounds familiar?

Source: HSBC

Q. Why isn’t Beijing addressing this rising systemic risk?
A. The PBoC has to tread carefully in order to avoid disrupting its growing domestic bond markets. The situation is quite fragile and any hint of a serious regulation could send the corporate and other bond markets tumbling (starting a deleveraging cycle). As the regulators try to figure out how to contain these risks (including endless discussions with the major banks), the WMP market continues to grow.

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6 reasons why markets discount the FOMC’s rate forecasts for 2016

As discussed in the previous post (here), the markets have completely discounted the stellar US payrolls report when projecting the Fed’s policy path in 2016. Futures-implied probability of 4 rate hikes (or higher) is only 6.5%. Why is the market so “dovish” relative to the FOMC?

As a backdrop, we now know from the FOMC minutes that the Committee members were quite jittery about disinflationary pressures, with many being ambivalent in their decision to raise rates in December.

Source: FOMC Minutes, FRB

Is the long-awaited jump in inflation about to make itself visible? Market participants remain skeptical. Here are some key reasons.

1. Most analysts have been forecasting – for some time now – a significant increase in US wages as the labor markets tighten. However thus far we have seen little evidence for this “acceleration”, with wages persistently growing below 2.5% per year.

2. With US crude oil prices below $33/bbl, many believe the energy impact on inflation is yet to be fully reflected in the official figures. Moreover, some think that weak energy prices will even partially bleed into the core PCE inflation measure (on a delayed basis).

Source: Investing.com

3. China’s ongoing devaluation will continue putting pressure on prices in the US as well.

As an example, the December jump in iron ore prices has been nearly fully reversed as China-related worries returned. In addition to China’s impact on commodities, most expect US import prices to fall further, also igniting disinflationary concerns.

Source: barchart.com

Of greater concern is whether China will continue devaluing the yuan further in order to stimulate its export sector. This could lead to “competitive devaluations” – or what some refer to “escalation of currency wars”. Here is a quote from Mexico’s finance minister.

FT: – “There is real concern that, in the face of the deceleration of the Chinese economy, the public policy response will be to start a round of competitive devaluations,” said Luis Videgaray, finance minister. 

He called that prospect “frankly perverse” because copycat devaluations would leave everyone in the same position and would not really alter anything. Mexico’s peso floats freely, but the central bank has been auctioning dollars in recent months to shore up the currency.

Such an outcome will be highly deflationary, resulting not only in further weakness in commodity markets and US import prices but also in a wave of shifting production and services offshore. Consider the fact that just over the past year the Mexican peso is down 18% – now at the weakest level on record. Shifting production and even some services out of the US becomes increasingly compelling.

In fact the trade-weighted US dollar index is now at the highest level since 2003 and “offshoring 2.0” could be the next major trend for US businesses. This of course doesn’t bode well for stronger wage growth.

4. We’ve already seen some of the impact of this dollar strength in the struggling US manufacturing sector. Growth in US services sector is moderating as well (see summary). Does it make sense to hike rates aggressively in such an environment?

5. Given some of the trends above, market-based inflation expectations remain near the lowest levels since the Great Recession. While a number of analysts as well as many Fed officials view this as a “transient” effect, these measures have remained stubbornly low for some time now.

6. Finally, a number of economists are becoming concerned about aggressive rate hikes at a time when the corporate sector is about to undergo deleveraging.
                                                  

Source: Citi research

Of course we know that all the years of highly accommodative monetary policy in fact caused corporate leverage to rise to begin with (see post from 2014). Nevertheless, with a number of analysts calling the end of the credit cycle, managing this deleveraging process should become a consideration for the Fed this year.

Source: Citi research

These are some of the key reasons markets view four or even three rate hikes as being off the table for 2016. Some are even calling for the Fed to take rates back to the 0-25bp level. It’s unlikely the FOMC would do this because such an action would damage the central bank’s credibility. Nevertheless some are hoping the Fed would pay more attention to what the ECB is currently doing.

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