Rules recently introduced by China’s financial regulators will transform the country’s asset management industry. Aidan Shevlin, Managing Director, Head of Asia Pacific Liquidity Fund Management at J.P. Morgan Asset Management, unpacks the rules and explains what they mean for investors.
Managing Director, Head of Asia Pacific Liquidity Fund Management
In less than four years, China’s asset management industry has doubled in size to over US$15trn, approximately equivalent to China’s overall GDP.
The growth of the industry was originally triggered by financial and interest rate liberalisation, which has encouraged significant financial innovation. However, the recent, rapid development in shadow banking products is driven by less desirable factors including regulatory arbitrage, implicit guarantees and opaque, complex products which are designed to circumvent central bank-imposed regulations in order to provide borrowers with access to credit, while also providing investors with higher-yielding products. The asset management sector has thereby served the real economy and fuelled much of China’s recent economic development.
The asset management industry’s boom has also created risks in the Chinese economy, however. Most notably, indebtedness in China has quadrupled since 2008. This has seen China’s debt-to-GDP levels skyrocket to 266% at the end of last year. Whilst this figure is comparable to that of the US, UK and Japan, it is significantly higher than other emerging market economies and the speed of growth appears unsustainable, translating into concerns that a financial crisis may be brewing.
The systemic risk that this credit growth poses to the Chinese economy is recognised by the country’s government, which has made deleveraging a key objective in order to de-risk the economy and create financial stability. China’s regulators have already introduced several new rules, including measures adopted last year by the China Securities Regulatory Commission (CSRC) to strengthen the mutual fund industry (which equates to 10% of China’s entire asset management industry) and new macro-prudential rules by the People Bank of China (PBoC) to reduce bank risks.
Now the remaining 90% of the asset management industry, which Aidan Shevlin, Managing Director, Head of Asia Pacific Liquidity Fund Management at J.P. Morgan Asset Management describes as containing “less desirable financial activity”, is to be curtailed. This is after rules introduced by the Financial Stability and Development Committee – a ‘super regulator’ designed to unify the rules covering the entire asset management industry – were signed into law in April.
Under the spotlight
Titled ‘The Guiding Opinion on Regulations in the Asset Management Business of Financial Institutions’, the rules seek to curb financial risks and enhance investor protection. The headline change is that existing investment products sold by the asset management industry, such as trust products and wealth management products (WMPs), will be unified under a single product umbrella: the Asset Management Product (AMP).
Publicly sold AMPs must conform with strict rules. For example, these products must no longer provide an implicit or explicit guarantee that an investor’s principal is secure. It is a move that Shevlin believes is positive. “The guarantee that these investment products offered created a dislocation between risk and return in China,” he says. “Removing it will realign the principles of risk and return and force investors to be diligent when making investments – something they haven’t had to be in the past because of the guarantee.”
AMPs must also only invest in ‘standard assets’ – defined by the regulators as assets that have a market price. “This will impact the returns that these funds can offer because the yield of WMPs was often boosted by funds investing in opaque loan structures and using techniques such as layering, which is no longer permitted,” says Shevlin. “But the change will also drastically reduce the risk in these funds, which is a good step for the industry and is what the Chinese regulators are trying to achieve.”
Another rule change is that all AMPs must be mark-to-market, meaning investors will no longer be assured a guaranteed rate of return. “It will drive more transparency in the industry, making it clearer for investors to know what they are buying and what risk they are taking,” says Shevlin.
In an effort to ensure a smooth transition, the Financial Stability and Development Committee has granted a transition period until the end of 2020 for existing products to comply with the new rules. Any new products launched after April 2019 must obey the new rules immediately.
“Extending the transition period to two years is a sensible move, as many existing products have one or two-year maturities,” says Shevlin. “Investors will get their money back and the underlying loans that the product is investing in will be paid off before they transit under the new AMP rules. It is uncertain what will happen to those products that have longer maturity dates, however.”
The impact that these rules will have on the asset management industry should not be downplayed. Indeed, Shevlin says that the rules will “essentially kill off nearly all the existing investment products used in China today”. So what will happen to all the cash? Shevlin says that some of it will likely flow back into time deposits – and banks have been preparing for this by increasing the rates of return on these products.
Shevlin also expects cash to flow into the ‘traditional’ mutual fund sector – which is not directly impacted by the new rules. “Money market funds, which are already well-regulated and offer good disclosure, are unaffected by the new rules and would appeal to investors focused on liquidity, security and return,” he says.
Whilst this is a boon for the fund management industry, Shevlin notes that fund managers cannot rest on their laurels and that the industry must innovate to retain investor cash. “I hope to see more products launched that cater for the entire risk spectrum,” he says. “This will give investors more choice and play a key role in boosting the sophistication of the investment community in China.”
The new rules are expected to have a negative short-term impact on commercial banks in China. Some banks generate up to 12% of their total revenues issuing WMPs, and this revenue-generating ability will be greatly reduced under the new regulatory regime. What is more, those banks that don’t have a separate asset management subsidiary will now be required to create one in order to conduct asset management business.
Whilst Shevlin expects that those banks with a stronger traditional loan/deposit franchise and capital base will be best placed to withstand the impact of the changes, it is likely that bank funding costs will increase overall, making banks less inclined to provide credit to corporates. This may lead more corporates to the bond market, thus increasing spreads – and possibly resulting in more credit events taking place in China over the coming years.
To alleviate this impact and ensure the banks will fund the real economy, the PBoC cut the reserve requirement ratio (RRR) in anticipation of the new rules. “This releases some funding back to the banks at no cost,” says Shevlin. “And we expect to see the PBoC continue to do this over the coming year as it adopts a more neutral monetary policy and debt flatlines.”
Next steps for investors
For corporates in China, particularly those that use guarantee products, changes will be required in terms of how they invest. But Shevlin says that there is no need for panic.
“Corporates that have exclusively used WMPs and trust products need to revisit their investment policies to ensure these are broad-based and flexible,” he says. “This will enable them to invest in suitable products under the new regulatory regime. They also need to think about changing their investment procedures and make sure that they are doing their homework on the products they are buying because of the greater link between risk and return.” Shevlin adds that for western investors that rarely invest in WMPs, the impact on their investments should be minimal.
“That being said, as always it is important to stay close to your fund manager as sudden change is par for the course in China,” he says. “But overall these new rules should be seen as a positive that will reduce systemic risk and moral hazard in China, and help the government achieve its goal of creating sustainable financial stability.”