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China markets reel as US$1.7t in shadow funds unwind

[SHANGHAI] A US$1.7 trillion source of inflows into Chinese markets has suddenly switched into reverse, roiling the nation's money management industry and sending local bonds and stocks to their biggest losses of the year.

The turbulence has centred on so-called entrusted investments - funds that Chinese banks farm out to external asset managers. After years of funneling money into such investments, banks are now pulling back in response to a series of regulatory guidelines over the past three weeks that put a spotlight on the risks. Critics have blamed entrusted managers for adding leverage to China's financial system and reducing transparency.

The banks' withdrawals helped erase US$315 billion of stock market value over the past six days and sent bond yields to the highest level in nearly two years, highlighting the challenge for Chinese authorities as they try to rein in shadow banking activity without destabilising financial markets. While the government has plenty of firepower to prop up asset prices if it wants to, forecasters at Australia & New Zealand Banking Group Ltd predict the selloff will deepen this year.

"We are seeing an exodus of funds," said He Qian, a Shanghai-based portfolio manager at HFT Investment Management Co, which oversaw about 189 billion yuan (S$38.4 billion) as of last year. He was one of about half-a-dozen asset managers and analysts who said banks have started scaling back their entrusted investments.

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The arrangements have become an important part of China's shadow finance system. When banks sell wealth-management products - the ubiquitous savings vehicles that offer higher yields than deposits - the firms sometimes farm out client money to entrusted managers such as hedge funds and mutual funds. The managers invest the cash in bonds, stocks and other securities, hoping to generate enough income to cover the banks' promised returns to WMP clients - plus some extra for themselves.

Chinese banks allocated an estimated 3.46 trillion yuan of WMP cash to such managers as of Sept 30, according to PY Standard, a Chengdu-based research firm. When the banks' own money is included, the total size of entrusted investments swells to 11.8 trillion yuan, according to SWS Research in Shanghai.

Regulators are thought to be wary of entrusted investments in part because some asset managers have more leeway than banks to employ leverage - an approach that authorities have discouraged after an explosion of debt in Asia's largest economy in recent years. The use of entrusted managers also makes it harder for banks and regulators to track whether WMP money is flowing into restricted sectors of the economy, such as real estate or cash-strapped commodity producers.

The China Banking Regulatory Commission has asked lenders to report the scale of their entrusted investments, including products issued by mutual funds, trusts, futures firms and brokerages. While the CBRC didn't explicitly ban entrusted investments, it asked banks to submit reports on their businesses by June 12 and to rectify any irregularities involving high leverage, multiple layers of investment, or regulatory arbitrage by Nov 30, according to a document obtained by Bloomberg News. It's unclear as yet what banks will do with the money they withdraw from entrusted investments.

"Banks have clearly taken note from the recent regulatory hints and have been on the defensive, even though no clear ban has been made," Meng Xiangjuan, head of fixed income research at SWS Research, said in an interview.

The CBRC didn't respond to a faxed request for comment.

The guidelines are part of a wider effort by Chinese regulators to reduce risks in the financial system. Guo Shuqing, who was appointed chairman of the CBRC in February, has presided over a raft of new directives on everything from interbank markets to property financing and the use of WMPs. His counterpart at the China Securities Regulatory Commission has pledged to curb the use of excessive leverage and combat market manipulators.

The crackdown doesn't mean authorities will let markets tumble, according to Shanghai Chongyang Investment Co, one of the nation's largest onshore hedge fund managers. The People's Bank of China should intervene by injecting cash into the financial system to smooth over any bumps in the nation's markets, the firm wrote in a note on April 21.

"The purpose of financial deleveraging is to reduce the probability of outbreak of systemic risks," Shanghai Chongyang wrote. "Therefore amid the strong enforcement of regulatory policies, the PBOC should increase liquidity supply when needed to smooth market volatility caused by the deleveraging."

So far, the slump in Chinese markets hasn't led to any signs of dramatic intervention. The Shanghai Composite Index sank 1.4 per cent on Monday, extending its retreat from this year's high on April 11 to nearly 5 per cent. Benchmark corporate debt yields climbed for eight straight days, while rates on 10-year government bonds reached 3.5 per cent on Monday, the highest level since August 2015.

The sovereign yield will probably climb to 3.8 per cent by year-end, according to ANZ.

The Shanghai Composite rose 0.2 per cent on Tuesday, while yields on 10-year government notes slipped about 6 basis points.

"Banks are pulling out entrusted investments in both government bonds as well as corporate bonds," Raymond Yeung, chief greater China economist at ANZ in Hong Kong. "That will put continued pressure on China's yields."