Beijing's crackdown on risky debt is throwing Chinese investors for a loop

Key Points
  • Beijing's steps to rein in debt are sending ripples through local markets.
  • On Friday, the Chinese 10-year bond yield hit its highest since August.
  • The regulatory moves may reflect greater financial and economic maturity.
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China's latest efforts to crack down on high and increasingly risky forms of debt in its financial system are shocking local markets.

Bond yields are rising, stocks are falling and more loans are defaulting, keeping investors on edge.

"Most equity investors we talked to recently cared much more about the financial regulation than the real economy," Macquarie's head of Greater China economics, Larry Hu said in a note released late Sunday ET. "We remain cautious for now regarding the financial market, as regulations are weighing on risk appetite and pushing up interest rates."

In the last several months, the People's Bank of China has raised short-term interest rates, and authorities are reportedly including murky off-balance-sheet wealth management products in their assessments of banks' finances. Tighter regulation on Chinese stock markets has also dampened stocks — the Shanghai composite is roughly flat for the year.

Higher rates

The Chinese government 10-year bond yield closed last week at 3.56 percent, its highest since August 2016, according to Macquarie's Hu. High interest rates increase the burden of debt Chinese companies must repay, and expected Federal Reserve rate hikes also act to boost rates.

"The upward repricing of interbank market rates ... since the start of the year has led to worries that further aggressive tightening in short-end rates may trigger more selling pressure in the domestic bond market," Kinger Lau, chief China strategist at Goldman Sachs, said in a Friday note.

Lau added that the situation could lead to "unfavorable" effects on stocks akin to last December, when the Chinese 10-year yield jumped to its highest in more than a year after the Fed raised rates and surprised markets by saying it would deliver three hikes in 2017, rather than the two that were expected.

More bond defaults — but not too many

The number of Chinese bond defaults has also picked up in the last year — from 23 in 2015 to 79 in 2016, according to data from Shanghai-based Wind Information. So far this year, Wind data shows 16 bond defaults.

The very first Chinese bond default on record happened three years ago in 2014. Most analysts anticipate that Beijing will allow more companies, especially those in oversupplied industries such as steel, to default on their debt in a show of slightly freer markets. But experts generally don't expect bond defaults to become widespread across China.

China growth is on target: Mobius

"A little bit of market disruption will be needed to convey the seriousness of the tightening and to alter market behavior, but too much is unlikely to be allowed. As always in China, the pace of reform will be controlled. China does not like 'Big Bang' reforms," said James Stent, author of "China's Banking Transformation" and a former board member of China Minsheng Bank and China Everbright Bank.

"The timing has been delayed until the economy is performing well enough to permit this tightening without endangering economic growth. Now the timing is good, as the economy can withstand being reined in," Stent said.

The steps Beijing has taken recently may be signs of growing financial and economic maturity.

Higher interest rates typically indicate economic improvement, and increased regulation is designed to limit the growth of a new debt balloon. Restricting stock ownership also reduces the chance that investors will borrow so much to speculate on stocks that China sees another market collapse, as it experienced in 2015 when markets fell by 40 percent.

China is scheduled to report official inflation figures and new loans in the next few days.