(James Saft is a Reuters columnist. The opinions expressed are his own.))
NEW YORK, July 18 (Reuters) - Chinas all-powerful rulers are taking arguably needed steps to guard against financial risks which is exactly why investors should give the country a wide berth.
China shares on Tuesday extended a two-day selloff, with many shares falling by the 10 percent limit, after news from a Communist Party meeting of a renewed focus on regulation and deleveraging.
The National Financial Work Conference, chaired by President Xi Jinping himself, on Saturday created a special committee to preside over regulation and the reduction of financial system debt over the next five years.
This was followed shortly by the China Banking Regulatory Commission announcing it will take firmer control over issues like credit provision, liquidity and off-books shadow banking.
To us, these announcements signal that lowering financial leverage and stabilizing corporate debt levels is a medium-term project that Chinese policymakers are keen to see through, but there is no rush to get it done this year, Wei Yao, China economist at Societe Generale wrote in a note to clients.
Therefore, the authorities will probably keep the pressure on shadow lending, but will be careful in terms of limiting the damage to the real economy at the same time.
Careful the authorities may be, but damage they will do, and it will be felt keenly by equity investors, many of whom have been hoping to see higher prices driven by inflows of global capital after MSCI decided in late June to include China mainland shares in its benchmark indices.
China's banks extended a record 12.65 trillion yuan in loans in 2016, responding to a government push for economic growth but credit and money expansion have since slowed rapidly, with broad money growth slowing in June to a record low of 9.4 percent.
Total social financing plus bonds, the broadest measure of credit, grew at 14.7 percent in June compared to 15.3 percent in May.
A slowing of credit growth is wise. There is good evidence that the quality of investment in projects and assets financed by credit has declined markedly in recent years and ultimately the model which helped China grow has been too reliant on fixed investment.
Certainly an increased focus on stability and soundness beats the counterfactual alternative. Had Chinese authorities announced they were prioritizing economic growth and financial innovation, stocks might have soared but only because investors were betting the new money would find its way, as it so often does, into the hands of bigger fools than existing owners.
Still, the order of business, in which the Party sent a signal and speculative shares tumbled, provides two excellent reasons why global investors should fight shy of China's shares, MSCI inclusion or not.
The first is that a transition from credit-fueled growth of export-oriented production capacity to a more consumer-based economy will inevitably be bumpy.
China has the worlds largest credit-to-GDP gap at 30 percent. Using this Bank for International Settlements measure, credit growth is too rapid credit and the efficiency of those projects and assets that the credit is funding is too low.
This implies distressed assets of more than $3 trillion, which, if credit is indeed rationed better, will have to be written off or marked down to more realistic prices.
Credit reckonings of that scale rarely, if ever, happen without very large collateral damage to investors, especially ones who are treated as capriciously as outsider capital often is in China. Even if China pulls of an immaculate deleveraging there will be pain for investors.
That brings us to the second issue.
If your technology stock index is selling off by 5 or 10 percent because of something outwardly anodyne the government has said then you either have (a) too much speculation, (b) a too powerful government, or in Chinas case both.
And this is not just small tech stocks.
Shares in property company Sunac China Holdings fell as much as 13.5 percent on Tuesday after reports Chinese regulators told banks to stop providing funds for several overseas deals of Dalian Wanda including one in which Sunac plans to buy $9.3 billon of tourism and hotel assets.
This is being interpreted as part of an attempt to crack down on capital flight which may have been disguised by overseas takeovers, but that is not the point.
Dalian Wanda is controlled by China's second richest man. What is allowed today may not be tomorrow and no one is immune to changes in the prevailing winds.
The point is that an investor in China takes on the huge political risk that their particular holdings will fall foul of the state. This is a risk almost impossible for insiders to mitigate, and arguably not what outsiders like global fund managers are good at or should be paid to run.
The combination of deleveraging and political risk is too great. China is huge and ultimately most investors will be forced to hold substantial exposure to its $8 trillion equity market.
One party power and risk isnt going anywhere, but it may at least be wise to wait until the deleveraging has made more progress.
( At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaftzjamessaft.com and find more columns at http://blogs.reuters.com/james-saft ) (James Saft)