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With Chinese President Xi calling for a heightened effort to reduce systemic financial risk, regulators have started to tackle the bloated shadow banking system. Since taking office in February, Guo Shuqing, China's top banking regulator—with the nickname “Whirlwind Guo” for his no-nonsense management style—has already issued a series of directives to reduce leverage. For example, banks were asked to implement higher standards for interbank lending and for selling third- party wealth management products (a primary source of funding for the shadow banking system). In April, China's top insurance regulator was detained for corruption, and the regulatory agency has since taken disciplinary actions against some high-profile insurance companies that have deviated from the core insurance business by using shorter-term funding to finance corporate takeovers, as well as overseas acquisition sprees. Tomorrow Never Knows While we believe China’s economy should hold up well going into the 19th Party’s Congress this autumn, its growth is likely to decelerate, and the lagged effects of the tightening measures on the shadow banking system and on the housing market could become quite visible by 2018. Housing price changes could be flat or even negative by this time next year. If the past is any guide, Chinese policymakers may once again loosen property purchase restrictions next year to stimulate growth. Therein lies the moral hazard—it is well known that Chinese policymakers would not risk a sizeable correction in the housing market, and therefore would reflate again to strengthen economic growth. However, with property prices in China’s tier-one cities already on par with or even exceeding those of major global cities, it will be hard to rationalize another CHART 4: YEAR-OVER-YEAR CHANGE IN CHINESE IMPORTS (BILLIONS OF USD) 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% 2011 2012 2013 These measures have driven up China interbank lending rates, as well as corporate bond yields. The squeeze on the shadow banking system has led to a big jump in aborted bond issuance. In May, China’s net corporate bond issuance dropped to a record low of negative 217 billion yuan as some bond issuers were unable to roll over their maturing bonds. On the housing front, various cities have rolled out new administrative measures with the aim of keeping housing prices flat. A few cities even resorted to the draconian measure of a 10-year lock-up period for new apartment purchases—buyers of new apartments built on recently auctioned off land are prohibited from selling their units for a decade. China has also continued to stem the capital outflow. Starting this July, Chinese banks and financial institutions have to report all domestic and overseas cash transfers of more than 50,000 yuan ($7,700), compared to the prior threshold of 200,000 yuan ($29,338). Funds transferred overseas are prohibited from purchasing properties, investments, and insurance products. Various new restrictions have also been placed on Bitcoin trading exchanges, as well as overseas use of credit cards. In short, it appears that capital flight from China will get somewhat more difficult for ordinary citizens. 2014 2015 2016 2017 Source: Bloomberg round of substantial price increases. In other words, using the property market as a lever to stimulate economic growth is not a sustainable long-term solution. Although equity volatility picked up some in June, most equity investors still appeared to be basking in the glow of a synchronized global recovery. However, the canary in the coal mine may be iron ore: having rallied from the December 2015 low of $37.50 per metric ton to nearly $95 in February 2017, it has lost roughly 30% to $65 a metric ton by the end of June. In the final analysis, the global economy has benefited from China’s rapid growth. However, China will likely be at a crossroads as President Xi embarks on his second term in 2018. Will policymakers inflate the housing bubble further to support economic growth? Will they find new levers to keep the economy growing above 6% per annum, or will they settle for a lower but more sustainable pace? The law of large numbers portends that the next five years will likely be more challenging for Chinese policymakers than the last five years. @ GLOBAL FORESIGHT THIRPD QUARTER 2017 HOUSE_OVERSIGHT_012087