Date
23 August 2017
As off-balance-sheet risks are brought back gradually, Chinese banks' risk provision and funding costs are expected to rise. Photo: Reuters
As off-balance-sheet risks are brought back gradually, Chinese banks' risk provision and funding costs are expected to rise. Photo: Reuters

Re-pricing risks under new China bank regulations

Hong Kong market risk premium is approaching historic lows, hinting at euphoric sentiment. 

Historically, when the risk premium was at the current level or lower, the market subsequently sank into crises, such as the ’94 LatAM crisis, ’97 Asian crisis, the 2000 TMT bubble and finally the 2007 global financial turmoil.

The current market euphoria is a concern for contrarians. But we have seen other ominous charts recently, such as the chart of an extremely low VIX, and the chart of equal-weighted market indices failing to rise further with the other cap-weighted indices. We must investigate further before drawing conclusion.

While Hong Kong’s risk premium is plunging to its historic lows, China’s risk premium remains calm around its long-term average. It is odd.

Shanghai market risk premium is around its long-term average, even though tightening banking regulation could trigger risk events. Recently, China’s banking regulation tightening is up several notches. In essence, the myriads of new banking rules are trying to make banks account for their credit risks properly. In the past few years, banks have been moving risks off balance sheet to avoid regulatory supervision and risk provision. Consequently, banks, especially the medium and smaller ones, have been able to expand their balance sheets rapidly.

As off-balance-sheet risks are now brought back gradually, banks’ risk provision and funding cost must rise. Previously, these off-balance-sheet risks were hidden and unaccounted for. Risk premium has been suppressed, and consequently the capital cost in the Chinese economy. Chinese asset valuation must have been more expensive than it should be.

With the new regulations bringing risks previously hidden back onto lenders’ balance sheets, banks’ funding costs must rise, and the entire economy will feel it. As such, risk premium must be re-priced higher. But neither the on or off-shore China market seems to be considering the latent risks. In the past, falsely depressed risk premium distorted the cost of capital in China, keeping Chinese asset valuation higher than it should be, and inducing asset bubbles one after another.

The process of revaluing risks in the mainland market will be gradual. “Resolving risks in the existing scheme should not trigger new systematic risk,” as emphasized by the regulators. Together with some intervention from the national team, this is the reason why Shanghai’s market risk premium is lingering around its long-term average, despite a hostile backdrop.

As such, the mainland money, which used to be accustomed to a much lower risk premium, buys into Hong Kong through the Stock Connect program. Such buying with lower risk premium must have depressed the risk premium in Hong Kong, rendering a facade of extreme optimism for now. This is one way to explain Hong Kong’s unusually low risk premium.

Our trend timing model is still suggesting allocation value for Hong Kong stocks, and has been so ever since February 2016. This model conclusion, together with our elevated but not extreme market sentiment model, paints a more benign market outlook for Hong Kong than the extreme risk premium suggests. With southbound flows increasing through the Stock Connect program, the mainland money with higher risk tolerance has moved south, and then depressed the risk premium in Hong Kong. Much to our chagrin, we cannot comprehensively validate this hypothesis with data.

With rising funding costs, both bond and stock markets are starting to pay for quality. Credit spread is widening, and large caps are outperforming smaller caps. A-shares will remain weak. After consolidation at its current overbought levels, Hong Kong will probably make a final dash towards new high – till the systematic risk suggested by the historic low risk premium unravels.

– Contact us at [email protected]

BN/RC

Hong Hao is the Managing Director and Head of Research of BOCOM International

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