Fitch warns of challenges to Chinese reforms after sell-off

July 17, 2015 08:01
China's banks have limited exposure to the stock market, for now. Photo: Bloomberg

The Chinese government’s strong policy response to equity market turmoil has raised questions among investors about its market-oriented financial reforms, Fitch Ratings said in a study released Thursday.

“It could indicate that the government is shifting positions to prioritise growth over reform, and also underscores the underlying issue of moral hazard in China's capital markets,” it said.

By implementing policies to back-stop equity prices, the government is reinforcing an expectation that the state will protect against any downside.

For example, banks have been encouraged to provide interbank financing to support margin lending, highlighting the policy and social stability role that they are expected to play and “extremely high state support for the banking system”, the rating agency said.

Hedge funds are now reassessing their positions and questioning the role of the government in China’s stock market, the New York Times reported Monday.

It quoted Dawn Fitzpatrick, chief investment officer of UBS O’Connor, a US$5.6 billion hedge fund, as saying “this is a huge setback for Chinese capital market liberalization. The government’s moves …will materially impact their ability to attract foreign capital, which has been a key policy initiative”.

Although trillions of US dollars of value were wiped out as stocks plunged by more than a third, Fitch stressed the turmoil should not pose a systemic risk to the real economy or the financial system, given the small exposure of banks to the equity market and data showing stable growth in gross domestic product in the second half.

The Economist said in a commentary in its latest issue: “If economic stability is not in peril, the best explanation for the intervention is politics … regulators want to shore up the leadership’s reputation”.

Fitch said the policy responses may create significant operational risks for some financial institutions, especially brokers, which have exposure to the equity market.

On a systemic level, the recent volatility and suspension of initial public offerings may also threaten the role of the equity market as a source of new capital to mitigate the high level of leverage in the economy.

More risks related to the sell-off may not yet be visible, Fitch warned.

It said several key unknowns include gray-market leverage obtained by investors through wealth management products or from small trust/finance companies and even some banks.

Some of the risks that have built up from the growth in margin financing could also appear in other areas of the financial system, though it remains to be seen where contagion could most likely spread, the rating agency said.

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EJ Insight reporter