China is making yet another attempt to rein in its overleveraged financial system, threatening to hamper the economy at a time when credit growth is already decelerating.

Investors outside the country don’t seem to care, but they should. China probably isn’t going to create another global financial scare as it did in 2015 and at the start of 2016, but the effects will still ripple around the world.

China this year has tightened monetary policy and launched a regulatory assault on off-balance sheet and interbank lending, squeezing financing for speculative vehicles. In the past China’s crackdowns on shadow banking have proved temporary, but the new head of the China Banking Regulatory Commission, Guo Shuqing, has more credibility than his predecessors.

The CBRC has this year issued a flurry of orders including detailed work aimed at “regulatory arbitrage,” or rule-dodging.“Basically every commercial bank in China is involved in at least some of the long list of activities now targeted by regulators,” said Chen Long at Gavekal Dragonomics in a note to clients.

Yields on Chinese bonds have risen and share prices in Shanghai and Shenzhen fallen as Chinese investors came to realize that Mr. Guo was serious in his attack on shadow banking.

Investors elsewhere shrugged. Sure, China’s debt load has increased scarily fast, and much of the recent increase has involved tricks to get round previous lending rules.

But China watchers are reassured that the authorities won’t do anything to risk upsetting the economy before Xi Jinping’s expected second term as president is signed off by the Communist Party Congress in the fall. Economic stability is assured, the argument goes, because anything else would be unthinkable.

The perennial concern about China is that its credit boom must eventually follow every other in history and turn to bust. But China has demonstrated time and again that it can delay the moment of reckoning, and it might even delay it long enough to grow out of its credit excesses, so long as it can head off further worsening.

Slower growth with less new debt would be a good thing, so long as the old debt can be contained. The reason to be concerned about China now is that a slowdown in credit hurts growth and could spread to the rest of the world, piling pressure on commodity producers.

“Chinese reflation lifted global trade [last year],” said Gene Frieda, global strategist at Pimco. “Now the credit impulse from China is tightening the most since 2010, and the pressure on shadow banking only adds to that.”

The twin China panics of August 2015 and January 2016 came when international investors feared that the country would export deflation to the rest of the world, devaluing its currency to avoid a domestic slowdown.

Such an outcome seems less likely this time. Politically a devaluation is harder when President Donald Trump has only just backed away from his accusation that China is manipulating its currency. Stricter capital controls introduced in the past year make it easier for Beijing to prop up the yuan.

Instead of a global catastrophe, a well-handled reduction in credit growth implies only slower domestic growth, and so less demand for raw materials—particularly iron ore and copper.

The prices of both have dropped back from their highs earlier this year, with iron ore down more than 20% in six weeks, but this likely has more to do with the need to cut back overcapacity in steel production than a broader slowdown in demand.

It is the pace of change of credit growth that matters, with a deceleration tending to hit the economy as much as a year later. With the deceleration only recently visible in the credit numbers, it may be some time before it becomes clear whether China will be held back.

But if it is real, and assuming China avoids devaluing, the first impact should be on China’s main suppliers of raw materials, notably Brazil and Australia. The broader impact will hit emerging markets in general, which are more dependent on commodity production than the developed world and are bigger suppliers to China.

The reaction has been bigger inside China. Stocks in Shanghai and Shenzhen both fell last month as the regulatory crackdown on shadow banking intensified, and 10-year bond yields rose above 3.5% for the first time since the 2015 devaluation.

China might once again remove the pressure on shadow banking once it begins to affect growth. Equally, growth might this time be less susceptible to the credit deceleration than in the past. But the likelihood is that China’s credit-fueled economy will slow, and that isn’t good news for its suppliers.

By James Mackintosh

Wall Street Journal


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