China could be setting the stage for another boom-and-bust economic cycle as a result of the government's campaign to curb financial risks.
Regulators have been sending chilling messages on credit policies to the banking and financial sectors for the past month, threatening them at one point with "the harshest crackdown on financial risks in history."
Red lights flashed for financing after a speedup in credit-fueled economic growth in the first quarter.
Gross domestic product jumped 6.9 percent during the period, racing ahead of the government's goal of "about 6.5 percent" for 2017.
The overtopping of the target added urgency to policies at the People's Bank of China (PBOC) designed to guard against "asset bubbles."
At a key meeting of the Communist Party of China (CPC) Central Committee on April 25, President Xi Jinping sounded a warning that unrestrained financing schemes had gone too far.
"Accurate judgment of potential financial risks serves as a precondition for maintaining financial security," Xi said, pushing regulatory agencies to tighten their policies.
The PBOC, the China Banking Regulatory Commission (CBRC) and other agencies were already on alert after efforts to cap a surge in January lending largely failed due to a flood of "shadow bank" loans.
The authorities have been particularly worried about loans indirectly financed by popular "wealth management products" (WMPs). The high-yielding instruments are sold to investors by banks but then passed on to "entrusted" managers and investment funds to generate the needed returns, masking the risk.
Critics see such schemes as little more than a shell game that could lead to defaults and the collapse of a shadow financing industry valued by Moody's Investors Service at U.S. $8.5 trillion (58.5 trillion yuan).
Bank balances of WMPs stood at 30 trillion yuan (U.S. $4.36 trillion) at the end of April, the CBRC said.
Much of the unregulated funding has flowed into sectors that the government has tried to restrict, including property speculation and heavily-indebted state-owned enterprises (SOEs).
By late April, entrusted investments were already showing signs of a downturn due to regulatory warnings, Bloomberg News reported.
The crackdown spreads
The crackdown on financial risk has since spread to a host of other areas.
On May 3, the Ministry of Finance (MOF) ordered provincial governments to "examine their financing practices and rectify all irregularities by the end of July," the official Xinhua news agency reported.
This month, the CBRC told commercial banks to reclassify and revalue their collateral for loans at least once a year.
Regulators have ordered insurance companies "to stop the illegal use of insurance funds" and warned against borrowing for stock speculation, threatening "the maximum punishment."
Overseas investments by state-owned enterprises (SOEs) will also be subject to stricter auditing, the State Administration of Foreign Exchange (SAFE) said.
But the wave of new rules has raised concern that the government's penchant for administrative measures could be getting out of hand, running the risk of choking off economic growth.
The financing curbs came before the economy showed signs of cooling with reports that April growth of industrial output slipped to 6.5 percent from 7.6 percent in March.
The authorities have been cracking down on financing, the real estate sector, and outbound direct investment (ODI) at the same time, driving the Shanghai Stock Exchange Composite Index down by more than 7 percent from April highs by early May.
In a commentary on May 10, Xinhua acknowledged that "some grumble about ripples from the tightened regulation," but it slammed profit-seeking investors as speculators "dreaming of a wonderland in China."
"The ongoing tightening campaign addresses longer term challenges rather than alleviating immediate needs of China's economy. Investors should adapt to these circumstances and prepare for long-term interests," it said.
The latest PBOC report on April lending suggests that the pressure on shadow financing is having an effect.
Traditional bank loans rose nearly 8 percent from a month earlier to 1.1 trillion yuan (U.S. $159.4 billion), but all- inclusive aggregate financing fell by 34 percent to 1.39 trillion yuan (U.S. $201.5 billion) as shadow lending slumped, the South China Morning Post said.
An awkward time
The crackdown on financing comes at an awkward time as China seeks maximum publicity for its "Belt and Road" initiative to forge new trade routes with promises valued by Reuters at up to U.S. $124 billion (855 billion yuan).
On the sidelines of the Belt and Road Forum in Beijing on May 14, Premier Li Keqiang assured Christine Lagarde, managing director of the International Monetary Fund, that China is "capable of maintaining financial market stability and warding off regional and systemic financial risks," Xinhua said.
Scott Kennedy, deputy director of China studies at the Center for Strategic and International Studies in Washington, said the strong first-quarter GDP may give the government more room to address financial problems without suffering a major economic setback before the CPC's 19th Party Congress in the fall.
So far, the financial sector has remained "essentially untouched" by the government's anticorruption push, said Kennedy.
"It's the one part of the economy that hasn't been subject to the anticorruption campaign," he said. "Whatever the reason, it wouldn't have made sense to get to the 19th Party Congress without some sort of digging and reform."
Kennedy cited the influence of Guo Shuqing, who took over as chairman of the CBRC in February, as spurring the shakeup in the financial sector after playing a similar role at the China Securities Regulatory Commission (CSRC) in 2011-2013.
As with all of China's campaigns and administrative controls, the government may face the consequences of overdoing the crackdown, setting the stage for another boom-and-bust cycle.
"If you go too far, you run the risk of strangling the economy, which you obviously don't want to do," Kennedy said in a phone interview.
Last week, a CBRC official tempered earlier warnings, pledging that the agency would implement new rules "in an orderly way."
Banks will be given a "buffer period of four to six months for self-scrutiny and rectification," said Xiao Yuanqi, head of the CBRC's prudential regulation bureau.
On Monday, the PBOC-affiliated Financial News said in an editorial that there was "no need to panic" over financial deleveraging. Recent measures were not "a kind of 'shock therapy,'" the paper said, as quoted by Xinhua.
‘Cut the weeds, trim the grass’
The outlook suggests that the flurry of new regulations and warnings will gradually subside over coming months.
The approach of the critically important party congress with the expectation of senior leadership changes may mean an easing of the financial restrictions sooner than the "long-term."
"I think this is going to be taken in the same way that other types of reforms are," said Kennedy. "You cut back the weeds and trim the grass, but you're not going to fundamentally change the political economy of the system."
Official commentaries in China have also sounded a note of caution.
"Deleveraging is no overnight task. It will be a gradual process calling for a delicate balance between tightening regulation and avoiding financial turmoil," Xinhua said in another commentary on May 4.
A similar approach may be taking place with regard to warnings in March that government agencies were drafting rules to bar overseas investment in real estate and other sectors as part of controls to curb capital outflows and alleviate pressure on the yuan.
As China's foreign exchange reserves have risen slightly in April for the third month in a row and outflows have eased, so have concerns about new ODI restrictions.
But even if regulators succeed in striking a balance between risk reduction and growth in time for the party congress, uncertainties will remain for investment and liquidity.
The recent history of China's administrative measures suggests that excessive investment and over-regulation are companion forces in creating asset bubbles as investors seek high returns.
Regulators tried to deflate the housing bubble in 2014 but only succeeded in inflating the stock market.
Excess liquidity was then chased into the bond market and outbound investment, and back into the property sector again.
After the crackdown on WMPs and the financial sector runs its course, where will the money go next?
"That's a great question," said Kennedy. "There's certainly plenty of cash in the system that's got to find some place," he said.