It has been almost 3 months since stricter regulations against financial leverage were enforced. Regulatory tightening was followed by meaningful adjustments in financial asset prices, as well as market expectations for growth and inflation. While the period of the most” abrupt” market reactions could be behind us, liquidity conditions remain tight. Meanwhile, risk appetite continues to be depressed, given the uncertainties surrounding the timeline, policy objectives, and impacts of the ongoing regulatory tightening. In this note, we share our thoughts on how to monitor the “stress level” of financial institution, the progress of deleveraging, as well as its potential spill-over effect to the real demand.

In our view, regulatory adjustments targeting the “financial leverage” will likely be a dynamic process, rather than one that follows a strict pre-set path. With potential changes to the “grace period” and incremental tightness of the policy, the degree of “discomfort” during the process will also change meaningfully.

Judging from the price actions of financial assets, the most abrupt market adjustments may be behind us, but the “stress level” remains high.

A potential “easing” of the market “stress level” may manifest itself through signals from both the “price” and “quantity” indicators.  We identify the interbank O/N and 7 day rates (R007 & DR007), interbank CD issuance rate, and credit spread between treasury and the less liquid bonds as some of the most representative “price” indicators. Meanwhile, we also monitor changes of the related items on the aggregated bank balance sheet, as well as the net issuance amount of liquidity-sensitive market instruments as the most telling “quantity” indicators.

Similarly, we follow a few key indicators on both the “cost/price” and “quantity” of financing for the real economy to forecast the potential dampening effect from financial deleveraging on real demand. On the “price” side, timelier indicators include rediscounted bill rates, Wenzhou private lending rate, trust product issuance rate, and market-based mortgage rates. Meanwhile, we continue to favor adjusted TSF growth as a gauge for broader domestic financing activities.

All considered, the more coordinated policy approach towards deleveraging still appears pragmatic and well-balanced at this point. Beyond the immediate short term, it is unlikely for the elevated short-term rates and flat yield curves to linger on for months on end; neither is the downward adjustment for expectations of growth and inflation.