I believe China’s ‘Great (Financial) Cleansing‘ has begun.

This new ‘GFC’ will affect China’s investment markets and those nations dependent on Chinese capital, such as Australia, Canada and South East Asia…but fortunately, only in the short term.

Following my 12 April newsletter about China’s financial risk to the world via their wealth management products (WMPs), there’s been more signs that the CPC (Communist Party of China) is cracking down hard on its financial markets. These markets are seen as presenting systemic risks to the nation.

Most China watchers say the CPC will not take any actions that would cause instability ahead of the National Congress in late 2017.

I disagree. I believe the CPC is seeking to engineer a short but sharp financial cleansing over the next 6 months. This is instead of doing too little now and risking chaos after China’s National Congress when President Xi is in ‘full control’ and will then have to take the blame.

The outcome sought by the CPC is to present a ‘cleaned slate’ by end of 2017 when Xi takes full charge of the nation for his next 5-year term. A cleaned slate includes political, big business and financial corruption and mismanagement being curtailed, and allowing a ‘renewed CPC under Xi’ to fulfil the ‘China Dream’.

The risk to the CPC is that the ‘great cleansing’ disrupts markets too dramatically, and will snowball into chaos as severe as the global financial crisis of 2008.

Here’s my reasoning and assumptions for China’s Great Cleansing.

Xi believes his team is set to take all the leadership roles at the National Congress. (see our article last week re; In the Name of the People as one hint that Xi is in a strong position)

Therefore, he is politically secure enough now to address China’s biggest risk which is its chaotic financial markets. (see our article re China’s risk to the world 12 April)

On 24 April, Xi chaired a meeting with the nation’s financial regulators and members of the 25-seat Politburo to set a tough tone on controlling the markets.

In recent days, regulators announced new rules and are drafting new policies to curtail over-leverage, reduce debt and crack-down on illegal financial activity. (see Bloomberg and Caixin)

Many newly appointed CEOs of listed companies in the West write down assets (causing a short-term fall in the share price) and start with a clean slate soon after taking charge (so that history and their bonuses will be based from a low point when they started at the company). Similarly, President Xi’s CPC is doing the same thing but on a bigger scale, just ahead of Xi taking full charge in late 2017.

CPC believes the ‘great cleansing’ will not descend into chaos due to a stronger economy, and more stable yuan in recent months, with its foreign reserves stabilising.

But just in case, the CPC is also placing more stringent controls of news reporting by China’s financial and internet media, in order to more effectively influence local investors and reduce the risk of ‘mania’s on the downside’.

China’s commodity futures markets are the ‘canary in the coalmine’ for hints that the markets may be in for an even wilder ride.

Most WMPs have a maturity between 1-4 months and managers of these WMPs need their Chinese retail investors to roll over by buying new WMPs. If this stops or slows, (which is happening now – see Bloomberg) it will result in assets being force-sold by fund managers to pay back expiring WMPs. The liquid assets that have boomed in recent months such as iron ore futures, will be, and have been, the first to be sold. Next to be sold will be shares, international assets and local property and local corporate bonds if there is still a functioning market for them.

As discussed in my April 12 newsletter, this liquidity mismatch (between short-term WMPs and long-term assets) and the slowing of new capital flows into WMPs, is now the main risk to China’s financial markets. To paraphrase Warren Buffet, when the tide goes out, we will see who is swimming naked. Keep your eyes peeled.