By Rachel Rosenthal

China is embarking on a financial high-wire act.

At the top of regulators' agenda in China for 2017 is a campaign to wean the nation's sprawling financial system off of cheap borrowing and rising credit levels. Years of easy money have helped fuel growth, but also have sparked a worrisome surge in asset prices and other financial risks.

The latest target is the $9 trillion bond market, where the central bank has been gradually tamping down short-term credit to discourage the kind of borrowing many financial institutions use to make risky investments. This tightening also helps address China's other big headache: keeping its currency stable to stem the flood of cash heading overseas.

As much as $833 billion mayhave left China in 2016 through November, estimates French investment bank Natixis, compared with an outflow of $742 billion in all of 2015. The yuan is hovering around its weakest levels since 2008 and slid 6.5% against the U.S. dollar in 2016.

The trouble is that the easy money is funding a massive tangle of investments by banks, insurers, brokers and speculators in everything from real estate and troubled infrastructure projects to corporate bonds and soybean-meal futures. Any tightening can threaten the debt-saddled corporate sector and potentially sow turmoil in unexpected places.

This means that Chinese officials need to tread carefully in the coming months to tighten monetary conditions, curb risky investment practices and keep the yuan from depreciating too far while keeping China's economy healthy.

"It's a difficult balancing act," said Matthew Phan, a credit analyst at research firm CreditSights in London. "They wantto prevent asset bubbles like with the stock market, the bond market and the property market, but at the same time they can't tighten too much. They need to keep injecting liquidity, but prevent this liquidity from going places they don't want."

The challenge was highlighted in mid-December, when regulators cracked down on leveraged stock investments by some insurers, sending Chinese shares down 2.5%, their biggest daily drop in half a year.

Later that week, tightening short-term rates combined with other factors to trigger a big selloff in the bond market and scattered defaults by brokers and asset managers. The yield on China's benchmark 10-year government bond has since shot as high as 3.4% intraday -- a 15-month high. Chinese authorities briskly stepped in, pumping in hundreds of billions of yuan to arrest the rout. That yield stood at 3.066% on Friday.

Analysts say that China has the firepower to keep up this pace of liquidity injections, while it still has a foreign-exchange war chest of $3.05 trillion that it can tap to defend the yuan.

The central bank's challenge shows up in its balance sheet, where a rise this year in assets associated with liquidity injections -- which tend to lower the yuan's value -- has roughly offset the shrinkage in foreign reserves, Mr. Phan says.

The most recent buildup of financial-system leverage began in 2015, when the central bank started holding short-term borrowing rates at a very low stable rate to support growth, which had started to slow. Many investors tapped the cheap funds to buy bonds and other financial products, then used those securities as collateral to invest even more, a loosely regulated cycle repeated many times over, which clouded the magnitude of risk in play.

By the summer of 2016, roughly 90% of interbank borrowing was in the overnight market, the shortest and cheapest form of funding, whilethe daily volume of transactions there surged to a peak of nearly 4 trillion yuan ($575.9 billion), according to data from BNP Paribas. That fell to 2.75 trillion yuan in late December as officials pushed borrowers to longer-term maturities as a means of deleveraging, sending short-term borrowing costs up sharply.

China's money supply has more than quadrupled since 2007, sending more cash chasing after a shrinking pool of appealing investment options after global central banks' accommodative monetary policies pushed yields around the world to record lows earlier this year.

The yield on China's benchmark 10-year government bond, for example, fell to 2.66% in October, a 14-year low, from as high as 4.709% in January 2014. The spread between China's triple-A rated corporate debt and government bonds with the same maturity shrank to its narrowest on record in October, in data going back to 2007 from Wind Information. Spreads have sincebegun to widen.

The recent spasms in the bond market are also trickling through to the real economy: Some 89 bond issuances were delayed or canceled since the start of December, according to Wind Information. That compares with 32 for all of November.

"The credit market is freezing," Kun Shan, head of China local markets strategy at BNP Paribas in Shanghai, said in December. "If this is not functional, it will jeopardize growth of the economy and maybe next year we will not be able to achieve the growth target."

Write to Rachel Rosenthal at Rachel.Rosenthal@wsj.com

(END) Dow Jones Newswires

January 01, 2017 07:14 ET (12:14 GMT)

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