Where does China’s financial risk lie?

23 Nov 2016

You can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time – Abraham Lincoln

Summary

  • The focus on China’s rising debt level and worsening asset quality is exaggerating the fear about a banking crisis. China’s financial risk is still localised in nature because the current system distorts rational domestic creditor’s behaviour and, ironically, reduces systemic risk.
  • We cannot ignore the risk of local financial accidents which could turn viral if not tackled properly when the system changes over time. The local risk stems from the rapid expansion of small and regional banks that rely on wholesale funding and abuse financial innovation for regulatory arbitrage.
  • However, comparison of China’s situation with the US pre-subprime-crisis conditions is inappropriate because of the differences in funding structures and creditor behaviour. In China, no one can easily pull the plug on the banking system and send it into a tailspin yet.

That China’s banking system has a non-performing loan (NPL) problem is nothing new. The predictions of a Chinese banking crisis have been proven wrong for more than three decades because pessimists treat China as an open-market driven system with a liberalised capital market and an open capital account, which is clearly not the case. This is not to deny China’s financial risk. But the concerns should lie somewhere else in the system rather than in a systemic blow-up.

A systemic financial “bomb” that won’t detonate

Despite its high debt level, China’s financial risk is still localised in nature rather than systemic3, though this will change as China continues to liberalise its financial sector and capital account. However, as long as the current system set-up remains, or changes very slowly, an increase in bad assets per se is probably not enough to trigger a financial crisis. This is because the government still owns the major banks which are funded by stable retail deposits. Its implicit guarantee policy is the linchpin that holds the system together by, ironically, distorting creditors’ behaviour.

If China were an open and mature market and given its NPL problem, the creditors would lose faith in the debtors and cut funding, leading to a systemic collapse in the form of a debt-currency crisis. However, the majority of the creditors in China are the households, who are ultimately backed by the government’s implicit guarantee policy.

So long as there is no loss of public confidence, the creditors in China will not cut off funding to the banking system which, in turn, will not cut off funding to the corporate sector. This “irrational” behaviour suggests that no one could pull plug on China’s financial system easily, so there would not be a financial crisis or capital flight or a collapse in the renminbi exchange rate. Meanwhile, China’s closed capital account helps lock up domestic liquidity and keep the banking system whole.

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