IMF sees complexity and opacity of China's financial system as threats to financial stability

The IMF this month released its comprehensive Financial System Stability Assessment (FSSA) for China, which is based on the Financial Sector Assessment Program (FSAP) of the IMF and World Bank. Since the last report published in 2011, China's financial sector has grown rapidly and increasingly embraced shadow banking sector instruments that increase systemic complexity and reduce transparency. The size of the banking sector is 310 % of GDP and the overall financial sector 470 % of GDP.

The FSSA notes that under-pricing of risk in China has led to excessive borrowing and that low bank deposit interest rates have encouraged flight to riskier investment vehicles. The rapid growth in popularity of such financial instruments as wealth management products and short-term wholesale funding is due in part to regulatory arbitrage, where regulation of novel financial instruments is not as comprehensive as in the case of bank lending. Non-bank financial sector operators such as trust, insurance, securities and wealth management firms have grown faster than the banking sector. Even so, such firms have inextricable hidden connections to the banking sector.

The report praised financial market reforms introduced since 2011, in particular the implementation of Basel III standards and a deposit insurance scheme, deregulation of interest rates and improvements in macroprudential supervision. The IMF welcomed China's improved financial sector regulation and monitoring for systemic risks. The current challenge is making sure policy signals on the importance of reducing financial market risk reach provincial and local levels, where obsessions with maintaining high growth still prevail. China today by and large complies with international financial regulatory and supervision standards, but its regulators face limited independence, inadequate resources and insufficient coordination among regulatory bodies.

China's large banks are better capitalised than other banks, with the greatest risk allocated to smaller banks that have grown rapidly in recent years. The banking sector's generally low ratios of non-performing loans (NPLs) to total loans evidently overstate the quality of loans as an increasing share of bank lending is made with novel financial instruments. Most of this lending goes to sectors with low profitability and branches with regulatory limits to bank credit (e.g. branches suffering from overcapacity, real estate and construction). Thus, even if China's banking system meets the minimal Basel III requirements, the FSSA recommends targeted increases in bank capital as risks may be larger than estimated.

The implicit guarantee is a special feature of Chinese financial markets. It increases moral hazard and excessive risk-taking. Because financial companies face a loss of reputation from sour deals, investor losses rarely materialise. Moreover, the state is assumed to guarantee the borrowing of state-owned enterprises and the debts of local governments. The state also intervenes to prevent losses in falling stock and bond markets. Credit is extended to unviable businesses. State ownership and control dominates the financial system, making it difficult to price risk when the state is both the owner and the regulator. Consequently, the IMF warns that financial market corrections can be huge in such conditions. China, however, still has substantial buffers and plenty of administrative tools to deal with a possible crisis.

The IMF said that lower growth in indebtedness and more effective credit monitoring will require reform of state enterprises and the winding down of unprofitable businesses. State guarantees either should be phased out or made explicit. Financial sector reforms should be sequenced to minimise the risks from dismantling moral hazards and implicit guarantees. The quality and comprehensiveness of statistical data should be improved to help the reform process.