Improving Financial Stability In China

from the International Monetary Fund

— this post authored by Ratna Sahay and James P. Walsh

China’s leaders have made financial stability one of their top priorities. Given the size and importance of the Chinese market, with the world’s largest banks and second-largest stock market, that is welcome news for China and the world. The financial system permeates virtually all aspects of economic activity, having played a key role in facilitating rapid economic growth and in sharply reducing poverty rates.

China is moving from the world’s factory floor toward a more a more modern, consumer-driven economy. During this transition, however, some tensions have emerged in the financial sector.

Three concerns

The IMF recently concluded its latest evaluation for China under the IMF’s Financial Sector Assessment Program (FSAP). The assessment identifies three important and interconnected concerns about the Chinese financial system:

Lending boom. A focus on maintaining growth and employment has resulted in sustained rapid credit growth despite the slowing economy. This debt is largely owed by companies – some of which may not have good prospects – and local governments, but an increasing share is owed by households. Credit growth is an important indicator of future financial distress, because lending standards often fall in the rush to make more loans.

Complexity. Rules on bank lending to traditional sectors, such as construction and real estate, have pushed risky borrowers away from banks and toward more lightly regulated financial products. At the same time, banks are offering increasingly complex wealth management products to savers looking for higher-yielding assets.

Guarantees. Banks often compensate investors for losses on financial products to preserve their reputations; the government has repeatedly intervened to stabilize financial markets; and investors have come to believe that state-owned enterprises will be bailed out if they get into trouble. But protecting investors and companies from losses encourages them to underestimate risk and can lead to a misallocation of investment to less productive economic activities.