The Real Risks to China's Financial System

Yukon Huang Op-Ed November 17, 2011 Financial Times

Summary

Beijing has been using the financial system to fund public expenditure needs, many of which are not commercial in nature and would normally be undertaken through the budget.

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The recent assessment of China’s financial stability by the International Monetary Fund highlights increasing vulnerabilities stemming from the government’s role in the lending process, and an inflexible interest rate policy. Those who regard weaknesses in the banking sector as a likely trigger for a financial collapse have railed against China’s negative real interest rates and the speculative activity this has spawned. They see the heavy reliance on credit expansion to stimulate the economy during the global financial crises as eventually leading to a surge in non-performing loans. All this is viewed as part of a strategy of financial repression that postpones the day when China’s big four state banks can operate as real commercial banks.

But focusing on emerging financial risks is a case of treating the symptoms of the problem, rather than understanding and dealing with its origins. When Deng Xiaoping launched his efforts decades ago to boost economic growth, he needed to secure the resources to ramp up investments along the coast. But the Communist party leader faced the reality that government revenues had fallen to only 11 per cent of gross domestic product by the mid-1990s and the only alternative was to tap household savings in the banking system. Although revenues have been increasing steadily, China’s national budget still amounts to only 25 per cent of GDP, compared with an average of 35 per cent for other middle income countries and over 40 per cent for OECD economies.

With its responsibilities for providing a broad range of services for a mixed socialist economy, it is surprising how small China’s budgetary footprint actually is. Thus, Beijing has been using the financial system to fund public expenditure needs – many of which are not commercial in nature and would normally be undertaken through the budget. While this was unavoidable in the earlier years, it has turned out to be a politically attractive and effective option in dealing with the volatility of the global economy over the past decade. As such, these hidden banking losses are actually quasi-fiscal deficits, rather than traditional non-performing loans. While on paper China does not run major budgetary deficits, these quasi-fiscal deficits in the banking system have been accumulating over the years, awaiting the time (as in the past) when the non-performing loans are formally recognised and written off – with China’s substantial reserves and relatively low public debt ratios providing the cushion.

One cannot dispute that China needs to act on financial reforms, but the real challenge is for Beijing to recognise the importance of strengthening its fiscal system to undertake expenditure requirements in a more transparent and potentially less destabilising fashion. Unless the leadership takes this decision, admonitions for more flexible monetary policies and improved governance of key financial institutions will continue to fall on deaf ears.

Unfortunately the budgetary problems that have paralysed both the eurozone and US do not help the case. Beijing is watching with amazement as political leaders across both continents struggle to forge the consensus needed to strengthen their countrys’ fiscal positions. This only reinforces China’s view that budgetary processes are too politically cumbersome to deal with the unpredictable nature of the global economy. It makes it all the more likely that Beijing will continue to use the banking system for purposes that textbooks never saw as appropriate.

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Source: http://carnegieendowment.org/2011/11/17/real-risks-to-china-s-financial-system/7g6k

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