14 July 2014
Chinese Bank of China

China's financial market challenges

China's financial markets are emitting mixed messages. Its banks are the biggest in the world. Its financial system is increasingly fragile. What is really going on?

China's financial markets are emitting mixed messages. Its large state-owned banks are the biggest in the world. Its financial system is increasingly fragile. As China's economy needs rebalancing, so does its financial system.

What is really going on?

Chinese large state-owned banks would appear to be among the strongest in the world, according to some measures. ICBC (Industrial and Commercial Bank of China) has recently topped The Banker’s Top 1000 World Banks ranking, the first time ever for a Chinese bank.

ICBC moved from third to first place on the back of a 15% increase in capital. Last year’s winner Bank of America fell back to third while JP Morgan stayed second. The rankings are based on Tier 1 capital.

China’s second largest bank China Construction Bank (CCB) also grew its capital by 15% to $137.6bn and dislodged Citigroup from fifth place. China now holds four places in the Top 10, and has 96 banks in the Top 1000 ranking.

These heady statistics were however tempered by comments from Brian Caplen, editor of The Banker: "On most measures (Chinese banks) now score as well or better than Western banks but their big test will be how they cope as China’s growth slows over the next few years.”

A wise caution, indeed. Some of that Tier 1 capital may not be so safe. Indeed, credit ratings agencies like Fitch, as well as other commentators, including from the Chinese government, have been expressing alarm at the stability of China's financial system.

Since the Lehman shock of 2008, China's state-owned banks, which dominate the financial sector, have undertaken massive lending to state-owned enterprises and above all to local governments to help prop up the economy by infrastructure projects, many of which are white elephants. The rise in China's debt is even greater when "shadow banking" is taken into account. Even China's own national audit office has said that some banks have violated lending regulations.

Fitch has estimated that total credit (including shadow-bank lending) may have reached 198% of GDP at end-2012, up from 125% four years earlier. "The proliferation of other forms of credit beyond bank lending is a source of growing risk from a financial-stability perspective," it said. Fitch lowered its ratings on China's yuan-denominated government debt to single-A-plus from double-A-minus.

In recent weeks, we have also seen a credit crunch in China's interbank lending market, engineered by China's central bank, a sign that it wants to reign in excessive credit growth.

What seems clear is that China's banks are sitting on a whole lot of contingent liabilities and bad debts. This is the inevitable consequence of too much credit being directed and allocated for political, rather than commercial reasons.

This is nothing new to China. The government bailed out the banking system in the late 1990s, and has the wherewithal to do it again. But it represents a terrible waste of resources for a country where many people still live in poverty, and a large share of its much-vaunted emerging middle class is still very much in the vulnerable lower middle class category.

Over the past couple of years, the Chinese government has also made moves to progressively internationalize the Chinese currency, the yuan or renminbi. This is a sensible move for the world's second biggest economy. But this is only being done at this stage for international trade transactions ("current account"). The government is not yet ready to liberalize China's capital account in part because the financial system is still underdeveloped.

At the same time, the Chinese economy hemorrhaged $3.8 trillion in illicit financial outflows from 2000 through 2011, despite capital controls, according to Global Financial Integrity. There was in fact a sharp rise in annual illicit financial outflows over the period, increasing from $172.6 billion in 2000 to $602.9 billion in 2011 -- with reports of even greater outflows in 2012 in the lead-up to China's political leadership change.

The vast majority of these illicit financial flows were due to a trade-based money laundering technique known as ‘trade misinvoicing’. Illicit financial outflows from China are by far the highest of any country worldwide.

All things considered, the Chinese financial system has come a long way since 1978, and served its rapid development trajectory relatively well. It has helped finance the rise of large state-owned companies, some of which now compete on international markets and invest overseas. It has facilitated the building of the nation's impressive infrastructure. And it has managed to stabilize the economy in the face of the recent global financial crisis. However, much of China's rise as an export dynamo has been financed by foreign direct investment from multinational enterprises (rather than Chinese companies) which are still responsible for the majority of China's exports.

But the current functioning of China's financial system is also very costly, and is not well adapted to the country's development requirements moving forward, for several reasons.

While continued state ownership, guarantees and intervention in bank activities enables the government to pursue its macroeconomic, sectoral and other goals, finance is not allocated efficiently. On the contrary, too much is wasted in infrastructure of little value, and industries with massive excess capacity. The financial system is very much bank dominated, with the five biggest banks accounting for half of all loans. Capital, equity, insurance and asset management markets are all underdeveloped. And official restrictions on the formal financial sector have spurned a big informal or shadow banking sector outside the formal regulatory structure. Overall, China's financial market development lags behind its "real economy".

The inefficiencies of China's financial system mean that it is very costly to maintain and potentially unstable. And while huge foreign exchange reserves provide a useful buffer against currency crises, as Japan has shown, they do not provide protection against the risk of a domestic financial crisis.

The Chinese government has recognized that it must rebalance its economic development away from its export- and investment-driven model towards a more consumption-driven one. And for China, rebalancing development also means rebalancing its financing model from the situation where the main beneficiaries of bank finance are state-owned enterprises and local governments.

In particular, if consumption is to play a greater role in the Chinese economy, this implies a greater role for the services sector and especially for micro, small and medium enterprises in the private sector. They need greater access to financial services than they enjoy today. And since innovation will have to become a more important driver of Chinese productivity growth, venture capital and private equity activities will also be needed.

Consumption-driven development must also be supported by greater access to finance by consumers through banks, credit unions and microfinance institutions. Seriously tackling the grotesque financial and other corruption, a major cause of inequality, is another very important thing that should be done to boost consumer spending.

The goal must be to develop a competitive, balanced, efficient, safe and sound financial system. The reform agenda is simple, as many commentators have suggested, in particular: full commercialization and ideally privatization of the financial sector; further liberalization of interest rates; deepening capital markets; upgrading financial infrastructure and the legal framework; strengthening the regulation and supervision framework; and building a financial safety net and developing crisis management and insolvency schemes.

The overall guiding principle should be that the fundamental role of finance is to serve the economy, not special interests, as is too often the case now. The financial sector should mobilize savings, allocate them to the best investment projects, manage the payments system, offer risk management services, and handle international finance.

The Chinese government understands these issues, and President Xi Jinping is eager to tackle China's "rebalancing imperative". But they face many obstacles in the form of the state-owned enterprises which are accustomed to their privileged access to finance, the banks which are used to operating without a hard budget constraint, as well as whole range of bureaucratic and political interest groups which benefit from the current system. Also, depoliticizing and commercializing the financial sector might initially provoke instability in the state-owned banking and enterprise sectors.

As difficult as it all may seem, the stakes are very high. Continued inefficient use of China's financial resources would weaken its future growth prospects and expose it to even great risks of financial instability.

History is littered with examples of political change provoked by financial crises. Ultimately, the Chinese Communist Party's "mandate from heaven" is at risk.


John West
Executive Director
Asian Century Institute
Tags: china, Chinese banks, China's financial system, shadow banking in China

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