The International Monetary Fund has concluded that China’s financial system is “robust overall,” but warns that it faces a “steady build-up in vulnerabilities.”
The judgement was made in the IMF’s first Financial Sector Assessment Programme review of the country, one of 25 systematically important countries that have agreed to mandatory assessment at least once every five years.
“While the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and the formation of bubbles, especially in real estate,” says Jonathan Fiechter, deputy director of the IMF’s Monetary and Capital Markets Department and the head of the IMF team that conducted the assessment.
“The cost of such distortions will only rise over time, so the sooner these distortions are addressed the better.”
The report enumerates several near-term risks in China:
- Deterioration in loan quality due to rapid credit expansion
- Growing disintermediation by shadow banks and off-balance sheet exposures
- Downturn in real estate prices
- Uncertainties of the global economic scenario
“Medium-term vulnerabilities are also building and could impair the needed reorientation of the financial system to support the country’s future growth,” the IMF added in a press release. “Moving along this path will pose additional risks, so priority must be given to establishing the institutional and operational preconditions that are crucial for a wide-ranging financial reform agenda."
The IMF urges action on a number of main areas of reform, among them:
- Steps to broaden financial markets and services, and developing diversified modalities of financial intermediation that would foster healthy competition among banks
- A reorientation of the role of government away from using the banking system to carry out broad government policy goals and to allow lending decisions to be based on commercial goals
- Expansion of the use of market-based monetary policy instruments, using interest rates as the main instrument to govern credit expansion, rather than administrative measures
- An upgrading of the financial infrastructure and legal frameworks, including strengthening the payments and settlement systems, as well as consumer protection and expansion of financial literacy
The IMF says China has begun to implement many of its recommendations.
The Fund also conducted stress tests jointly with Chinese authorities on the country’s largest 17 commercial banks. “Most of them appear to be resilient to isolated shocks,” the IMF reports, such as a sharp deterioration in asset quality (including a correction in the real estate markets), shifts in the yield curve, and changes in the exchange rate.
“If several of these risks were to occur at the same time, however, the banking system could be severely impacted,” the IMF warns.