A China Banking Crisis: Possible But Not Likely

The prediction that China faces a 60% risk of a banking crisis by mid-2013, made by Fitch Ratings senior director Richard Fox in an interview with Bloomberg, falls into that category of eye-popping but not inconceivable.  Fox’s number comes from a risk model designed by the credit-ratings agency to predict banks’ vulnerability to systemic stress in the face of sustained rapid credit growth, rising property prices and an appreciating real exchange rate.

China has ticked at least two of those boxes for a long while, and indeed, Fitch’s model put China into the most at-risk category last June, though seemingly not many noticed at the time.  The model is not infallible. It raised a red flag about Ireland and Iceland ahead of their crises but not Spain’s. Countries can also retreat from the at-most-risk zone. Brazil, France, Denmark and New Zealand are recent examples. We think China is likely to join them.

Likely though not certain. A bursting property bubble and the local government debt bomb going off (and the two are so closely linked that the one would likely trigger the other) are the banking system’s greatest vulnerabilities. Policymakers are tackling both, though neither are susceptible to a quick fix. As the raft of piecemeal measures over the past 18 months to cool property markets, soak up excess liquidity in the economy, get local government finances and governance on a tighter rein and shore up banks’ capital reserves attest, it is painstaking work.

Given the scale of China’s lending binge over the past couple of years, it is inevitable that the banks will end up with some odorous piles of bad debt on their books. The question, of course, is whether they are mountains or molehills. The rapid pumping up of capital reserve ratios and the bank-by-bank way they are being required suggests the regulators have some fix on their magnitude and which are most threatening. It is the unexpected, though, that blindsides even the best layers of plans.

Prudent macroeconomic policy is the best way of avoiding a banking meltdown anywhere. As we have noted, the shift in policy Beijing is now trying to pull off to minimize what it sees as politically threatening social disparities caused by full-pelt economic growth gives the economic planners additional priorities that will complicate prudent macroeconomic management. Further, some of the tools at Chinese policymakers’ disposal are still rudimentary, one reason that the new five-year plan makes much of the need to continue financial reform. Yet they do have one big advantage in managing a potential banking crisis: administrative guidance over both the dominant banks, which are state-owned, and their big customers, similarly state-owned. That guidance is not always followed to the letter, but if a systemic crisis loomed both banks and state-owned enterprises would soon find guidance coming with arm-twisting.

Beijing has already bailed-out the big banks once from their bad loans in the past decade, and it could do so again if necessary. It could also, we should say, would also, spread the stress of a developing banking crisis to avoid it causing a systemic failure. We still don’t think it is likely that it will have to absent that black swan, and the more progress there is on structural reform of the financial sector, the longer the odds get, but it is not impossible that it might.

Footnote: Economist Michael Pettis makes the point about the political protection of China’s banking system much more elegantly in a post on why the yuan won’t become a reserve currency any time soon (a point on which this Bystander also agrees):

It is worth pointing out that the Chinese banking system is one of the least efficient in the world when it comes to assessing risk and allocating capital, and would be bankrupt without repressed interest rates and the implicit (and sometimes explicit) socialization of credit risk.  Beijing accepts this because of the tradeoff that gives it banking stability.

Beijing greatly values this stability, even at the expense of capital misallocation, and is in no hurry to give it up by opening up the financial markets and, what’s more, for political reasons I think local governments will resist ferociously any further corporate governance reform.  Remember that the phrase “corporate governance reform” in the banking context is just another way of saying that credit decisions will be made on the basis of economic considerations, and not on the basis of government preference.  That particular reform will be politically contentious.

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