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The People’s Bank of China, the central bank, recently responded to a report—Financial Sector Assessment for China—jointly issued by the International Monetary Fund (IMF) and the World Bank on November 15, saying that the report was overall objective and positive, and the recommendations on the future reforms are constructive.
But the central bank pointed out that a few points are not sufficiently well-rounded or objective, and the time frame and priorities of some proposed reform measures need to be further analyzed by taking China’s actual situations into account.
In the report, the IMF repeated its call for interest rate reform, arguing that marketdriven interest rates would engender a more commercially minded banking system which would then clear the way for the full opening up of the capital account. It also urged Chinese authorities to loosen currency controls and give autonomy to the central bank and other supervisory bodies to help bring the system more in line with international practices.
“After years of reform, China’s financial system has made considerable progress toward commercialization,” said the central bank.
“With the completion of the stockholding reforms of major financial institutions, the government’s involvement in the financial system is now through participation in corporate governance as shareholders and through nominated directors, instead of direct and administrative means.”
As for macro adjustment of the credit supply, the People’s Bank of China abol- ished credit quota for commercial banks since 1998.
Currently, the central bank adjusts market liquidity primarily by indirect and market-oriented measures, such as open market operations, reserve requirement ratio and interest rates. In addition, reforms of the interest rate and exchange rate regime have made significant progress with market forces playing a fundamental role in the formation of interest rate and the yuan exchange rate, said the central bank.
“The government’s sway over financial markets has already evolved from direct intervention to asserting influence through regulation of financial companies,” it added.
The central bank also pledged to strengthen cooperation and exchanges with international financial institutions to promote steady development of its financial sector and prevent risks.
Hui Feng, a researcher at the University of Queensland in Brisbane, Australia, said China may adopt a few of the IMF’s suggestions.
“But I don’t see any momentum for a more fundamental reform of the financial system anytime soon, unless there is a systemic crisis that jeopardizes economic and social stability,” he said.
Zhao Qingming, a researcher with the China Construction Bank, recognized IMF’s proposal to diversify financing channels and wean off over-dependence on bank loans.
“Chinese firms, especially smaller ones, still lack a permanent and effective source of funding,”he said. “Solving the problem requires faster development of the securities and insurance markets.”
But Xie Taifeng, President of the School of Finance of Capital University of Economics and Business, raised doubts over the IMF’s suggestion about interest rate liberalization.
“Hasty financial liberalization will also ignite risks as smaller banks may scramble to bump up interest rates to attract deposits, posing a threat to financial stability,” he said.
The evaluation
The report recognized China’s achievements in financial commercialization, regulation and infrastructure.
“China has made remarkable progress in its transition toward a more commercially oriented and financially sound system,” said the report.
“Improvements continue to be made to the structure, performance, transparency, and oversight of financial institutions and markets. As a result, the financial sector entered the global financial crisis from a position of relative strength,” said the IMF.
The Financial Sector Assessment Program was launched in May 1999 to help strengthen the assessment and monitoring on global financial stability. China is one of the 25 countries that have agreed to mandatory evaluations at least once every five years, though the country has no obligation to implement the recommended reforms.
“China’s financial system is robust overall, but faces a steady build-up in vulnerabilities,” said the report. “Further reforms are needed to support financial stability and encourage strong and balanced growth.”
The report indicates that near-term domestic risks include the impact of the sharp credit expansion on banks’ asset quality, the rise of off-balance sheet exposures and lending outside the formal banking sector, the relatively high level of real estate and commodity prices, as well as increased imbalances due to the current economic growth pattern.
“While the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and formation of bubbles, especially in real estate markets,” said Jonathan Fiechter, Deputy Director of IMF’s Monetary and Capital Markets Department.
“The current system has encouraged over-investment and fuelled asset bubbles,”he added.
The report did not predict an imminent crisis, but it said China needed to act quickly given its vulnerability to risks. It called on China to move further toward using interest rates instead of administrative orders to regulate lending and allowing market forces to decide who can borrow. It said Chinese policymakers also should reduce their use of banks to carry out economic plans and instead pay for initiatives out of the government budget.
Banking concern
The IMF conducted a stress test over 17 Chinese commercial banks that account for 83 percent of China’s banking system. The test results showed the banks appear to be resilient to isolated shocks such as a fall in real estate prices, exchange rate changes and a sharp slowdown in economic growth.
“If several of these risks were to occur at the same time, however, the banking system could be severely impacted,” it said.
The IMF said the worst scenario assumed annual economic growth of 4 percent, sharply below the 9.1 percent posted in the third quarter; broad money supply growth of around 10 percent; a property price tumble of nearly 26 percent; and a change in deposit and lending rates of 95 percentage points.
“The banking system’s nonperforming loan ratio has been on a downward trend, reaching 1.1 percent at the end of 2010, thanks to strong economic growth and improvements in risk management,” the IMF said.
But if credit increases more rapidly, it may cause bank assets to lose some of the flare in the coming years, it added.
The banks’ non-performingloan ratio would rise by at least 1 percentage point for each 1-percentage-point drop in the GDP growth rate, according to the stress tests.
Lu Zhengwei, chief economist at the Industrial Bank Ltd., downplayed the worries.
“The probability of liquidity strain, economic slump and property market meltdown occurring together is quite slim,” he said.“As the policymaker fine-tunes monetary policies, market liquidity will become even more ample next year.”
“The whole system is still robust enough to withstand major risks,” Lu said.
Liu Mingkang, former Chairman of China Banking Regulatory Commission, said Chinese banks have built up strong capital reserves to weather even an acute crisis in case of a real estate market fallout and default of local government debts.
The risks looming over banks’ property loans are totally controllable even in the worst-case scenario where property prices fall 50 percent, he added.
However, he cautioned that China faces destabilizing forces from shadow banking simmering underground borrowing activities. Shadow banking occurs beyond the reach of traditional banking system, and it includes entities such as hedge funds, money market funds and structured investment vehicles.
Sun Maohui, Director of Financial Engineering Research Center of Shanghai Normal University, also ruled out likelihood of deeper economic downturn.
“The economic slowdown is a result of government’s rebalancing efforts, and will not necessarily lead to a surge in bad loans,”he said.
“The banks have avoided reckless lending and raised requirements for borrowers since credit demands remain buoyant,” he added.
“The IMF report obviously lacks indepth probe into the Chinese economy,” said Sun. “China should proceed with financial reforms in a reasonable manner and on its own pace.”
But the central bank pointed out that a few points are not sufficiently well-rounded or objective, and the time frame and priorities of some proposed reform measures need to be further analyzed by taking China’s actual situations into account.
In the report, the IMF repeated its call for interest rate reform, arguing that marketdriven interest rates would engender a more commercially minded banking system which would then clear the way for the full opening up of the capital account. It also urged Chinese authorities to loosen currency controls and give autonomy to the central bank and other supervisory bodies to help bring the system more in line with international practices.
“After years of reform, China’s financial system has made considerable progress toward commercialization,” said the central bank.
“With the completion of the stockholding reforms of major financial institutions, the government’s involvement in the financial system is now through participation in corporate governance as shareholders and through nominated directors, instead of direct and administrative means.”
As for macro adjustment of the credit supply, the People’s Bank of China abol- ished credit quota for commercial banks since 1998.
Currently, the central bank adjusts market liquidity primarily by indirect and market-oriented measures, such as open market operations, reserve requirement ratio and interest rates. In addition, reforms of the interest rate and exchange rate regime have made significant progress with market forces playing a fundamental role in the formation of interest rate and the yuan exchange rate, said the central bank.
“The government’s sway over financial markets has already evolved from direct intervention to asserting influence through regulation of financial companies,” it added.
The central bank also pledged to strengthen cooperation and exchanges with international financial institutions to promote steady development of its financial sector and prevent risks.
Hui Feng, a researcher at the University of Queensland in Brisbane, Australia, said China may adopt a few of the IMF’s suggestions.
“But I don’t see any momentum for a more fundamental reform of the financial system anytime soon, unless there is a systemic crisis that jeopardizes economic and social stability,” he said.
Zhao Qingming, a researcher with the China Construction Bank, recognized IMF’s proposal to diversify financing channels and wean off over-dependence on bank loans.
“Chinese firms, especially smaller ones, still lack a permanent and effective source of funding,”he said. “Solving the problem requires faster development of the securities and insurance markets.”
But Xie Taifeng, President of the School of Finance of Capital University of Economics and Business, raised doubts over the IMF’s suggestion about interest rate liberalization.
“Hasty financial liberalization will also ignite risks as smaller banks may scramble to bump up interest rates to attract deposits, posing a threat to financial stability,” he said.
The evaluation
The report recognized China’s achievements in financial commercialization, regulation and infrastructure.
“China has made remarkable progress in its transition toward a more commercially oriented and financially sound system,” said the report.
“Improvements continue to be made to the structure, performance, transparency, and oversight of financial institutions and markets. As a result, the financial sector entered the global financial crisis from a position of relative strength,” said the IMF.
The Financial Sector Assessment Program was launched in May 1999 to help strengthen the assessment and monitoring on global financial stability. China is one of the 25 countries that have agreed to mandatory evaluations at least once every five years, though the country has no obligation to implement the recommended reforms.
“China’s financial system is robust overall, but faces a steady build-up in vulnerabilities,” said the report. “Further reforms are needed to support financial stability and encourage strong and balanced growth.”
The report indicates that near-term domestic risks include the impact of the sharp credit expansion on banks’ asset quality, the rise of off-balance sheet exposures and lending outside the formal banking sector, the relatively high level of real estate and commodity prices, as well as increased imbalances due to the current economic growth pattern.
“While the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and formation of bubbles, especially in real estate markets,” said Jonathan Fiechter, Deputy Director of IMF’s Monetary and Capital Markets Department.
“The current system has encouraged over-investment and fuelled asset bubbles,”he added.
The report did not predict an imminent crisis, but it said China needed to act quickly given its vulnerability to risks. It called on China to move further toward using interest rates instead of administrative orders to regulate lending and allowing market forces to decide who can borrow. It said Chinese policymakers also should reduce their use of banks to carry out economic plans and instead pay for initiatives out of the government budget.
Banking concern
The IMF conducted a stress test over 17 Chinese commercial banks that account for 83 percent of China’s banking system. The test results showed the banks appear to be resilient to isolated shocks such as a fall in real estate prices, exchange rate changes and a sharp slowdown in economic growth.
“If several of these risks were to occur at the same time, however, the banking system could be severely impacted,” it said.
The IMF said the worst scenario assumed annual economic growth of 4 percent, sharply below the 9.1 percent posted in the third quarter; broad money supply growth of around 10 percent; a property price tumble of nearly 26 percent; and a change in deposit and lending rates of 95 percentage points.
“The banking system’s nonperforming loan ratio has been on a downward trend, reaching 1.1 percent at the end of 2010, thanks to strong economic growth and improvements in risk management,” the IMF said.
But if credit increases more rapidly, it may cause bank assets to lose some of the flare in the coming years, it added.
The banks’ non-performingloan ratio would rise by at least 1 percentage point for each 1-percentage-point drop in the GDP growth rate, according to the stress tests.
Lu Zhengwei, chief economist at the Industrial Bank Ltd., downplayed the worries.
“The probability of liquidity strain, economic slump and property market meltdown occurring together is quite slim,” he said.“As the policymaker fine-tunes monetary policies, market liquidity will become even more ample next year.”
“The whole system is still robust enough to withstand major risks,” Lu said.
Liu Mingkang, former Chairman of China Banking Regulatory Commission, said Chinese banks have built up strong capital reserves to weather even an acute crisis in case of a real estate market fallout and default of local government debts.
The risks looming over banks’ property loans are totally controllable even in the worst-case scenario where property prices fall 50 percent, he added.
However, he cautioned that China faces destabilizing forces from shadow banking simmering underground borrowing activities. Shadow banking occurs beyond the reach of traditional banking system, and it includes entities such as hedge funds, money market funds and structured investment vehicles.
Sun Maohui, Director of Financial Engineering Research Center of Shanghai Normal University, also ruled out likelihood of deeper economic downturn.
“The economic slowdown is a result of government’s rebalancing efforts, and will not necessarily lead to a surge in bad loans,”he said.
“The banks have avoided reckless lending and raised requirements for borrowers since credit demands remain buoyant,” he added.
“The IMF report obviously lacks indepth probe into the Chinese economy,” said Sun. “China should proceed with financial reforms in a reasonable manner and on its own pace.”