Systemic banking crisis not in sight, analyst says

Updated: 2014-04-07 17:17

By Wang Tao (China Daily USA)

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Finance | Wang Tao

Key differences with US mean that Lehman-style shock remains unlikely

As more trust and wealth management products mature and as the economy slows this year, the number of payment issues and defaults hitting headlines will inevitably rise. However, a systemic "Lehman-style" financial crisis remains highly unlikely in our view.

With the same 7.5 percent gross domestic product growth target and 13 percent M2 money supply target maintained for this year, it is unlikely policymakers will allow credit growth to slow much, hence our expectation is for overall credit to expand by 16 percent this year. That said, heightened liquidity and credit volatility will persist and remain a key risk for China this year, as interest rate liberalization continues to unfold, shadow credit defaults increase and the government tries to slow the pace of leveraging. While this is not our view, should a cluster of defaults trigger a meaningful loss of confidence in the shadow banking market, leading to liquidity shrinkage in those markets, a financial system meltdown akin to what occurred in the US in 2008 should not result, for four key reasons.

First is size. China's non-bank financial intermediation or shadow banking system is much smaller relative to the size of its overall financial system when compared with many developed economies such as the US. At the end of 2013, we estimate that China's shadow banking system ranged between 30 to 40 trillion yuan ($4.8 trillion to $6.4 trillion, 50 to 70 percent of GDP) compared with the 117 percent global average and 170 percent for the US at the end of 2012. The latter information was compiled by the Financial Stability Board, which also reported a much smaller China number of 25 percent of GDP. As a share of total system credit, China's shadow banking system accounted for just under 25 percent of the total, compared with the global average of 34 percent and the US' 65 percent. (Our broader definition puts China's at 25 to 33.3 percent.)

Systemic banking crisis not in sight, analyst says

Of course, although a smaller starting scale does have its advantages, any benefits will be rapidly eroded if growth continues to exceed expectations. Since 2008, China's overall debt has leaped by more than 70 percent of GDP, just under half of which was driven by shadow bank lending. The growth of China's shadow banking currently ranks fastest in the world. For now, though, the size remains manageable.

The second reason is the lack of leverage and securitization and mark-to-market mechanism in China's shadow banking system. Trust companies, corporate bond issuers and other shadow banking players in China are not highly leveraged. They also have almost no securitization, limiting the impact that any default would have on the entire financial system. Moreover, their underlying assets are mostly loans.

In the event that a cluster of defaults triggers a mass unwinding of shadow credit, assets that Chinese banks may be forced to bring back onto their balance sheets would largely be loan assets, which are simpler and more straightforward to "re-intermediate" than the structures that US banks had to deal with. Although China's banks may still suffer sizable losses, they can choose to record higher nonperforming loans over a longer period of time. Moreover, the absence of "mark-to-market" pressures on complex derivative positions should prevent a "wildfire" magnification of their losses.

Third is domestic liquidity. China's domestic credit expansion has been driven by domestic, not foreign funding. A critical difference between China's and the US banking system at the onset of the Lehman crisis is that the former does not rely on wholesale funding for credit growth. System-wide loan-to-deposit ratios in China now average below 70 percent, are lower for the bigger banks and remain comfortably below 100 percent even after adjusting for off-balance sheet credit. A high savings rate, under-developed capital market and still largely closed capital account mean that most household and corporate savings remain in China and mostly in bank deposits - which is where funds will return in the event of a shadow banking confidence shakeup.

We note that some smaller Chinese banks may have become reliant on wholesale interbank funding in the past couple of years (for example, up to 25 to 30 percent of funding needs for some listed smaller banks). What matters more from a system stability perspective, however, is that none of the big systemically important commercial banks is reliant on wholesale funding.

Fourth is the fact that China's banks remain largely State-owned and backed by a government with ample fiscal capacity to help out should the need arise. State ownership also means that most defaults in China will continue to be handled via drawn-out negotiations and protracted restructuring processes, not a rapid market-driven fire spread. In contrast to many emerging economies, China still has a sizable current account surplus, large foreign exchange reserves and a largely closed capital account - all of which should help to limit the damage that a default challenge can inflict upon the stability of China's financial system and currency.

Simply put, a systemic banking crisis is not in sight. Should a cluster of defaults trigger a credit squeeze, China's authorities have more than enough resources to prevent an escalation into a system-wide crisis. This is not only because of its strong fiscal balance sheet, ample domestic funding and State ownership interest in banks, but also because of the fundamental differences between the defaults facing China today versus those facing the US banking system a few years ago.

(China Daily USA 04/07/2014 page14)

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