From Credit to Crisis

Op-ed in Caixin Online. Reposted with permission.

October 24, 2013

The Chinese financial system has come a long way since the banking cleanup in the 1990s. A large commitment of government resources, deep internal restructuring, and assistance from foreign strategic investors helped to improve the performance of Chinese banks dramatically. Whether measured by profitability, capital levels, or non-performing loans, China's banking system is functioning much better than it used to.

The global financial crisis of 2008–09, however, reversed some of this progress, creating new problems in risk management and credit allocation. The government's stimulus in response to the crisis was largely through bank loans rather than through direct government spending. To stop the decline in growth, the government loosened credit controls, removed home purchase restrictions, and approved a large infrastructure program. The result was a massive increase in the stock of loans. Between December 2008 and December 2009, new bank credit increased by 11 trillion yuan, increasing the credit-to-GDP ratio by almost 25 percentage points. Another 2.5 trillion yuan of credit was extended through non-loan channels such as entrusted loans, trust loans, banker's acceptances, and corporate bonds. In short, the government unleashed a massive wave of new credit into the economy to prevent a financial downturn.

Five years after the crisis, the pace of credit growth in China has not returned to normal. This should be worrying to policymakers because rapid credit growth in emerging markets is strongly correlated with financial crises. The linkages between a rapidly growing shadow banking system and the traditional banking system have created new risks that threaten to undo the hard wrought progress of the past decade. Post-global financial crisis, China's financial sector once again appears vulnerable to large-scale credit misallocation and spiraling bad debts.

The sources of risk in the Chinese financial system today are more diverse than in the 1990s. First, the growth of credit outside traditional lending channels means that a tremendous amount of borrowing has taken place outside well-regulated modes of financial intermediation. Rapid credit growth combined with weak financial regulation is an almost certain recipe for financial distress.

Second, state-owned enterprises (SOEs) are likely to generate more bad loans due to declining profitability. Since 2007, SOEs have seen a drop in both their return on assets and interest coverage ratios relative to private firms. Many SOEs now have a return on assets significantly below borrowing costs.

Third, local governments have dramatically increased their borrowing to finance projects without sufficient cash flows. Prohibited from borrowing directly, local governments established local government financing vehicles to borrow and invest on their behalf. Despite efforts by the central government to decrease local government borrowing, such as by prohibiting new bank loans, local governments continue to rack up debt.

Fourth, the risk of widespread household financial distress has increased significantly. In recent years, households have been borrowing large amounts for home and consumption loans. This increase in debt has coincided with a sharp slowdown in disposable income growth and the growing possibility of a sharp correction in housing prices.

The most important reform to reduce risk in the financial system is to improve the regulation of non-loan financial products. The primary driver of excess credit growth in the post-crisis period, these financing channels boomed because they offered banks an avenue to engage in regulatory arbitrage. The other structural reform needed is the controlled introduction of default risk into the financial system. This will help reduce the tremendous amount of moral hazard present throughout the financial system, which contributed to excess credit growth.

The Chinese financial system stands at a crossroads. The response to the global financial crisis eroded some of the hard-earned discipline put in place during the 2000s. As a result, significant financial risks have accumulated during the past few years. Reducing these risks will take a new wave of concerted action. Bailouts will be necessary to deal with the bad debts that have accumulated, and structural reforms are needed to address the underlying distortions that have driven the rapid growth of credit.

Chinese policymakers were willing to discipline banks during the post-Asian financial crisis cleanup. As a result, the quality and health of the Chinese financial system significantly improved during the 2000s. In contrast, the global financial crisis did not spur a new wave of financial reform. Absent better regulation, the tremendous growth of non-loan financing channels allowed after the crisis has the potential to result in large-scale financial distress. Policymakers may not have the luxury of waiting for another external crisis before taking action to address the risks in the financial system.