Beware of Six Financial Risks in China

Although it is unlikely to see system-wide financial risks in China in the near future, there are however six potential risk areas that may significantly affect the Chinese economy, if not properly addressed.

High inflation

Annualised consumer price index (CPI) released in April had reached 8.5%, which is at an uncomfortable level. There are several reasons for the rapidly rising prices in China.

RMB appreciation has only limited impact on the rising price of commodity imports. The rising food and metals prices in the world have directly contributed upward pressure to China’s CPI, and the rising energy prices globally are increasing difficulties on Chinese government’s domestic price control measures.

The ability of downstream industries to absorb price pressures from upstream materials suppliers has become minimal. Back in 2007, although the Chinese economy was also growing rapidly, the CPI could nevertheless stay around 4%. This was because there had been a capacity surplus built up in downstream industries and the competition was intense.

But due to the rising RMB and price adjustments in environmental protection, labour and land last year, profit margins in downstream industries have been suppressed. Therefore upstream price rises are now being passed onto consumers.

Price controls may be hard to maintain. The government’s price control measures can certainly be effective to keep down price hikes in the short term, but it has been proven that the “control – subsidy” mechanism may not be sustainable. Take the example of refined oil products in China. The breakeven price for Chinese petrol refiners is about US$67 per barrel, but in the first quarter of this year, international oil prices had been around $100-110. So even though there are lots of fiscal subsidies to refiners, shortage of refined oil products are still occurring in some markets.

Foreign exchange risks

Due to US dollar depreciation, US Federal Reserve’s rate cuts and People’s Bank of China (PBC)’s rate increases, PBC’s foreign currency reserve portfolio is showing widening losses arising from foreign currency (mainly US dollar) asset depreciation and hedging costs.

According PBC’s balance sheet released in February, it had equity of 21.975 billion yuan (RMB:USD = 7:1), equivalent to an equity/asset ratio of merely 0.12%. Policy makers should now prevent the PBC from assuming dual responsibilities of monetary policy and exchange rate policy, and let the government take over some of PBC’s quasi-fiscal deficit. If such deficits are left to be self-digested within the financial system, they may eventually bring risks to China’s monetary policy independence and even to PBC’s credibility.

Sharemarket volatility

The Chinese sharemarket’s price to earning ratio reached a staggering 67 times in 2007, while it has gone down nearly 50% since 2008. Such volatility may lead the following impacts on the economy.

Social wealth will be further concentrated towards a small group of people. But due to the rapid ups and downs, a lot of the paper wealth hasn’t been converted into real consumption, hence little obvious impacts on the consumer market.

The sharemarket’s capital raising capacity has been severely impacted. The depressed sharemarket and the excess demand for capital have prompted the authority to place restrictions on IPO and refinancing activities, so that market integrity can be maintained.

On the other hand, in the overall context of excess liquidity in China, surplus capital may flow to other asset markets such as property market, resulting in new asset bubbles.

The declining sharemarket has also increased the difficulties of macro policy implementation and monitoring measures by the regulator, such as “market bailout” demand and how to control liquidity while not further hammering the market.

Mortgage crisis

China’s real estate problem is largely a financial problem. By the end of 2007, real estate mortgage balance of China was 4.8 trillion yuan, accounting for 17.3% of total lending balance. And real estate mortgage balance growth accounted for 28.9% of total lending growth in 2007.

Amid the tightening monetary policy, some real estate companies that heavily depend on bank credit are now facing the risk of funding deficiency, and the quality of existing loans in some real estate companies may also deteriorate.

Reduced home affordability among home buyers may increase the risk of default. Loan repayment ability review on borrowers by Chinese banks is still relatively loose, and the credit system is still unsophisticated. Bank interest rates have cumulatively increased 1.44 percentage points between April 2006 and Dec 2007, further increasing the risk of default by less affordable home buyers.

The severe correction in China’s real estate market may lead to substantial negative equity among property owners. For properties purchased within a year, if their prices go down 30%, many mortgages may become a negative equity for their buyers, or buyers may be forced to give up their property ownership.

Banking sector risk

Since the banking industry reform, the proportion of non-performing assets in Chinese banks has substantially reduced, but future operational risks still remain.

Bank profits are still relying on traditional business liens and non-marketised interest rate differentials. Although China’s banking industry has seen improved proportion of intermediary business income in 2007, such growth was heavily depending on wealth management businesses. As the sharemarket continues to decline, income from wealth management businesses is expected to shrink significantly in 2008.

Bank balance sheet management and liquidity management need to be adjusted. In January 2008, long term lending accounted for 50% of total lent assets in China’s financial institutions, up 13% from the 2001 level. But on the other hand, short term deposits amounted to 40.3% of total deposit base, with no corresponding decline from 2001.

Bank credits are still chasing heated industries. Loans from commercial banks have mainly concentrated in industries such as real estate, transportation, public utilities and manufacturing. Amid the tightening monetary environment, if banks suddenly reduce their lending to those overheated industries, it may lead to severe funding breakdown in some highly-leveraged companies, hence loan quality deterioration.

International currency crisis

The current international currency system possesses obvious deficiencies, but a dramatic adjustment to this system will not be beneficial to most economies, either. It will still be difficult for China’s financial system and financial industry to adapt to the complex international currency environment.

Firstly, China’s international trading activities are primarily settled in USD, hence heavy dependence on the USD in terms of foreign exchange rate setting and settlement system. Secondly, as a country with huge trade surplus, both the Chinese government and the private sector have accumulated enormous USD asset, therefore any USD depreciation will cause substantial losses to China’s foreign exchange asset. Thirdly, even though the USD’s international currency status is declining, RMB regionalisation is still at an early stage, not capable of filling up the requirement of a regional currency in Asia. Lastly, if any change in USD’s status affects the Hong Kong Dollar, which is pegged to the USD, mainland China may have to bear some kind of ramification responsibilities.

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