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Banking sector remains stable despite risks
By Thomas Byrne and Bart Oosterveld |
May 13, 2013, Monday
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SINCE the Chinese government announced its Reform and Opening Policy in late 1978, the economy has grown at an average annual 10 percent for each decade since the 1980s. Strategic reforms in 1994 and in 2001 steadied the economy and have maintained its strong, underlying growth momentum.
At the same time, the rapid, double-digit growth of the past three decades is over. Lackluster global growth and an incipient moderation in gross fixed capital formation are together constraining external and domestic demand as China enters its first decade of single-digit growth since liberalization began in the late 1970s.
China's policy-induced bank credit surge in 2008 and 2009 ensured that growth remained strongly positive following the collapse in global demand. However, since then, economic growth has become increasingly dependent on credit growth, mainly from the banking sector.
Slower growth
Our baseline growth scenario through 2017 suggests that China's annual average trend growth will remain strong, but will ratchet down to 6-7 percent toward the end of the decade. One reason is that the very strong boost from exports appears to be diminishing. In addition, China's competitive edge is eroding from exchange-rate appreciation and rising labor costs.
We assume that macro prudential regulation and the advancement of a broad range of reforms will be effective in preventing imbalances from building up.
Otherwise, contingent fiscal liabilities at the local government level and rapid credit growth constitute risks which could cause a sharper slowdown in growth.
Reform initiatives are taking shape under the new, fifth generation of leadership selected by the Chinese Communist Party last November and which took charge of governmental posts in March 2013.
The State Council announced an ambitious and wide-ranging strategy in February in its 35-point guideline on income distribution.
The strategy covers a range of initiatives affecting the labor market, the urban residential hukou system, the state enterprise sector, financial markets, the tax regime and legal system, along with initiatives to rein in corruption. But these guidelines lack detail, and there is no clear indication when any measures would be implemented and if they would produce systemic changes.
Near-term risks to the government's balance sheet are posed by the increase in local government off-budget investment financing and the possible deterioration in banking credit quality from a severe stress scenario. The National Audit Office reported that local governments added a negligible, net 300 million yuan in 2011 to 6.74 trillion yuan of local government debt reported at end-2010.
The 2012 figure is reportedly broadly unchanged. However, excluded from these figures is an additional 4.0 trillion yuan (equal to 8 percent of 2012 GDP) in lending, mostly by banks, to investment entities loosely affiliated with local governments, but not considered by the central authorities to be a direct obligation of the local governments.
Local government finances have become increasingly dependent on and vulnerable to land sales. In 2012, local governments received 2.69 trillion yuan from land sales, less than 20 percent of total general government revenue. The majority of local government funding comes from central government transfers and fiscal revenue, largely corporate taxes and value-added tax.
As long as economic growth remains robust (in line with our central scenario), the losses embedded in loans to local governments and financing vehicles and to the real estate sector during the 2009-2010 surge would be absorbable by the banks' capital, loan loss reserves and earnings. Our basic assumption is that the government runs modest deficits of 2.0-3.0 percent of GDP over the medium term, in contrast to the average 0.6 percent exhibited in the five years before the global financial crisis. The somewhat larger deficit would reflect greater social welfare spending and higher debt servicing costs from higher debt. We also assume that local government debt remains unchanged - repayments are offset by new borrowings as infrastructure projects are completed. The result is that government debt would stabilize at close to 30 percent of GDP.
Raising capital
However, continued rapid economic growth alone, even without the effect of deteriorating asset quality, will require Chinese banks to raise more capital over time.
The relatively large size of the country's banking system relative to GDP could amplify the effects on the economy and the government's balance sheet from banking-sector stress.
Shadow banking (defined as credit intermediation involving entities and activities outside the regular banking system) has been expanding recently in recent years.
Estimates vary widely, depending in large part on the range of activities considered as shadow banking products.
Roughly, the total size of this sector may be around 30 percent to more than 50 percent of GDP. Shadow banking potentially poses risks as borrowers with poor credit standing or those already heavily indebted may circumvent the banks' normal underwriting standards, increasing financial leverage. Shadow banking also raises credit risks for banks because of potential credit losses, legal liability and reputational damage. Its continued growth could add to disintermediation pressure on the banks.
Nonetheless, our stable outlook on China's banking system is premised on a crisis-free operating environment. Namely, local government debt and infrastructure investment will be contained and successfully managed by the central government, the real estate market will avoid a boom-bust cycle, and inflation will remain contained.
Thomas Byrne is a Singapore-based senior vice president at Moody's. Bart Oosterveld is a New York-based managing director with Moody's. The opinions are their own.
At the same time, the rapid, double-digit growth of the past three decades is over. Lackluster global growth and an incipient moderation in gross fixed capital formation are together constraining external and domestic demand as China enters its first decade of single-digit growth since liberalization began in the late 1970s.
China's policy-induced bank credit surge in 2008 and 2009 ensured that growth remained strongly positive following the collapse in global demand. However, since then, economic growth has become increasingly dependent on credit growth, mainly from the banking sector.
Slower growth
Our baseline growth scenario through 2017 suggests that China's annual average trend growth will remain strong, but will ratchet down to 6-7 percent toward the end of the decade. One reason is that the very strong boost from exports appears to be diminishing. In addition, China's competitive edge is eroding from exchange-rate appreciation and rising labor costs.
We assume that macro prudential regulation and the advancement of a broad range of reforms will be effective in preventing imbalances from building up.
Otherwise, contingent fiscal liabilities at the local government level and rapid credit growth constitute risks which could cause a sharper slowdown in growth.
Reform initiatives are taking shape under the new, fifth generation of leadership selected by the Chinese Communist Party last November and which took charge of governmental posts in March 2013.
The State Council announced an ambitious and wide-ranging strategy in February in its 35-point guideline on income distribution.
The strategy covers a range of initiatives affecting the labor market, the urban residential hukou system, the state enterprise sector, financial markets, the tax regime and legal system, along with initiatives to rein in corruption. But these guidelines lack detail, and there is no clear indication when any measures would be implemented and if they would produce systemic changes.
Near-term risks to the government's balance sheet are posed by the increase in local government off-budget investment financing and the possible deterioration in banking credit quality from a severe stress scenario. The National Audit Office reported that local governments added a negligible, net 300 million yuan in 2011 to 6.74 trillion yuan of local government debt reported at end-2010.
The 2012 figure is reportedly broadly unchanged. However, excluded from these figures is an additional 4.0 trillion yuan (equal to 8 percent of 2012 GDP) in lending, mostly by banks, to investment entities loosely affiliated with local governments, but not considered by the central authorities to be a direct obligation of the local governments.
Local government finances have become increasingly dependent on and vulnerable to land sales. In 2012, local governments received 2.69 trillion yuan from land sales, less than 20 percent of total general government revenue. The majority of local government funding comes from central government transfers and fiscal revenue, largely corporate taxes and value-added tax.
As long as economic growth remains robust (in line with our central scenario), the losses embedded in loans to local governments and financing vehicles and to the real estate sector during the 2009-2010 surge would be absorbable by the banks' capital, loan loss reserves and earnings. Our basic assumption is that the government runs modest deficits of 2.0-3.0 percent of GDP over the medium term, in contrast to the average 0.6 percent exhibited in the five years before the global financial crisis. The somewhat larger deficit would reflect greater social welfare spending and higher debt servicing costs from higher debt. We also assume that local government debt remains unchanged - repayments are offset by new borrowings as infrastructure projects are completed. The result is that government debt would stabilize at close to 30 percent of GDP.
Raising capital
However, continued rapid economic growth alone, even without the effect of deteriorating asset quality, will require Chinese banks to raise more capital over time.
The relatively large size of the country's banking system relative to GDP could amplify the effects on the economy and the government's balance sheet from banking-sector stress.
Shadow banking (defined as credit intermediation involving entities and activities outside the regular banking system) has been expanding recently in recent years.
Estimates vary widely, depending in large part on the range of activities considered as shadow banking products.
Roughly, the total size of this sector may be around 30 percent to more than 50 percent of GDP. Shadow banking potentially poses risks as borrowers with poor credit standing or those already heavily indebted may circumvent the banks' normal underwriting standards, increasing financial leverage. Shadow banking also raises credit risks for banks because of potential credit losses, legal liability and reputational damage. Its continued growth could add to disintermediation pressure on the banks.
Nonetheless, our stable outlook on China's banking system is premised on a crisis-free operating environment. Namely, local government debt and infrastructure investment will be contained and successfully managed by the central government, the real estate market will avoid a boom-bust cycle, and inflation will remain contained.
Thomas Byrne is a Singapore-based senior vice president at Moody's. Bart Oosterveld is a New York-based managing director with Moody's. The opinions are their own.
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