Posted by: mulrickillion | November 16, 2011

People’s Republic of China: Financial System Stability Assessment

INTERNATIONAL MONETARY FUND

PEOPLE’S REPUBLIC OF CHINA

Financial System Stability Assessment

Prepared by the Monetary and Capital Markets and Asia and Pacific Departments Approved by José Viñals and Anoop Singh

Country Report No. 11/321

June 24, 2011

EXECUTIVE SUMMARY

1. China has made remarkable progress in its transition toward a more commercially oriented and financially sound system. 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.

Potential risks

2. Despite ongoing reform and financial strength, China confronts a steady buildup of financial sector vulnerabilities. The system is becoming more complex and interlinkages between markets, institutions, and across international borders are growing. In addition, informal credit markets, conglomerate structures, and off-balance sheet activities are on the rise. Furthermore, the current growth model, the associated and relatively inflexible macroeconomic policy framework, and the government’s important role in credit allocation at the central and provincial levels are leading to a build-up of contingent liabilities. These could affect the needed reorientation toward domestic demand and new sectors of growth. These vulnerabilities are not easily quantified, however, in part due to limitations on monitoring, data collection, and inter-agency information exchange.

3. The main near-term domestic risks to the financial system are four-fold: (i) the impact of the recent sharp credit expansion on banks’ asset quality; (ii) the rise of off-balance sheet exposures and of lending outside of the formal banking sector; (iii) the relatively high level of real estate prices; and (iv) the increase in imbalances due to the current economic growth pattern.

4. Jointly conducted stress tests of the largest 17 commercial banks indicate that most of the banks appear to be resilient to isolated shocks. Such shocks included a sharp deterioration in asset quality, a correction in the real estate markets, shifts in the yield curve, and changes in the exchange rate. If several of these risks were to occur at the same time, however, the banking system could be severely impacted. A full assessment of the extent of these risks and how they could permeate through the economic and financial system, however, was hindered by data gaps, the lack of sufficiently long and consistent time series of key financial data, weaknesses in the informational infrastructure, and constraints on the FSAP team’s access to confidential data.

Reforms to strengthen the monitoring and resolution of risks

5. Continued advances in supervision and regulation, and the financial stability framework, together with the upgrading of banks’ risk management systems are required to effectively respond to these risks. As the range of financial activities offered in China grows, there is a need for a concomitant expansion of the regulatory and supervisory perimeter, combined with stronger supervision of financial groups and robust systemic oversight. This will require augmenting resources and skilled personnel, and improved coordination and information and data exchanges among the key agencies. The People’s Bank of China (PBC) and the various supervisory commissions must build staff capacity,

adopt new risk monitoring systems, strengthen their intervention frameworks, and establish more forward-looking approaches to assessing financial stability conditions. In support of this, continuing improvements in accounting requirements, data standards, reporting requirements, and meaningful disclosure should be an immediate priority.

6. Institutional reforms will help bring the system more in line with international practices. The mandates of the supervisory agencies should focus on ensuring the safety and soundness of regulated institutions, risk management, and proper market conduct and avoid taking on the responsibility for promoting the development of specific economic sectors or for making decisions on how capital should be intermediated and allocated. Ensuring the operational autonomy of the central bank and the financial supervisors is crucial. Implementation of a formalized financial stability framework and mechanisms for contingency planning is essential. Establishing a permanent committee on financial stability and systemic risk that builds on China’s recent experience with an ad-hoc committee set up in June 2008, would be a useful step. Chaired by a senior official with authority, the committee should have access to all relevant supervisory and other financial information. Consistent with its financial stability mandate, the PBC should serve as its secretariat.

7. A framework to resolve weak financial institutions on a timely basis is also needed. The framework would be designed to facilitate the orderly resolution and winding up of distressed financial institutions. A designated government entity should be vested with resolution powers to address institutions determined to be nonviable by their supervisor. As part of this framework, an explicit deposit insurance scheme presently under consideration should be established promptly to finance the orderly resolution of failed depository institutions and protect insured depositors, while minimizing the cost to the public purse.

Towards a more market-based system

8. In addition, broad policy changes will be needed to safeguard financial stability and to support continued strong and balanced growth. The existing configuration of financial policies fosters high savings, structurally high levels of liquidity, and a high risk of capital misallocation and asset bubbles, particularly in real estate. The cost of these distortions is rising over time, posing increasing macro-financial risks. So far, costs relating to the financial system have been absorbed by rapid productivity gains, and by an implicit tax on households through low remuneration on deposits, but these cannot be presumed to continue. To ensure strong and balanced growth going forward, needed financial system reforms include:

  • Improved management of systemic liquidity. The current high levels of foreign exchange intervention, limited exchange rate movements, and strong incentives for capital inflows hamper systemic liquidity management and control. Steps to drain large amounts of structural liquidity along with moves towards a liberalized and flexible exchange market will reduce financial stability risks and afford the central bank with greater levers for monetary control.
  • Greater use of market-oriented monetary policy instruments. Interest rates should be the primary instrument to govern credit expansion rather than administrative limits on bank lending. This would enhance the efficiency of capital allocation, strengthen the role of monetary policy, and reduce financial stability risks associated with off-balance sheet lending. Interest rate reform needs to be accompanied by strengthened supervision and improved bank risk management and corporate governance.
  • Broadening financial markets and services. Developing diversified modalities for financial intermediation would create competitive discipline on the banks, offer enterprises alternative avenues for financing, and provide households with a broader range of financing and investment possibilities. The government must move ahead with its priority to deepen fixed income markets and develop a diversified domestic institutional investor base.
  • A reorientation in the role and responsibilities of government. Banks’ large exposures to state-owned enterprises, guaranteed margins provided by interest rate regulations, still limited ability and willingness to differentiate loan rates, coupled with the implicit guidance on the pace and direction of new lending, undermine development of effective credit risk management in the banks. It is important that banks have the tools and incentives to make lending decisions based upon purely commercial goals.
  • Replacing the use of the commercial banking system to pursue broader policy goals. The use should be made of direct fiscal expenditures and subsidies, direct lending by policy banks, and explicit government-sponsored credit programs for developmental credit. The government must start establishing safeguards and policy reforms that remove distortions and curb those incentives that place risks on the public sector balance sheet as contingent liabilities.
  • An upgrading of the financial infrastructure and legal framework. Payments and securities settlement systems have been strengthened, but further progress is required along with continued improvements in the coverage and quality of the Credit Reference Center and oversight of credit rating agencies. As new products are introduced and access is increased, stronger consumer protection, including an expanded financial literacy program, together with improved insolvency proceedings are critical. Cross border and cross currency prudential framework should be strengthened given recent growth in cross-border financial activity and RMB transactions.

9. Given these challenges and build-up of vulnerabilities, calibrating the appropriate pace and order of future reforms will be key. A well-composed and properly implemented plan, including the various elements discussed above, will make an important contribution to sustaining China’s growth. International experience suggests that ad hoc or partial reforms could themselves pose a risk to financial stability. In the case of China this will be all the more critical given the close association between the macroeconomic policy framework and the financial system. Certain pre-conditions have to be made before broader acceleration of financial deepening, liberalization of interest rates, and, finally, full liberalization of the capital account. Such pre-conditions include putting in place a well functioning legal, regulatory, supervisory, and crisis management framework; improving the corporate governance in banks; early absorption of the current liquidity overhang in the financial system; and greater reliance on market-oriented monetary policy instruments. Therefore, careful planning will be critical to smoothly and safely transition to a more market-based system. To help with this process, a prioritized list of recommendations in key areas is presented in Table 1 along with an assessment of the main risk factors in Table 2.

>>Read the full Report here.

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