is china at risk of financial crisis? - melbourne law school · 2016-11-16 · is china at risk of...

Is China at Risk of Financial Crisis?

October 2016MICHAEL TAYLOR, MANAGING DIRECTOR – CHIEF CREDIT OFFICER FOR ASIA PACIFIC

This publication does not announce a

credit rating action. For any credit

ratings referenced in this publication,

please see the ratings tab on the

issuer/entity page on www.moodys.com

for the most updated credit rating action

information and rating history.

http://www.moodys.com/

2Is China at Risk of Financial Crisis?, October 2016

Key Messages

China’s government has policy tools and willingness

to prevent an imminent financial crisis

Rapid financial liberalisation would weaken the

authorities’ ability to manage systemic risks

Major imbalances created by rapid debt build-up are

likely to corrode credit quality over time

1

2

3


Abrupt Crisis Unlikely, “Slow-Burn” Scenario A Clear Risk

Source: Moody’s Investors Service

China’s authorities are aware of this

risk and will therefore continue to

apply existing capital controls more

rigorously over a prolonged period

This “benign scenario” would require

substantial economic and market

reform which we believe is unlikely at

present given slowing growth

momentum


Is there evidence of a looming crisis?1


Common Pattern In Financial Crises

Financial crises result from “the growing fragility of private sector balance sheets during

benign economic conditions…. These financial imbalances, associated with aggressive

risk-taking, are driven by, but also feed, an unsustainable economic expansion. At some

point, however, they unwind, potentially causing widespread financial strains.”

- Borio and Drehmann (2009), Towards an operational framework for financial stability:

“fuzzy” measurement and its consequences. Bank for International Settlements.

Two closely related factors are involved in the formation of financial imbalances:

(a) rapid debt accumulation, particularly when funded from international financial markets;

and

(b) the formation – and subsequent bursting – of asset price bubbles, especially in real

estate.


0

50

100

150

200

250

300

Q1 2000 Q1 2002 Q1 2004 Q1 2006 Q1 2008 Q1 2010 Q1 2012 Q1 2014 Q1 2016

Households Corporates

Total Debt Climbs to 280% of GDP Driven by the Corporate Sector

Source: Institute of International Finance

Debt as % of GDP


China’s Debt Increase in International Context

Sources: Moody’s Investors Service, Bank for International Settlements

Change in Non-Financial Sector Debt-to-GDP (2008-3Q 2015), percentage points

-20

0

20

40

60

80

100

120

Cha

ng

e in

Non

-Fin

an

cia

l Se

cto

r D

eb

t,

pe

rce

nta

ge

po

ints

(2

00

8-3

Q1

5)


GBR

NORDNK

ITL

SWESWE

BEL

FIN

GRC

IRL

PRT

ESP

ARG

BRA

URY

URY

MYS

PHL

THA

0

10

20

30

40

50

60

70

80

-10 -8 -6 -4 -2 0 2 4

Cre

dit-t

o-G

DP

Ratio,

5-Y

ear

Change

GDP Growth Change in Three Years Following Credit Boom

Followed by Banking Crisis No Crisis After

Debt Run-Ups Often End in Financial Instability

Source: IMF Staff Estimates and Calculations

Change in Credit and GDP Growth, percentage points

» Four countries over the past 50 years have experienced a similar scale of credit growth

to China, and all four suffered banking crises within three years of the boom period (IMF)


Rapid Build-Up of Debt Fueled by Excessive Credit

-15

-10

-5

0

5

10

15

20

25

30

35

Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Mar-16

Cre

dit-t

o-G

DP

Ga

p, %

Note: The credit-to-GDP gap is defined as the difference between the credit-to-GDP ratio and its long-run trend. Readings above 10 percent signal elevated risks

of banking strains, according to the BIS.

Source: Bank for International Settlements

China’s Credit-to-GDP Gap Climbs to the Record High

% of GDP


Deleveraging Has Not Yet Begun

* Total social financing (TSF) is an official measure of broad credit in the financial system: formal bank loans, shadow banking activities, direct financing

(bond and equity issuance) and others (e.g. microcredit). The series shown above has been adjusted from May 2015 onwards to account for distortions

from the local government debt swap program.

Sources: Moody’s Investors Service, PBOC, WIND

» Overall credit growth (total social financing - TSF) is still growing faster than nominal

GDP, leading to rising leverage. TSF may even understate the extent of the buildup in

leverage, as it excludes various forms of non-core shadow banking.

Annual % change

0

5

10

15

20

25

0

3

6

9

12

15

% y

/y

% y

/y

Nominal GDP growth (LHS) Outstanding total social financing* growth (RHS)


Accommodative Monetary Policy Sustains Credit Flows

* Core shadow banking components comprise entrusted loans, trust loans and undiscounted bankers’ acceptances in TSF.

^ Total social financing (TSF) is an official measure of broad credit in the financial system: formal bank loans, shadow banking activities, direct financing (bond and equity issuance)

and others (e.g. microcredit). The series shown above has been adjusted from May 2015 onwards to account for distortions from the local government debt swap program

Sources: Moody’s Investors Service and PBOC

Total Social Finance (TSF) Net Flows and Growth

RMB Trillion, Annual % change

0

5

10

15

20

25

-1

0

1

2

3

4

Net Core Shadow Bank* Credit Flow Net Formal Bank Credit Flow

Net Direct Finance Flow Local Government Debt Swap Program

Outstanding TSF Growth^ (RHS)


» Gap could point to declining monetary policy effectiveness or to M2 failing to track credit

growth (e.g. due to growing role of WMPs or ongoing local government debt swaps)

Widening Gap between M1 and M2 Growth

Sources: Moody’s Investors Service, National Bureau of Statistics, Haver Analytics

Monetary Aggregates

Annual % change

0

5

10

15

20

25

30

Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16

M1 M2


Property Market: Prices Continue to Accelerate

Prices in First-Tier Cities Continue to Rise Rapidly

Annual % change

Note: First-tier cities consist of: Beijing, Guangzhou, Shanghai, and Shenzhen. Second-tier cities comprise: Tianjin, Shijiazhuang, Taiyuan, Shenyang, Dalian,

Changchun, Harbin, Nanjing, Hangzhou, Ningbo, Hefei, Fuzhou, Xiamen, Nanchang, Jinan, Qingdao, Zhengzhou, Wuhan, Changsha, Nanning, Haikou, Chongqing,

Chengdu, Guiyang, Kunming, Xi’an, Lanzhou, Xining, Yinchuan, Urumqi, Wuxi, and Sanya. Lower-tier cities are any of the 70 major cities other than the first- and

second-tier cities mentioned above.).

Sources: Moody’s Investors Service, National Bureau of Statistics

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Year-

on-Y

ear

Change

First-tier cities Second-tier cities Lower-tier cities


Risk from Capital Outflows Persists

China’s Capital Account

USD Billion

Sources: SAFE, Haver Analytics

-1000

-800

-600

-400

-200

0

200

400

600

800

Q12013

Q3 Q12014

Q3 Q12015

Q3 Q12016

Outward Direct Investment Inward Direct Investment Portfolio Investment: AssetsPortfolio Investment: Liabilities Other Investments: Assets Other Investments: LiabilitiesTotal


China’s government has policy tools and willingness to prevent an imminent financial crisis2


Channels For Transmission Of Financial Shocks

1. Credit growth that exceeds the long-run trend in an economy, especially if funded by

borrowing from international markets. In the late stages of a credit boom funding

increasingly takes the form of lending granted directly to non-financial borrowers by

banks located abroad and by domestic banks’ borrowing abroad which is in turn on-lent

to non-financial borrowers. This leaves the economy vulnerable to a “Sudden Stop”

2. Rapid asset price appreciation, especially in real estate: a credit boom leads to the

growth of asset values above their historical trends. This can be subject to rapid

reversal in the event that the credit growth that has fueled it goes into reverse

3. Minsky's “financial instability hypothesis” posits that financing structures tend to

become riskier during periods of relative stability, eventually leading to an inflection

point – the “Minsky Moment”

4. So-called “twin crises” in which a currency crisis is associated with a full-fledged

domestic banking crisis around the same time. Stress in the financial sector

undermines the currency and capital flows out of the economy. In turn, large

depreciations and capital outflows raise banks’ funding costs and have a negative

impact on banks’ profitability, exacerbating the sector’s financial stress.


7.5%

8.0%

8.5%

9.0%

9.5%

10.0%

10.5%

11.0%

11.5%

12.0%

12.5%

13.0%

13.5%

4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5% 8.0%

CET1 Capital Ratio (June 2016)

Leverage ratio (June 2016)

CCB

ICBC

BOCBoCom

CMB

ABC

CITIB, NB, IB, CEB, SPDB, PAB

Major Banks Have Solid Capitalization…

Common equity Tier 1 (CET1) capital ratios and leverage ratios (end- June 2016)

Source: Company reports


…And Liquidity

Liquid assets as a percentage of total assets (end-2015 vs. end-June 2016)

Liquid assets in this context include interbank assets, government bonds and policy bank bonds. The ratios for the 12 banks are weighted average ratios.


0%

5%

10%

15%

20%

25%

30%

ICBC (baa2) CCB (baa2) BOC (baa2) ABC (baa3) BoCom (baa3) CMB (baa3) CITIB (ba1) SPDB (ba1) NB (ba1) IB (ba2) CEB (ba2) PAB (ba2) 12 banks

Liquid asset ratio (end-2015) Liquid asset ratio (end-June 2016)


Asset Quality: Reported NPLs Remain Manageable

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

ICBC (baa2) CCB (baa2) BOC (baa2) ABC (baa3) BoCom(baa3)

CMB (baa3) CITIB (ba1) SPDB (ba1) NB (ba1) IB (ba2) CEB (ba2) PAB (ba2) 12 banks

90+ day delinquencies (new formation in 1H 2015) 90+ day delinquencies (new formation in 2H 2015) 90+ day delinquencies (new formation in 1H 2016)

New problem loan formation dropped from a year ago, but higher than 2H2015New 90+ day delinquencies as a percentage of average loans (1H2015, 2H2015 & 1H2016)

0%

50%

100%

150%

200%

250%

300%

350%

400%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

ICBC (baa2) CCB (baa2) BOC (baa2) ABC (baa3) BoCom(baa3)

CMB (baa3) CITIB (ba1) SPDB (ba1) NB (ba1) IB (ba2) CEB (ba2) PAB (ba2) 12 banks

90+ day delinquencies (June 2016, LHS)

Low outstanding 90+ day delinquencies benefited from NPL write-off and sales90+ day delinquencies as a percentage of total loans and loan loss reserves coverage (June 2016)



China’s Debt Boom Has Been Domestically Funded with Relatively Small External Debt Exposure

Sources: Moody’s Investors Service, SAFE, WIND

External Debt, Domestic Bond Market, and Outstanding Renminbi Bank Loans, % of GDP (2015)

0%

20%

40%

60%

80%

100%

120%

140%

160%

External debt Domestic bond market Outstanding RMB banking loans

% o

f G

DP

(2

01

5)

» Furthermore, both large borrowers (SOEs, RLGs) and lenders (state banks) are explicitly

or implicitly backed by the government, which makes lenders more willing to refinance

maturing debt and facilitates the exercise of moral suasion by the government.


A “Minsky Moment” Remains Unlikely

» A Minsky Moment remains unlikely in China because

– Large banks are state-owned, increasing the effectiveness of “moral suasion”

– Government has willingness and capacity to inject additional liquidity

– Capital and liquidity buffers provide reasonable robust first line of defence

» Policy support will help mitigate the impact of a sharp asset price correction in real estate

– Household sector has low leverage

– Fiscal and monetary support is likely from central government in the event of price reversals


Policies would mitigate impact of real estate downturn



China’s External Position Remains Healthy

Sources: Moody’s Investors Service, International Monetary Fund

Adequate Reserves Are Estimated to Stand Between $1.5 - $2.5 Trillion Using the IMF’s Framework

Exchange Rate

RegimeShort-Term Debt Other Liabilities Broad Money Exports

Recommended Reserve

Levels

Without Capital Controls ($ Billion)

Fixed 161 91 2110 241 2603

Float 161 68 1055 120 1405

With Capital Controls ($ Billion)

Fixed 161 91 1055 241 1548

Float 161 68 527 120 878


Still Ample Reserve Cushion

China’s Exchange Rate and Foreign Exchange Reserves

Sources: Moody’s Investors Service, Haver Analytics

0

500

1000

1500

2000

2500

3000

3500

4000

45006.0

6.5

7.0

7.5

8.0

8.5

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Spot Exchange Rate (RMB/USD, LHS) Foreign Currency Reserves (Billion US$, RHS)


Where are the vulnerabilities in the authorities’ ability to manage systemic risks?3




China’s authorities are aware

of this risk and will therefore

continue to apply existing

capital controls more rigorously

over a prolonged period

This “benign scenario” would

require substantial economic

and market reform which we

believe is unlikely at present

given slowing growth

momentum


Capital Controls Have Proven Porous Over the Past 18 Months


Balance of Payments Errors and Omissions, $ BillionMonthly Change in Foreign Reserves, $ Billion

-150

-100

-50

0

50

100

150

$ B

illio

n

Monthly Change in Foreign Reserves

Six-Month Moving Average

-80

-60

-40

-20

0

20

40

2Q98 2Q00 2Q02 2Q04 2Q06 2Q08 2Q10 2Q12 2Q14 2Q16

$ B

illio

n


Financial Liberalisation Could Weaken the Authorities’ Ability to Manage Systemic Risks

Note: External Vulnerability Indicator (EVI) = (Short-term External Debt + Currently Maturing Long-Term Debt + Nonresident Deposits

Over One Year)/ Official Foreign Exchange Reserves.


External Vulnerability Indicator and M2 Money Supply/Foreign Reserves

China (Aa3)

India (Baa3)Indonesia (Baa3)

Malaysia (A3)

Philippines (Baa2)

Pakistan (B3)

Taiwan (Aa3)

Korea (Aa2)

Mongolia (B2)

Sri Lanka

Bangladesh (Ba3)Vietnam (B1)

Thailand (Baa1)

0

50

100

150

200

250

300

0 1 2 3 4 5 6 7 8

EV

I (2

016F

)

M2/Reserves (2015)

» Rapid opening of the capital account would increase the likelihood of banking sector

liquidity stress given relatively low M2/FX Reserves coverage, reduce the effectiveness

of policy stimulus and increase risk of a material currency devaluation


Changing Structure of Financial System Balance Sheet» Many mid- and small-sized Chinese banks are increasingly reliant on wholesale funding. These banks

fund themselves in the interbank market and then invest the funds in higher-yielding “Shadow Banking”

instruments such as Wealth Management Products. They thereby boost their assets and earnings by

taking higher risk.

» In contrast, biggest state-owned banks are net lenders in the interbank market.

* Midsize and small banks include banks whose total assets are less than 2 trillion Yuan (as of year-end 2008 demonstrated in both RMB and foreign currencies).

^ Big 4 State-owned banks include ICBC, CCB, ABC and BOC.

Sources: PBOC, Moody’s Investors Service

Midsize and Small Banks* Big 4 State-Owned Banks^

0%

10%

20%

30%

40%

Jan-15 May-15 Sep-15 Jan-16 May-16

% o

f to

tal sourc

e o

f fu

nds

Inter-bank Non-bank FIRepo Central bank borrowingBonds

0%

10%

20%

30%

40%

Jan-15 May-15 Sep-15 Jan-16 May-16

% o

f to

tal sourc

e o

f fu

nds

Inter-bank Non-bank FIRepo Central bank borrowingBonds


» Company level data also suggests most listed Chinese commercial banks have increased their use of

wholesale funds in 2015.

» Our concern is exacerbated by the risk that many banks channel these short-term, confidence-sensitive

funds to support growth in their illiquid assets, include some shadow banking lending and investment

activities booked as “investment in loans and receivables” on the balance sheet.

Role of Wholesale Funding Increased Throughout 2015

Source: Moody’s calculation based on company reports

-10%

0%

10%

20%

30%

40%

50%

60%

Non-d

eposit f

inancia

l lia

bili

ties a

s %

of to

tal

financia

l lia

bili

ties (

avera

ge b

ala

nce)

2014 average balance change in 2015


Rising Interconnectedness Increases Systemic Risks

» With more banks now actively engaged in the interbank financial product business, they have become

more sensitive to the risk of potential counterparty failure.

» An increasing use of wholesale funds constitutes a systemic risk as it raises interconnectedness in the

financial system, which might amplify collective reaction to negative news and trigger liquidity crunch.

* Midsize and small banks include banks whose total assets are less than 2 trillion Yuan (as of year-end 2008 demonstrated in both RMB and foreign currencies).

^ Big 4 State-owned banks include ICBC, CCB, ABC and BOC.

Sources: PBOC, Moody’s Investors Service

0%

20%

40%

60%

80%

100%

2015Q1 2015Q2 2015Q3 2015Q4 2016Q1 2016Q2 2016Aug

Share

of

non

-depository

FI

deposits

held

by

all

depository

FIs

Midsize and small banks* Big 4 State-owned banks^ Others


Major imbalances created by rapid debt build-up are likely to corrode credit quality over time4




China’s authorities are aware

of this risk and will therefore

continue to apply existing

capital controls more rigorously

over a prolonged period

This “benign scenario” would

require substantial economic

and market reform which we

believe is unlikely at present

given slowing growth

momentum


Challenges Derived from Rapid Debt Accumulation Will Weigh on Growth and Corrode Credit Quality Over Time

Return on Assets for Industrial Corporates, %Incremental Capital-Output Ratio and Debt-Servicing

Ratio

Note: ICOR calculated as gross capital formation divided by the annual increase in real GDP. A higher value represents a lower

productivity of capital.

Sources: Moody’s Investors Service, Institute of International Finance, Haver Analytics

0%

2%

4%

6%

8%

10%

12%

14%

199

9

200

0

200

1

200

2

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

Retu

rn o

n A

sse

ts, %

SOEs Private Sector

2.0x

3.0x

4.0x

5.0x

6.0x

7.0x

0%

5%

10%

15%

20%

25%

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

Incre

menta

l C

apital O

utp

ut

Ratio

Debt

Serv

icin

g R

atio,

%

Debt Servicing Ratio, %

Incremental Capital-Output Ratio


Misallocation of Resources Reduces Growth Efficiency

China’s Capital Productivity is Decreasing

Incremental Capital-output ratio, %

Note: The Incremental Capital-Output Ratio is calculated as gross capital formation divided by the annual increase in real GDP. A higher the value

represents a lower productivity of capital.


2

3

4

5

6

7

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015


Deflationary Pressures Reflect Overcapacity and Weak Domestic Demand

Prolonged PPI Deflation and Subdued CPI Inflation

Annual % change


-9

-6

-3

0

3

6

9

Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16

Consumer Price Index Producer Price Index


SOE Reform Key to Economic RebalancingReform Tracker

Broad Reform Initiative Detailed Objective Date Policy Issuer Action/Progress

SOE Reform

Reduce overcapacity 2016.07 State CouncilPublishes “Suggestions on pushing forward central SOE corporate structure adjustment and

M&A”

Open state sectors for greater competition 2016.07 State Council Publishes “Suggestions on deepening investment and financing system reform”

Monitor trading activities 2016.07 SASAC and MOF

Publishes “state owned asset trading and monitoring administration method”, with the purpose

to standardize state owned asset trading activities and increase monitor to prevent state owned

asset loss.

Open state sectors for greater competition 2016.07 SASAC

Plans to expand the pilot scope of the 10 SOE reforms, such as to select 3-5 SOEs as state-

owned asset investment pilot companies and select 2 as state-owned asset operation pilot

companies. Pushes forward asset securitization. RMB 30 trillion state owned asset is

estimated to enter the stock market in near future.

Reduce overcapacity 2016.04PBPC, CBRC, CSRC,

CIRCReleases guideline on lending to steel and coal industries

Open state sectors for greater competition 2016.03 MOF Launches RMB 180 billion PPP fund

Open state sectors for greater competition 2016.03 State Council, NDRCIssue a circular to facilitate various reform initiatives, including the mixed-ownership reform of

SOEs

Open state sectors for greater competition 2016.02 State Council Launches 10 pilot programs to deepen SOEs reforms

Reduce overcapacity 2016.02 MOF, State Council Sets up fund (RMB 100 billion) for unemployment focus on the steel and coal sectors

Reduce overcapacity 2016.01 State Council Unveils guideline to address overcapacity in the steel industry

Financial Liberalisation Capital account liberalisation 2016.02 PBOCRemoves quotas for most overseas financial institutions to invest in onshore interbank bond

market

Fiscal System

VAT 2016.03 MOFVAT reforms are fully implemented in May 2016, expanding to the construction, real estate,

financial and consumer services industries

Individual tax 2016.03 MOF, SAT Work out a reform plan on individual income tax

RLG tax 2016.01 MOF Introduces guideline to enhance management of special transfer payments

Social

Hukou/Urbanization 2016.04 NDRC Sets tasks for urbanization in 2016, including helping more rural migrants settle in cities

Education 2016.03 State Council

Plans to raise the average number of years of education that Chinese working-age population

receives by 0.57 years to 10.8 years in five years, according to the draft outline of the 13th

Five-Year Plan (2016-2020)

R&D 2016.03 State CouncilPlans to boost R&D investment to reach 2.5% of GDP by 2020 according to the draft outline of

the 13th Five-Year Plan (2016-2020)

Environment 2016.03 State CouncilSets caps for consumption of water, energy and carbon emissions, according to the draft

outline of the 13th Five-Year Plan (2016-2020)

MarketResource pricing 2016.05 MOF, SAT Expands reform of resource taxes nationwide since July 1

Resource pricing 2016.01 NDRC Modifies retail fuel price mechanism

Government Administration Organization structure change 2016.05 State Council Vows to further cut red tape


Debt Burden Will Impose Substantial Cost on Economy, Which Will Need to be Allocated Between State, Banking System, and Corporate and Household Sectors

» Rising interest burden from elevated debt levels could eventually crowd out productive

investment, reducing the economy’s long-run growth potential. This outcome would be

credit negative for the sovereign and RLGs, as they would be likely to engage in

additional borrowing to support growth

» Delays to SOE restructuring would result in further resource misallocation at the

expensive of more productive companies. Direct government debt or contingent liabilities

related to rising SOE leverage would increase

» For the banking sector, the price is likely to be large unrecognised losses and the

associated impairment of sector profitability. In the absence of major debt restructuring,

banks may be under pressure to extend further loans to already highly indebted

borrowers, further impairing their performance and raising their recapitalisation needs

» Current policy mix, with credit growth continuing to outpace GDP expansion, a cautious

approach to restructuring highly indebted SOEs in overcapacity industries, and a renewed

emphasis on investment as a growth driver, make the above scenario more, rather than

less, likely in the medium term.


Key Takeaways4


Key Messages

China’s government has policy tools and willingness

to prevent an imminent financial crisis

Rapid financial liberalisation would weaken the

authorities’ ability to manage systemic risks

Major imbalances created by rapid debt build-up are

likely to corrode credit quality over time

1

2

3


Questions & Answers

41

Michael Taylor

Managing Director, Chief Credit Officer for Asia Pacific

Credit Strategy and Research

+852.3758.1327

[email protected]


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