At one level, this seems to be China’s moment. At a time of growing political incoherence and diminished leadership in the US and Europe, China seems to be the only adult in the house, taking the leadership on issues of critical importance to the globe such as trade and climate change. On the surface, the economy looks better, with economic growth stable, receding deflationary pressures and strong consumer confidence.

But, just as investors breathed a sigh of relief, new risks seem to be emerging. The financial sector is raising questions, while the rapid depreciation of the renminbi has increased speculation that a further fall in the currency could destabilise emerging economies. Given how important China is to the world economy and Asia, we need to understand how serious these risks are and what could go wrong, starting with the growing financial challenges.

Financial indicators are flashing red
The rapid pace at which China’s credit binge unfolded continues to create stresses in the financial system. Authoritative commentators are increasingly warning of rising risks for a variety of reasons:

  • The Bank of International Settlements has turned more cautious. BIS employs a measure comparing the actual credit-to- GDP ratio with its trend line. This so-called credit-to-GDP gap has reached 30.1 in China. Since BIS believes any level exceeding 10 signals an impending crisis, it sees a high risk of China suffering a banking crisis within the next three years.
  • The increasing dependence on wholesale financing raises alarm bells. A number of analysts have pointed to financial ratios that also signal rising chances of a shock. The Financial Times calculates a ratio of private-sector credit outstanding to standard commercial bank deposits to quantify the dependence of lenders on more risky wholesale funding — this ratio surged to 117% by the end of March this year from 84% at end-2008. On the other hand, S&P Global Ratings has a separate measure called the adjusted loan-to-deposit ratio, which includes a number of off-balancesheet items. This ratio has risen over time, reaching 80% at end- June for the system as a whole, but with some of the smaller banks already over the 100% level. Clearly, too many banks are resorting to off-balance-sheet lending through special purpose vehicles and sales of so-called wealth management products. While this trend is starting off from a low base, it raises the risk of contagion when a crisis of confidence occurs and credit flows dry up. There is no imminent threat, but the trend is worrying.
  • Corporate debt levels are high and rising. They now stand at 210% of GDP as at 1Q2016. The corporate debt service ratio is also on an uptrend. With the economy slowing and reforms to reduce overcapacity moving at glacial pace, corporate profits will come under greater pressure, resulting in a more onerous debt servicing burden. BIS estimated that the debt service ratio has reached a troubling level of 5.4.
  • The housing bubble is real. Soaring housing prices have prompted the authorities to roll out a slew of measures to curb property prices, but the housing market remains at elevated levels. Housing prices in Tier-1 (and even some Tier- 2) cities have soared more than 20% in 2016 year to date. Weak affordability ratios reflect how unsustainable this housing rally is. In Tier-1 cities, the ratio of house prices to household disposable income was close to 15 times at end-2015 and is estimated to be 18 to 20 times currently.

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