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Financial Sector Reform Vital to Rebalance, Sustain China's Growth

Customers at a Bank of China branch in Shanghai: the country’s financial system has grown more complex (photo: Qilai Shen/Newscom)

CHINA'S FINANCIAL SECTOR

Financial Sector Reform Vital to Rebalance, Sustain China's Growth

IMF Survey online

November 14, 2011

  • IMF's first China check-up part of review of the world's 25 major financial sectors
  • More complex financial system in China means more risk
  • Reforms will upgrade ability to respond to crises, support domestic demand

With China’s economy booming over the last two decades, faster reform of the country’s financial system is essential to sustain strong economic growth, support rising domestic demand, and keep risks at bay, according to the International Monetary Fund.

The IMF said in a report that the financial sector’s failure to continue to evolve, innovate, and operate on a prudent basis will create economic imbalances, and amplify the potential for problems in China’s financial sector to affect its economy.

China’s recent progress in creating a properly functioning financial system has helped the economy weather the global economic crisis. As the world’s second largest economy continues to grow, the demand for credit is growing rapidly, exacerbated by rising asset prices, including housing. As a result, credit is increasingly being sought from outside the formal banking system as the government tries to manage the flow of bank credit.

In its first assessment of the health of China’s financial system under the Financial Sector Assessment Program, the IMF said the risks are manageable, and can be addressed by reforms that upgrade the country’s capacity to respond to crises while supporting strong domestic demand.

“China’s banks and financial sector are healthy, but there are vulnerable elements that need to be addressed by the government, and experience in other countries has demonstrated the sooner these are addressed, the better,” said Jonathan Fiechter, deputy director of the IMF’s Monetary and Capital Markets Department and the head of the IMF team that conducted the assessment. “

China is one of the major 25 financial sectors that must undergo a review of its financial health as part of the IMF’s surveillance. The global economic crisis laid bare the devastating economic consequences a financial crisis in one country can have on the global economy. Countries with financial sectors that have the greatest impact on global financial stability are now required to undergo in-depth reviews of their financial health by the IMF every five years.

Risks are manageable with reforms to financial system

China’s financial system is growing more complex, with linkages between financial markets and institutions both within China and around the world, the IMF said.

The main risks to the financial system within the next three years are:

• The impact of the recent sharp credit expansion on banks’ asset quality

• The rise of off-balance sheet exposures and of lending outside of the formal banking sector

• The potential fall in the relatively high real estate prices

• The need for greater sophistication of financial regulation and supervision

• The contingent fiscal risks generated by the financial system

• The increase in economic imbalances due to the current growth pattern.

Four key reforms

The IMF recommended a wide range of actions to improve financial stability in China, and identified four high priority reforms to be implemented within the next three years.

The IMF said China should build a framework to identify, monitor and manage risks to the financial system as a whole; this should include increasing the resources and capacity of the People’s Bank of China and financial regulatory agencies carrying out regular stress tests.

China should expand the use of market-based monetary policy instruments using interest rates as the main instrument to govern credit expansion. This process should be supported by improved risk management in the banks and improved tools and techniques for sterilizing structural liquidity.

China’s should broaden and deepen its financial markets and services to create a more diversified and innovative financial sector. This will help provide businesses and household with access to long-term financing and facilities credit and capital-raising decision based purely on commercial principles.

The IMF said China should reduce the government’s reliance on the commercial banking system to pursue broader policy goals by making greater use of direct fiscal expenditures and explicit government sponsored credit programs,

Right pace of reforms will help transition

Careful planning, along with right pace and sequence of reforms will be critical to help China move to a more commercial-based financial system, according to the IMF. The following should be in place to help China’s transition:

• An effective and properly skilled regulatory and supervisory framework

• A well developed financial stability and crisis management framework

• Further moves toward greater exchange rate and interest rate flexibility, and capital account liberalization

• A clearer role for the government in the financial sector.

Stress tests

Chinese officials and the IMF conducted stress tests of the largest 17 commercial banks and found most would weather isolated shocks, such as a drop in asset quality, a housing market crash, cross-border exposures, and changes in the exchange rate regime.

The IMF found that if several of these risks were to occur at the same time, however the impact on the banking system would be severe.