Testing times

It is imperative that contingency plans are in place to cope with any financial crisis

China's socioeconomic development is faced with a more challenging international environment under the complex global landscape right now. As its economic growth is suffering the triple pressures of shrinking demand, supply shocks and weakening expectations, it is important to adopt strong measures to prevent and resolve systemic financial risks across the board.

The systemic financial risks are mainly in four sectors: non-financial businesses, the real estate sector, local governments and small and medium-sized financial institutions. And they are closely intertwined.

The leverage ratio of non-financial enterprises in China is significantly higher than that of other emerging economies. The rise in the leverage ratio of the non-financial corporate sector over the past decade can be mainly attributed to the rise in the debt of State-owned enterprises and the financing platform of local authorities. The debt risk of non-financial enterprises will lead to the deterioration of the balance sheets of commercial banks and worsen the solvency of local governments due to hidden guarantees.

The leverage ratio of China's real estate sector rose rapidly after the global financial crisis. Consumer loans, especially home mortgages, are the main component of household debt. If risks break out in the real estate sector, there will be widespread loan defaults, which will lead to a deterioration in the balance sheets of banks and a decline in the revenue of local governments from land sales.

The debt risk of the public sector is mainly concentrated at the local level. The debt risks of local governments not only present a huge burden to the central government, but also worsen the balance sheets of financial institutions that are related to local State-owned enterprises and financing platforms.

Risks in the financial sector can be found mainly among small and medium-sized financial institutions. Compared with larger institutions, the smaller ones, mainly joint-stock commercial banks and local financial institutions, have lower capital adequacy ratios and are more vulnerable to financial risks. Such institutions could see their capital chains under threat in the event of exogenous shocks, which will further aggravate the transmission of financial risks due to the interconnected nature of the financial system.

China's financial security is now faced with shocks from the following.

The country's economic growth rate has been slowing since 2007, mainly because of a decline in the potential growth rate. The decline of China's potential economic growth rate is closely related to an aging population and the transitioning from traditional to new growth engines.

The COVID-19 pandemic continues to have an impact on all aspects of social and economic development, and it has also spawned financial risks. On the one hand, the pandemic has disrupted the operations of Chinese enterprises, especially small and medium-sized ones, and the profitability of non-financial businesses has been significantly affected. On the other hand, the pandemic has hit the fiscal income of local governments hard.

China's financial market, which is an important part of the global financial market, has suffered significant repercussions from global geopolitical conflicts. The violent fluctuation of China's financial market may aggravate the operational risks of small and medium-sized financial institutions. Meanwhile, risks in the global financial market may be transmitted across borders. For example, the rapid rise in bulk commodity prices could result in imported inflation in China.

The US Federal Reserve may sharply raise interest rates and shrink its balance sheet. The Fed's continuous interest rate hikes and the global geopolitical conflicts may exacerbate capital outflows from emerging market countries, which may be confronted with negative shocks such as depreciation of currencies, rising foreign debts and falling asset prices. In addition, due to the high sensitivity of risk asset prices to interest rate hikes, interest rate hikes by the Fed may trigger turbulence in US and other financial markets, and put China's financial security at risk.

China must resort to a host of measures to respond to the risks.

First of all, it is necessary to take the approach of preventing the formation of new risks while diffusing old ones. China should focus on the handling of local government debts, excessive volatility in the real estate market and gaps in the capital of small and medium-sized financial institutions. The existing risks in China's financial sector originate from the blind expansion of financial institutions and shadow banks, the blind development of the real estate market and the disorderly growth of local government debts.

The nation should coordinate the resources from both home and abroad, and maintain appropriate capital controls to rein in the impacts from frequent and large-scale capital flows over the short term. Expedited steps in the opening of the financial system often mean an increase in potential systemic financial risks, which must be taken seriously. Meanwhile, in order to prevent and defuse systemic financial risks and prevent international spillovers of risks, the government should maintain appropriate capital account controls to create a relatively stable domestic financial environment.

It is important to actively promote the internationalization of the renminbi and strive to gain more say in the global financial sector. The continuous evolution of global geopolitical conflicts and the financial sanctions that the United States-led Western hegemony has imposed show that Western nations dominate the international finance, the power of discourse and the right to print money. In order to ensure China's financial security, one of the important starting points is to actively promote the internationalization of the renminbi, especially to enable the Chinese market to obtain stronger pricing power for bulk commodities through renminbi-denominated trade settlement.

Finally, the government should also actively develop contingency plans to deal with potential crises. Financial crises, after all, cannot be completely avoided, and their breakout is unpredictable. A government will not only be caught off guard but also miss the best opportunity for remediation if it waits for risks to break out at a financial institution and then makes a temporary plan. Relevant contingency plans need to focus on three key aspects: controlling the scope of any financial crisis, ensuring the contingency plan targeted and effective, and taking advantage of the crisis to push forward reforms.

Zhang Ming is deputy director of the Institute of Finance and Banking at the Chinese Academy of Social Sciences and deputy director of the National Institution for Finance and Development. Pan Songlijiang is a doctoral candidate at the School of International Relations, University of Chinese Academy of Social Sciences.

The authors contributed this article to China Watch, a think tank powered by China Daily.

The views do not necessarily reflect those of China Daily.

Contact the editor at editor@chinawatch.cn