China's debt levels pose stability risk, says IMF

Health check of financial system says reforms have not gone far enough and notes similarities to US before 2008 crisis

Fears that China risks being the cause of a fresh global financial crisis have been highlighted by the International Monetary Fund in a hard-hitting warning about the growing debt-dependency of the world’s second biggest economy.

The IMF’s health check of China’s financial system found that credit was high by international levels, that personal debt had increased in the past five years, and that the pressure to maintain the country’s rapid growth had bred an unwillingness to let struggling firms fail.

While praising China’s president, Xi Jinping, for his commitment to improving financial security, the IMF said reforms by Beijing in recent years had not gone far enough.

“The system’s increasing complexity has sown financial stability risks,” the IMF’s assessment said. “Credit growth has outpaced GDP growth, leading to a large credit overhang. The credit-to-GDP ratio is now about 25% above the long-term trend, very high by international standards and consistent with a high probability of financial distress.

“As a result, corporate debt has reached 165% of GDP, and household debt, while still low, has risen by 15 percentage points of GDP over the past five years and is increasingly linked to asset-price speculation. The buildup of credit in traditional sectors has gone hand-in-hand with a slowdown of productivity growth and pressures on asset quality.”

The report said China should put less emphasis on targets for growth, which led to excessive credit expansion and higher levels of debt at local level; that it should beef up financial supervision and put increased emphasis on spotting risks ahead; and that it should gradually increase the amount of capital targeted banks should hold.

China was one of the prime engines of world growth when countries in the developed west were struggling during and after the financial crisis of 2008-09, but the expansion relied heavily on higher public spending and easy credit. Xi is trying to move China to a different model where growth is slower but more sustainable.

The IMF supported this approach, noting that tensions had emerged in various areas of the Chinese financial system. There had been a commitment to supporting growth and jobs, coupled with pressures to keep non-viable firms open. The credit needed to stimulate higher growth had “led to a substantial credit expansion resulting in high corporate debt and household indebtedness rising at a fast pace, albeit from a low base”.

The IMF also noted developments in the Chinese financial system similar to those in the US in the years before the financial crisis of a decade ago. Supervision of banks had been tightened up but demand for high-yield investment products had led to attempts to escape regulations though increasingly complex investment vehicles. “Risky lending has thus moved away from banks toward the less well-supervised parts of the financial system,” the IMF said.

It added that risk-taking was encouraged by a reluctance among financial institutions to allow individual investors to take losses, an expectation that Beijing would bail out state-owned enterprises and local government financing vehicles, and efforts to stabilise financial markets in volatile times.

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Larry Elliott Economics editor

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