Crisis looms: The challenges facing China’s banks and their global implications - I by IMD (2024)

A banking crisis in China has the potential to disrupt global financial markets, supply chains, and international trade – causing widespread economic repercussions. What can be done to avert such a disaster?

A January ruling by a Hong Kong court opened a new chapter in the downfall of China Evergrande, the world’s most indebted real estate giant. The decision to wind up the company arrived some two years after its official default, an event that itself sent shockwaves through the Chinese financial system.

Today, China’s banks are still grappling with the prolonged turmoil in the property sector. In a bid to stabilize wobbly regional banks, Chinese provinces injected a record $31bn of capital last year through special-purpose bonds, underscoring the vulnerabilities within one of the world’s most crucial financial systems.

Several other indicators suggest the potential for a banking crisis in China, rooted in its ailing property sector. There’s been a sharp rise in consumer credit defaults in the country, particularly in the real estate sector. The number of individuals blacklisted for missed payments across various financial obligations, including mortgages and business loans, reached a record high of 8.5m last year, up from 5.7m in early 2020.

This is putting immense pressure on Chinese lenders, leading to the use of special-purpose bonds to prop them up. And given the state-owned nature of many of these banks, there’s a risk that the crisis could spread beyond the banking sector and affect the broader economy – already at its slowest rate of expansion in decades.

China’s economic growth has been heavily reliant on the real estate sector, averaging 13.4% of GDP since 2013. With hundreds of millions of people transitioning out of poverty and entering the middle class in the past 40 years, property ownership has been a key indicator of prosperity and stability for many Chinese households.

Despite previously rapid growth, the Chinese economy is now experiencing a slowdown amidst challenges such as record debt levels and a low birth rate. For decades, the Chinese economy grew by more than 8% a year, but growth slipped to 5.4% last year and is projected to slow further to 3.5% by 2028, according to the International Monetary Fund (IMF).

Dependence on state intervention creates ‘a systemic risk’

Unlike Western banks, which operate more independently, Chinese banks are predominantly state-owned, with the government holding majority ownership of the five largest commercial banks, accounting for over half of the country’s banking system assets. This ownership structure means Chinese state-owned banks provide loans with the understanding that the government will step in with support if borrowers encounter difficulties in repaying their loans.

However, this reliance on state support creates, in my view, a systemic risk. If there’s a widespread banking crisis, as I suspect there will be, the government may struggle to honor all the guarantees it has provided, leading to financial instability.

He potential impact of a banking crisis in China could be exponentially greater than even the US subprime mortgage crisis of 2007-08, given the size and interconnectedness of Chinese banks with the global financial system. The four biggest banks in the world by total assets are all Chinese, led by the Industrial and Commercial Bank of China with assets totaling $5.4tn.

This highlights the importance of monitoring systemic risks and addressing vulnerabilities in the Chinese banking sector.

Ripple effects on global financial markets and international trade

As some of the largest banks in the world, any significant problems in the Chinese banking system would reverberate throughout the global financial system.

Consider how China is a key player in global supply chains, with many multinational companies outsourcing production to Chinese manufacturers. A banking crisis could disrupt these supply chains, leading to potential delays in production, increased costs, and supply shortages for businesses worldwide. This could impact industries ranging from technology to automotive to consumer goods, all of which rely on China as “the world’s factory.”

Moreover, financial markets are highly interconnected, and a banking crisis in China could trigger a contagion effect, spreading panic and instability to other parts of the world. Investors may become more risk-averse, leading to selloffs in global equity markets, increased demand for safe-haven assets, and disruptions in credit markets.

Implications for domestic businesses, consumers, and China’s global competitiveness

The performance of Chinese banks is integral to the country’s economic competitiveness. A banking crisis would have significant implications for both domestic businesses and consumers due to the central role of the banking sector in the economy – and the government’s influence over it.

A crisis would likely result in tightened credit conditions as banks become more cautious about lending due to heightened risk aversion and capital constraints. This could make it difficult for businesses to access financing for investment, expansion, or day-to-day operations, potentially stifling economic growth and job creation.

Furthermore, uncertainty and financial instability could dampen consumer confidence and spending. Faced with job insecurity or reduced access to credit, consumers may cut back on discretionary purchases, leading to a slowdown in domestic consumption and overall economic activity.

China is already experiencing deflationary pressures, with consumer prices falling at their quickest annual rate in 15 years in January. That may, in turn, impact demand for goods and services from other countries, affecting global trade flows and economic growth.

Another risk is that the Chinese government may prioritize stabilizing the banking sector during a crisis, potentially diverting resources and attention away from other areas of the economy. This could result in delayed or limited support for struggling businesses and consumers, exacerbating the economic impact of the crisis.

And, unlike in some Western countries where businesses can turn to public debt markets for financing, China has a less developed bond market. This means that businesses may have limited alternative sources of funding during a banking crisis, further exacerbating their financial challenges.

What’s more, the performance of Chinese banks influences international perceptions of the country’s economic stability and reliability as an investment destination. A banking crisis could dampen investor confidence, leading to reduced investment in the Chinese market.

Transparency and credit standards: key strategies for resilience

In the short term, mitigating the risk of a banking crisis relies primarily on measures implemented by the People’s Bank of China (PBOC), its central bank, and the central government. The PBOC and other regulatory authorities oversee the banking sector to ensure compliance with prudential regulations and risk management standards. This includes monitoring capital adequacy, liquidity, and loan quality to prevent excessive risk-taking and promote financial stability.

The Basel Committee on Banking Supervision, based in Switzerland, sets global standards for banking regulation, including capital adequacy requirements and risk management practices. Chinese banks comply with these standards, which help mitigate systemic risks.

Beyond this, deposit insurance plays a crucial role in protecting depositors and maintaining confidence in the banking system. Chinese regulatory authorities have been working to strengthen deposit insurance mechanisms to provide greater stability and ensure that depositors are adequately protected in the event of bank failures.

Additionally, regulatory authorities are focusing on improving risk management practices within banks to identify and mitigate potential vulnerabilities. This includes measures to strengthen corporate governance, enhance transparency, and improve the assessment and monitoring of credit and market risks.

Private sector mechanisms can promote financial stability and efficiency

But while state support has traditionally played a significant role in China’s banking sector, there’s a growing recognition of the importance of private sector mechanisms in promoting financial stability and efficiency.

There’s a broader push to encourage market reforms and foster greater competition within the banking sector. This includes initiatives to liberalize interest rates, promote the entry of private and foreign banks, and reduce regulatory barriers to innovation and competition.

Encouraging market reforms will be essential. A banking system dominated by state-owned lenders with limited competition will suffer from inefficiencies, bureaucratic hurdles, and a lack of incentive to innovate. Opening the financial sector to greater competition can spur efficiency gains, enhance financial services, and support economic development. There can be no capitalism without competition.

Additionally, increasing transparency about risks is a crucial step towards ensuring the stability and resilience of the banking industry. Clear and comprehensive disclosure of lenders’ financial health, risk exposures, and risk management practices can help both regulators and investors better understand and assess the risks within the financial system before they escalate into crises.

Tight credit standards are also essential for maintaining the quality of bank assets and mitigating the risk of loan defaults. By enforcing rigorous lending criteria, such as assessing borrowers’ creditworthiness and collateral, banks can reduce the likelihood of non-performing loans and preserve the integrity of their balance sheets.

The precarious state of China’s financial system raises alarm bells for global economic stability. By reducing the dominance of state-owned banks and fostering a more competitive environment, China can fortify the resilience of its lenders and uphold its competitiveness on the world stage.