IMF sees China’s financial sector risks elevated and still rising

The IMF’s latest country financial system stability assessment for China under its Financial Sector Assessment Program (FSAP) was released on April 30. China, other large emerging economies and advanced economies constitute the group of countries of greatest systemic importance to the international financial system. For these countries, IMF risk assessments are mandatory and typically performed regularly every five years. The latest China assessment has been long awaited as its previous assessment was conducted almost eight years ago in 2017.

The IMF notes that Chinese financial sector risks, which have increased since 2017, are expected to increase further. Much of the risks stem from the four-year contraction in the construction and real estate sector and the struggles of local governments to deal with debt incurred through the use of off-budget local government financial vehicles (LGFVs), and at the same time the economic growth is slowing. Thus, the quality of bank portfolios is under pressure from many directions. In addition, banks’ net interest margin has narrowed in recent years, eroding bank profitability. This trend may continue as the central bank is expected to lower its policy rates further to support economic growth and fuel inflation.

The IMF’s concerns focus largely on small banks, which tend to have smaller capital buffers and higher financing costs. China’s large financial institutions appear to be in better shape and perform better in stress tests even under major shocks. On the other hand, the actual quality of bank loan portfolios is suspect as loan servicing flexibility granted during the pandemic persists and implicit government guarantees distort the pricing of risk. The IMF is also concerned about non-bank financial intermediaries. These entities have significant operations and close bank relations, yet so little is known about their linkages to the financial system the risks they pose are impossible to assess.

At several points in its assessment, the IMF laments the failure of Chinese officials to provide requested detailed financial sector reporting. These weak areas include data on the exposure of banks to LGFV indebtedness and sometimes even key balance-sheet items. The assessment also highlighted the lack of information about smaller banks and non-bank intermediaries. One of the functions of the FSAP is to help local officials identify financial sector risks, which is very challenging when local officials fail to provide the relevant information. The IMF notes that the under-reporting may mask hidden vulnerabilities to the financial sector.

Based on the assessment, the IMF offered 33 recommendations to China on developing its financial sector. Among other things, the IMF called for China to devise a comprehensive plan for dealing with LGFV indebtedness and encouraged Chinese officials to come up with a comprehensive crisis resolution framework for the banking sector and a framework for providing emergency liquidity financing. Banking sector transparency could also be improved in a number of ways. More information about financial institutions needs to be publicly available and the quality of the information needs to be better. Officials should assure that Chinese financial institutions can identify risks, report anticipated losses in their entirety and adopt market-based pricing of risk.