On November 10, 2017, the Executive Board of the International Monetary Fund (IMF) discussed the IMF’s latest Financial System Stability Assessment (FSSA) of the People’s Republic of China.1
Since the 2011 Financial Sector Assessment Program (FSAP), China’s impressive economic growth has continued, and it is now undertaking a necessary but prolonged economic and financial transformation. While the financial system has facilitated this high growth rate, it has developed rapidly in size and complexity, and it has emerged as one of the world’s largest with financial assets at nearly 470 percent of GDP.
Tensions, however, have emerged in various areas of the Chinese financial system. First, monetary and fiscal policies aimed at supporting employment and growth have, in recent years, been expansionary. Pressures to keep non-viable firms open—rather than allowing them to fail—are strong, particularly at the local government level, where these objectives, at times, conflict with financial stability. As a result, the credit needed to generate additional GDP growth has led to a substantial credit expansion resulting in high corporate debt and household indebtedness rising at a fast pace, albeit from a low base.
Second, demand for high-yield investment products coupled with strengthening oversight of the banking sector has led to regulatory arbitrage and the growth of increasingly complex investment vehicles. Risky lending has thus moved away from banks toward the less-well-supervised parts of the financial system. Non-bank financial institutions, including asset managers and insurance companies, which offer a proliferation of investment products, have grown even faster than the banking sector. Banks continue to be positioned at the core of this highly interconnected system of indirect lending, with uncertain linkages among numerous institutions constituting a challenge for supervision.
Third, widespread implicit guarantees have added to these risks. A reluctance among financial institutions to allow retail investors to take losses; the expectation that the government stands behind debt issued by state-owned enterprises and local government financing vehicles; efforts to stabilize stock and bond markets in times of volatility; and protection funds for various financial institutions, have all contributed to moral hazard and excessive risk-taking.
The system’s increasing complexity has sown financial stability risks. Given the centrality of banks to the financial system, the FSAP team recommended a gradual and targeted increase in bank capital. The authorities have recognized these risks, including at the highest level, and are proactively taking important measures to address them. These include the strengthening of systemic risk oversight, further improving regulation, and moving toward functional supervision.
Executive Board Assessment
Executive Directors broadly agreed with the findings and recommendations of the FSSA. They welcomed the significant steps taken by the People’s Bank of China and regulatory agencies to strengthen financial sector supervision against a background of rapid financial sector growth and deepening. Directors commended the authorities for major reforms undertaken since the 2011 FSAP, notably in introducing Basel III standards, a risk-oriented solvency standard for insurers and improving oversight of securities market products. They encouraged the authorities to implement the recommendations of the FSSA to further strengthen systemic risk analysis and oversight, data quality and collection, and information sharing.
Directors noted the tension between sound microprudential oversight and significant risks posed by credit overhang and “shadow banking”. They noted that unresolved tensions between policies promoting the economic and financial transition and concerns to smooth the effects of adjustment—notably by maintaining GDP growth and protecting employment—could give rise to financial stability risks. In this context, they encouraged the authorities to align incentives at the national and regional levels to ensure that due priority is given to financial stability. For this, enhancing supervision of financial conglomerates and carefully sequenced reforms to tackle implicit guarantees, including for financial institutions and state-owned enterprises, will be important. Directors also recommended further efforts to ensure credible loan classification and uniform treatment of similar financial market products.
Directors stressed the importance of adequate legal protection, clear institutional mandates and accountability to ensure sufficient independence and resources for oversight agencies to act effectively and foster interagency cooperation. Clear prioritization of financial stability over development objectives at the agency and cross-sectoral levels—including in the proposed Financial Stability Sub-Committee—will be crucial to ensure that risks outside the regulatory perimeter are monitored. There is also a need for increased emphasis on functional supervision in addition to the current institution-based approach. Strengthening the financial safety net and the legal framework for bank resolution would improve incentives and reduce the potential risks to public resources that could arise from the failure of financial institutions.
Directors noted the significant expansion of fintech in the Chinese market and its benefits for financial inclusion and urged the authorities to further develop the oversight framework for digital finance, balancing innovation with safety and soundness.
Directors welcomed the progress in enhancing the AML/CFT framework. They called on the authorities to overcome remaining deficiencies and continue with efforts to align the framework with the revised Financial Action Task Force standard.