THE CHINESE financial system faces “a steady build-up in vulnerabilities” that require the government to relax its grip on banks, the exchange rate and interest rates, the International Monetary Fund said in its inaugural evaluation of China’s financial sector.
The IMF applauded the progress that China has made in giving freer rein to market forces and strengthening regulation, but warned of a series of short-term risks facing the world’s second-biggest economy, from defaults on infrastructure projects to the rise of shadow banking.
“While the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and the formation of bubbles, especially in real estate,” said Jonathan Fiechter, head of the IMF team that conducted the analysis.
“The cost of such distortions will only rise over time, so the sooner these distortions are addressed the better.”
In charting out a rough guide for policymakers, the IMF said that one of the most important early reforms for China was to make its exchange rate more flexible.
At the same time, it said that banks, which are still owned and closely controlled by the government, needed to operate on a more commercial basis.
Focusing on the danger from a fall in housing prices – something that has started over the past month, long after the IMF completed its assessment – the report was cautiously optimistic.
The evaluation noted that both real estate developers and mortgage borrowers had relatively low leverage, mitigating the impact of a downturn on the banking system.
But the IMF also said that banks “could be severely impacted” if a housing correction occurred at the same time as other risks such as capital outflows and tumbling equity markets.
It added that some of the new risks facing China were products of the reforms that it has set in train over the past three decades: “The system is becoming more complex and interlinkages between markets, institutions, and across international borders are growing,” the IMF evaluation added.
In the medium term, the IMF said that a relatively inflexible macroeconomic policy framework and the government’s heavy hand in the banking sector “could impair the needed reorientation of the financial system to support China’s future growth”.
The IMF conceded that its assessment was hindered by data gaps and constraints on access to confidential information.
The report was based on the Financial Sector Assessment Program for China conducted by the IMF and World Bank from June to December last year.
It was the first such report published about China after the assessments were made a mandatory part of surveillance by the IMF every five years for jurisdictions deemed systemically important. – (Copyright The Financial Times Limited 2011)
