A year after the Bank for International Settlements (BIS) warned that a Chinese banking crisis was likely within three years, many of the flashing red indicators that led to the warning have disappeared. The most recent economic news has been more positive, featuring increased company profits and the reform of state-owned enterprises (SOE). In truth, though, such positivity should be met with skepticism. China may have successfully managed to stem its capital outflows and started coping with its huge debt pile, but the underlying problems remain almost as large as before. After the 19th Party Congress in November, China will have to address its issues in earnest. That process is likely to be fraught with risks.
A year ago the BIS, an international organization for central banks based in Switzerland, pointed out that China's credit-to-GDP gap, the BIS's favorite indicator of financial overheating, was well over the line of danger, considered to be 10 percent. In the first quarter of 2016, China's gap hit 30.1 percent — meaning there was an extremely high risk of a banking crisis within three years. Such a high and increasing level of debt was just one of several problems facing China; another was capital flight. A strengthening dollar and rising fears about China's economy had driven Chinese investors to quickly move their money abroad, forcing China to dip into its large pile of foreign exchange reserves to support the yuan. Between 2014 and 2016 these reserves had fallen from $4 trillion to $3 trillion. Warning lights flashed everywhere.
A Mixed Outlook
Today the situation looks considerably better for several reasons. First, the global economic environment has improved. Starting in 2016, a revival in energy prices increased inflation and a new positivity filled the global economy, which had been struggling against the threat of deflation for several years, and this positivity has outlasted a subsequent stagnation in energy prices. By the end of that year, every single region of the world was exceeding expectations in the Economic Surprise Index prepared by investment bank Citigroup. This positivity also reached China, which is tightly connected to the global economy. Meanwhile, the U.S. dollar, the strength of which had been challenging China's ability to defend the yuan, has weakened considerably through 2017 as markets have increasingly discounted the likelihood that U.S. President Donald Trump will achieve his economic ambitions. There has been growing acceptance that Trump's campaign promises on tax reform and deregulation will not be fully met, if they are met at all, and the administration's trade policy could prove harmful to the United States.
Within China, steps have been taken to stabilize areas that had been in danger of spiraling out of control. Starting in 2016, additional regulations were put in place to stop capital from leaving the country, and there has also been a campaign to deter Chinese companies from making unnecessary foreign investments. That move is likely to adversely affect property prices in Western cities such as Sydney, Toronto and London as investment capital returns to China. These steps have cumulatively reduced the downward pressure on China's currency, and the country's foreign exchange reserves topped shrinking in January and have remained stable since July at $3.08 trillion.
The picture of the debt and asset price bubbles in China tells a similar story. The government has pursued a dual strategy of keeping credit and monetary policy relatively loose in order to avoid an accident (some kind of credit event in which debtors can't repay their liabilities), while simultaneously damping down the most dangerous parts of the economy via regulation. For example, the introduction of macroprudential policies, targeted regulations which limit risk in specific parts of the financial system, to property transactions has helped reduce home prices in the top tier cities. The government has also raised the interbank lending rate, which is the rate at which banks borrow from each other (often small from large). And new regulations have helped curb the breakneck growth of wealth management products (WMPs), which are uninsured and one of the most worrying areas of Chinese debt.
This dual strategy is an attempt to sap some of the most dangerous risk out of the economy while keeping things stable in a crucial year. In November the Communist Party of China will meet for its 19th National Congress, when the country's leaders will take stock of China's progress and plan out a strategy for the years ahead. President Xi Jinping and his Politburo are highly motivated to avoid any major disruptions in case they reflect badly on the government at a time when protests or any sort of disorder could carry outsize weight. But risks are still prevalent. China's credit-to-GDP gap, which the BIS warned about last year, has fallen from its 2016 highs, but it is still at 24.6 percent, well above the 10 percent danger mark.
The Risk of a Funding Crisis
The most striking economic risk, particularly in the immediate term, is that of a funding crisis. With 130 trillion yuan in corporate debt outstanding, and much of that in short-term liabilities such as WMPs, the key danger is a crisis triggered in the money markets that keeps debtholders from rolling over their liabilities — similar to what happened to Lehman Brothers in 2008. While this is a real risk and has been for several years as China's debt has grown, it is one that is unlikely to explode in the next quarter. Considering the importance of the quarter, the government will be keeping a close watch and should be standing by to inject liquidity into any part of the system that needs it.
Of course, delaying a crisis is not the same thing as avoiding one, and while steps have been taken to reduce the economic risk, there is still a mountain of debt that needs to be disposed of safely. Using regulation to constrain debt growth is one thing, but at some stage it is likely that the government will have to actively attack the problem. Debt write-downs and bailouts could be combined with the doling out of harsh lessons. Those lessons would remove the moral hazard that results from investors believing that the government will always be there to save them, since an assumed rescue has been a primary driver behind the debt accumulation in the first place. The potential banking crisis outlined by the BIS may not be set to arrive before the end of the year, but China is still a long way from escaping it altogether.