Executive Summary
As the global economy continues to struggle during the Covid-19 pandemic, China’s return to economic growth in the second quarter of 2020 was a rare positive surprise. Conventional wisdom credits China’s quick recovery to the distinct characteristics of China’s economy: a high degree of state control, directed flows of credit, and a high level of domestic policy credibility in responding to economic downturns.
But those same elements have also pushed China’s financial system deep into a gauntlet of systemic financial risks. Throughout the past decade, China’s financial system has ballooned in size much faster than its real economy. Economic growth has been facilitated by the largest single-country credit expansion in over a century. Yet until the Covid-19 outbreak, China had not faced a rapid slowdown, nor a financial crisis.
Despite rising inefficiency, China’s financial system has served as the shock absorber that has helped China’s economy recover from the virus outbreak and maintain growth. But as even Beijing acknowledges, a tree cannot grow to the sky, and the slow-motion credit risks now accelerating within China’s banking system are breaking through the calm surface of economic data. China’s financial system is highly vulnerable to the threats of falling property prices, defaults on loans and corporate bonds, tightening interbank market conditions, and capital outflows. But it is difficult to determine when these medium-term vulnerabilities will catalyze short-term financial stress and when that stress will become too severe for Beijing to handle.
The answer in this report, drawing from a previous CSIS report, Credit and Credibility, is that China’s financial system becomes most vulnerable when Beijing’s credibility erodes and implicit guarantees on assets are suddenly questioned. In some cases, credibility weakens during attempts to reform China’s system, while other events may force Beijing to react to rising credit risks and defaults. Building on the earlier work, this report explores the specific conditions and markets in which changes in government credibility can have a significant impact on systemic stability in China.
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