The rapid expansion of China’s economy over the past several years has cooled recently from prior GDP growth rates in the double digits as the government has become more willing to initiate policies to curb some of the excesses that drove that growth. But the country needs to do more according to a new report from the International Monetary Fund (IMF).

The IMF on Thursday published its Financial Sector Stability Assessment on China and noted that the country is now “undertaking a necessary but prolonged economic and financial transformation.” That transformation is one that is moving China away from its prior model based on exports and investment and toward a “more sustainable” economy based on services and consumption.

That transformation needs to prod China toward a more demand-driven system where markets, not government planners, play the primary role in resource allocation and one where the consequences of risk are well understood and accepted.

The IMF notes three areas of tension in the country’s financial system. First, while expansionary monetary and fiscal policy in recent years have promoted employment and growth, there is significant pressure — especially from local governments — to support failing firms rather than allowing them to close their doors. As a result, the IMF said, “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, investors seeking high-yield products, along with recent strengthening of government oversight of the country’s banks, has led to “regulatory arbitrage and the growth of increasingly complex investment vehicles.” Many of these investment vehicles are offered by non-banking institutions like asset management and insurance companies. Banks remain engaged in this system of indirect lending, “with uncertain linkages among numerous institutions constituting a challenge for supervision.”

Third, a reluctance among financial institutions to allow investors to lose money has led to a widespread belief in implicit government guarantees. The IMF noted:

[T]he 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.

To address the complexities — and problems — of China’s financial system, the IMF recommends a “gradual and targeted increase in bank capital.”

China’s corporate debt has now reached 165% of the country’s gross domestic product of nearly $12 trillion. U.S. corporate debt, excluding financial institutions, was about $8.4 trillion at the end of the third quarter of last year according to the Federal Reserve, or less than half of U.S. GDP of $19.4 trillion.

The IMF proposed a list of 35 recommendations to add to the stability of China’s financial system. Among the high-priority items on that list are these:

• De-emphasize high GDP growth projections in national plans that motivate setting high-growth targets at the local level.
• Trigger the countercyclical capital buffer, and review banks’ capital requirements with a view to a targeted— and in some cases substantial—increase in capital.
• Enhance group risk supervision and the ability to supervise banking and wider financial groups, as well as ownership structures, including the identification of ultimate beneficial owners.
• Eliminate the use of collateral in loan classification, constrain banks’ ability to roll-over credit to non-small and medium enterprise corporate borrowers, and classify all loans overdue by more than 90 days as non-performing.
• Triggers for activating a government-led crisis response should be more clearly defined, and limited to systemic cases that may require public resources.
• Develop a special resolution regime for banks and systemically important insurance companies.

In September, Standard & Poor’s lowered its sovereign debt rating on China from AA- to A+ due partly, at least, to “diminished financial stability.” It appears the IMF sees the same holes.

The IMF press release is available here and the full report is available here.

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