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IMF raises red flags about China's financial system

China intervention | IMF raises red flags about China's financial system Ian Fraser

In its first ever formal assessment of the stability of China's financial system, the International Monetary Fund has blamed heavy-handed government intervention for creating "vulnerabilities" in the system, whilst providing Beijing with a detailed blueprint for reform. What the IMF recommended and what China's reaction was is a fascinating discussion to read into.

The Washington-based fund conceded that the People's Republic has made significant strides in its transition towards a more market-based and financially sound system, but said there's room for improvement in the "structure, performance, transparency, and oversight of financial institutions and markets".

Jonathan Fiechter, deputy director of the IMF monetary and capital markets department, said:

“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. The cost of such distortions will only rise over time, so the sooner these distortions are addressed the better.”

In its 74-page report, published on November 14, the IMF said China's growth model, its inflexible macroeconomic policy framework, and the government’s role in credit allocation were leading to a build-up of contingent liabilities. As a preliminary step, the Washington-based fund urged Beijing to loosen its grip on the yuan currency by removing the dollar peg, saying:

"The current high levels of foreign exchange intervention, limited exchange rate movements, and strong incentives for capital inflows hamper systemic liquidity management and control. Steps to drain large amounts of structural liquidity along with moves towards a liberalized and flexible exchange market will reduce financial stability risks and afford the central bank with greater levers for monetary control."

The fund also recommended that, to improve monitoring, regulation and supervision of the financial system, the country's central bank, the People's Bank of China, should be given greater independence and should form the secretariat of a new body to be called the Financial Stability Committee, which would take on responsibility for macro-prudential surveillance.

The IMF said the proposed new body would be expected to keep track of liquidity in China's financial system and monitor other systemic risks -- as well as making recommendations to address these. The IMF also recommended that the People's Bank of China start by absorbing the significant "liquidity overhang" in China.

"This will involve a much more aggressive use of open market operations to reach a point where the PBC no longer needs to rely on administrative limits on bank lending. As liquidity conditions tighten, banks will have incentives to improve their internal liquidity management functions and focus more on assessing risk-return trade-offs in allocating loans."

The IMF made a total of 29 detailed recommendations on how Beijing might reform and strengthen the Chinese financial system. Others included: allowing state-owned banks to make lending decisions based on commercial risk as opposed to government diktat; determining the country's interest rates by "supply and demand"; and introducing a broad-based property tax to promote more orderly development of the real estate market. To address the property price bubbles, the IMF suggested:

"A comprehensive set of measures—including the completion of the interest rate and exchange rate reforms, further capital market development, gradual opening of the capital account, and fiscal reforms, including initiating a broad-based property tax."

The IMF said stress tests of China's 17 largest commercial banks had revealed that "most" are capable of withstanding "isolated shocks". However, the fund warned that a confluence of events - possibly including a slump in property prices, a sharp deterioration in asset quality, a change in the yield curve, changes in the exchange rate - could "severely" impact the Middle Kingdom's banks, many of which are exposed thanks to the rise of off-balance-sheet liabilities and the country's recent property bubble.

In a statement published on November 15 the People's Bank of China said:

"While the assessment in the report is overall objective and positive, and the recommendations on the future reforms are constructive, we also noticed that a few points in them are not sufficiently well-rounded or objective, and the time frame and suggested priorities of some proposed reform measures need to be further analyzed by taking account of many reality factors of China."

Further reading on China and China's financial system:

Tags: asset price bubbles , asset quality , banks , Beijing , capital allocation , China , China economy , china financial policy , china future , China housing bubble , china real estate , Chinese banks , Chinese government , currency manipulation , future of china , global liquidity , global liquidity imbalances , IMF , International Monetary Fund , Jonathan Fiechter , liquidity , liquidity overhang , liquidity risk , PCB , People's Bank of China , property price bubbles , property tax
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