The China Economic Risk Matrix
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 the same elements have also pushed China’s financial system deep into systemic financial risks.
At a time when China’s economy is recovering much faster than the rest of the world from the COVID-19 outbreak, it may seem counterintuitive to start talking about systemic risks in China rather than those in other economies. But the same factors that facilitated that rapid recovery—a high degree of state control, directed flows of credit, and a high level of domestic policy credibility—are also among the factors that are now pushing China’s financial system deep into a gauntlet of systemic risk.
In Credit and Credibility, released two years ago, we tried to explain why China’s financial system had been so resilient to crisis despite experiencing the largest single-country credit expansion in the last century, with the banking system quadrupling in size in only a decade. Beijing’s credibility itself—in supporting financial asset prices through implicit and external guarantees—was the critical factor, rather than China’s high savings rates or the internal nature of its debt. But that credibility was beginning to fray as those guarantees needed to be extended into increasingly risky and fragile asset markets, where Beijing could not defend against financial losses and had no interest in doing so. Investors are now questioning Beijing’s guarantees—for risky investment products, bonds, companies, and even banks.
The consequences of that weakening credibility are now readily apparent in China. Last year, a bank failed in China for the first time in two decades. In May 2019, Baoshang Bank in Inner Mongolia was suddenly seized and reorganized. Four other banks have followed Baoshang into restructuring. Trust companies are seeing protests outside their headquarters from investors facing losses on trust products. Smaller regional banks have been subject to sudden bank runs. Even state-owned firms and local government financing vehicles are defaulting on both onshore and offshore bonds.
The COVID-19 outbreak and the resulting economic slowdown have compounded the credit risks within China’s financial system. More banks are being asked to roll over loans to highly indebted corporates that are short of cash, and thousands of small services sector businesses have closed their doors, perhaps permanently. This year marks the largest shock to household income and spending since Zhu Rongji’s state-owned enterprise reform in the late 1990s. But the economy and financial system as a whole still appear resilient, and it is difficult to ascertain when the pressures, bubbling beneath the surface, might burst into a larger financial crisis.
The need for better diagnostic tools of financial stress in China drove the development of the China Economic Risk Matrix, similar to a threat matrix in security parlance. The risk matrix attempts to track developments within the key areas of financial risk in China where changes in Beijing’s credibility can have an outsized impact on financial stability. It is not a predictive tool but a diagnostic one—more like a flood warning system rather than a signal that a particular dam will break.
The full report, The China Economic Risk Matrix, was authored in cooperation with the Center for Strategic and International Studies’ Trustee Chair in Chinese Business and Economics. It has been released today on the CSIS website.
Click below for the full report: