The financial risks facing China's banking sector and the Government

In an article entitled "Revisiting China's Financial Asset Structure and Policy Implications", Yi Gang, Governor of the People's Bank of China (PBOC), analyzed the changes in China's financial asset structure from a risk-taking perspective.According to Yi, diversification, management, and allocation of risk are the basic functions of finance. The essential characteristic of the market economy is that economic entities make decisions dispersedly and bear their own risks. On the one hand, this is conducive to the diversification of risks, on the other hand, it is also a kind of incentive mechanism, whereby economic entities can get a corresponding return by taking risks.The responsibility of the government is to protect property rights and related rights and interests, so that social and economic entities have the initiative to take risks, so as to obtain the corresponding returns. It would be more efficient to give full play to the role of the market, with decentralized economic entities making decisions and taking risks, and the financial system would be more robust.

Financial assets are not risk-bearing to whoever holds them. Some assets are low risk to holders, such as savings deposits, insured by deposit insurance, and so on, and the risk is largely borne by the financial sector (a major part of which is ultimately borne by the government). There are assets where the risk can be transferred, such as mortgages, and banks can transfer some of that risk away.There are also some assets with different nominal and actual bearers of risk, such as many financial products before the regulation, which is supposed to be "entrusted financial management, bearing risks by oneself". However, due to the rigid payment, financial institutions such as banks actually bear the risks of investors.

According to the actual risk attribution of the major financial assets held by various departments, Yi's study roughly calculates the financial asset risks taken by households, enterprises, governments, financial institutions, and foreign departments. The general conclusion is that in recent years, the risk of financial assets has beenobviously concentrated in banks and other financial institutions, and a considerable part of the risk of financial institutions is ultimately borne by the government. At the end of 2018, the financial assets under the risk of financial institutions and government departments were RMB 365.9 trillionand RMB 118.7 trillion respectively, 5.85 times and 2.60 times of that at the end of 2007, accounting for 54.5% and 17.7% of the total financial risky assets, which amounted to 72.2%, 2.6 percentage points higher than that of 2007. The trend of risk concentration towards financial institutions is obvious. At the end of 2018, the proportion of risks taken by financial institutions increased by 14.2 percentage points compared with that at the end of 2007. In other sectors, the share of risk borne by the households, enterprises, and foreign sectors at the end of 2018accounted for 9.4%, 13.8%, and 4.6%, respectively.

Yi believes that risks should be dispersed and shared in a market economy. However, for more than a decade since the international financial crisis, the risks of China's financial assets have been concentrated in the banking sector, and debt financing. There are two main reasons for this:

First, the growth of direct financing, especially equity financing, has been slow. Direct financing involves direct transactions between non-bank economic entities and has higher requirements on the rule of law and credit environment. Direct financing, especially stock financing, has a low growth rate, and financing in the real economy is still dominated by indirect financing and debt financing, leading to a significant increase in the proportion of bank loans in all kinds of financing. At present, among financial instruments, the bond market is more constrained than bank loan financing, and the equity market is more constrained than the bond market. The concentration of risks in financial institutions, especially banks, is likely to distort incentive and constraint mechanisms, affect the efficiency of financial resource allocation, distort risk pricing, thereby leading to an excessive expansion of total financial assets and the deterioration of the quality of some assets, which in turn would magnify financial risks.

Second, macroeconomic performance has had an important impact on the financial structure. From 2003 to 2008, before the international financial crisis,China's economy was in an upturn with strong internal growth momentum. During this period, China's high savings supported domestic investment while generating a current account surplus. High economic growth also attracted large amounts of foreign investment, thus reducing the dependence of enterprises on debt financing such as credit. As economic growth exceeded credit and other debt growth, the macro leverage ratio declined steadily. After the outbreak of the international financial crisis, banks' debt financing grew rapidlyin the process of hedging economic downward pressure and expanding domestic demand. Not only did loans grow rapidly, but banks also financed some of their off-balance sheet and shadow banking activities through financing channels such as interbank, equity, and other forms of investment, which were mostly debt financing in nature.The significant rise in debt financing, coupled with the decline in nominal GDP growth, has led to a sharp rise in macro leverage.

In China, the study of financial assets is inseparable from real estate. According to the Financial Survey and Statistics Department of the PBOC, housing assets accounted for nearly 70% of urban household assets in 2019, exceeding the financial assets held by residents. There is a dual relationship between real estate and financial assets: (1) Real estate is an important asset of households and enterprises, while households and enterprises in turn constitute liabilities to banks through real estate financing. The financial assets of banks partly correspond to the real estate of households and enterprises. (2) A large number of loans were lent with real estate as collateral, and the rise of real estate prices will leverage more loans through collateral channels, which will reinforce each other.As loans are highly dependent on collateral, the distribution of collateral becomes an important factor affecting the capital flow and capital allocation of banks, which in fact is not conducive to the cultivation of a credit lending culture in banks, and is not conducive to the banks' function of identifying entrepreneurs and supporting innovative development as financial intermediaries. In recent years, the share of new real estate loans in new yuan loans rose from 25.4% in 2010 to 41.5% in 2017.

Over the past decade or so, the proportion of bank loans in all kinds of financing in China has increased significantly. After the international financial crisis, the role of domestic demand in economic growth has increased, and the demand for loan financing has become higher. It is inevitable that debt leverage will rise to some extent. However, the rapid expansion of credit backed by government credit and real estate as collateral leads to the concentration of financial risks towards banks and governments, and tends to form self-reinforcing mechanisms to accumulate excess capacity, real estate bubbles, and debt leverage risks. International empirical studies show that there is a relativelyobvious "inverted U-shaped" relationship between government debt and economic growth. Once the government debt ratio exceeds the threshold, it may have a negative impact on long-term economic growth and the economic growth rate.

On the basis of the judgment that the economic growth model driven by excessive debt expansion is unsustainable, the policymakers emphasize that they would not engage in intensive stimulus, and while maintaining the basic stability of aggregate demand, they would take the supply-side structural reform as the main policy to promote economic restructuring and reform,so as to achieve high-quality economic development. In recent years, China's overcapacity problem has been significantly alleviated, overall supply and demand have become more balanced, and the economy has become more resilient. From 2007 to 2015, China's GDP growth decelerated from 14.2% to 7%, a decline of 7.2 percentage points in nine years. From 2016 to 2019, China's GDP growth decelerated from 6.8% to 6.1%, a decline of 0.7 percentage points in four years. The overall downward adjustment of economic growth is converging. At the same time, the excessive rise in the macro leverage ratio has been contained. From 2017 to 2019, it has increased by a total of 2.8 percentage points, far lower than the average annual increase of over 10 percentage points from 2008 to 2016, and has remained basically stable, with corporate leverage ratio declining.

In the view of the researchers at ANBOUND, the 10-year comparative analysis of China's financial asset structure conducted by Governor Yi Gang actually provides a summaryof the current situation ofChina's financial sector from the perspective of asset structure.The relevant analysis is to observe and infer the changes in financial risks from the "static results" of financial asset composition in different time periods. From the perspective of research thinking, the relevant quantitative analysis does not analyze the causes, driving mechanism, and development logic of financial risks from the perspective of the causes of risk. However, the judgments on financial risks derived from the quantitative analysis are basically consistent with the macro observations and judgments. There is a clear trend of financial risk in China, i.e. financial risk is concentrated towards banks and the government, and it is significantly correlated with real estate.The COVID-19 pandemic, which is now spreading around the world, poses new challenges for China in addressing financial risks. Chan Kung, the chief researcher of ANBOUND, has studied the interrelationship between credit expansion, excess capital, financial risk, and crisis from the perspective of urbanization in the past. Chan Kung has long pointed out that the capital surplus caused by excessive urbanization is the most important feature of the current global market, and the "crisis triangle" constituted by "urbanization - capital surplus - economy and financial crisis" is an important reason for affecting or even controlling the economic pulse (see "Crisis Triangle", Chan Kung, September 2015). Based on this understanding, we should realize that a systemic solution to mitigate the financial risks facing China is certainly not something that can be solved in a piecemeal manner, but ratherit should be a systematic solution.

Final Analysis Conclusion

The empirical study of the PBOC shows that the concentration of financial risks in China towards banks and the government has a significant relationship with real estate. In the future, there is no magic bullet for mitigating China's financial risks, but rather a systemic approach is needed.