Abstract

As financial risks take shape, it is vital to accurately identify and effectively respond to these risks. The Chinese financial system specifically faces four major types of risks: credit risks, asset bubble risks, foreign exchange/foreign exchange reserve risks, and liquidity risks, as well as systematic risks thus triggered. In this paper, we probe into the formation and interaction of these risks and make concrete suggestions on how to boost the real economy, deleverage, and reduce bubble risks based on global cases, expert interviews, literature review, and BCG’s experience working with governments and businesses worldwide. In reference to the U.S. macro prudential regulatory system, we also suggest China regulate and prevent systemic risks through strong legislation, information communication, as well as better organizational structures and stronger state responsibilities.

• Credit risks: Credit grows too quickly with allocation failure, leading to credit risks
The Chinese economy features high leverage, excessive growth of loans, and imbalanced allocation of credit resources. Credit transfers—directly or indirectly—the operational risks of the state-owned part of the real economy to the financial system via shadow banking. In particular, massive overcapacities and redundant construction projects by local governments threaten the financial system’s ability to pay, build up credit risks, and thus lead to liquidity risks.

• Asset bubble risks: Ample liquidity that flows out of the real economy, together with shadow banking, blows the asset bubble
Monetary policy creates ample liquidity for economic growth, but credit resources are not allocated to the real economy where the return on investment is too low. Instead, the surplus money leaves the real economy for the real estate and stock markets. Shadow banking and financial innovations aloof from the real economy result in money circulating only within the financial system, which blows the asset bubble even bigger. Since the high-risk asset bubble is not sustainable, breaking the bubble will add to credit risks and cause liquidity risks.

• External risks: The expectation of a weaker Chinese yuan aggregates risks for foreign exchange reserves
As the foreign exchange rate fluctuates due to the U.S. Federal Reserve’s exit from quantitative easing (QE) and the appreciation and rate hike of the U.S. dollar, the Chinese financial system will have to deal with capital outflow, falling asset prices, and growing pressure on Chinese enterprises to pay back the principal and interest. In particular, the anticipated depreciation of the Chinese yuan is squeezing the liquidity space at home and propelling some liquidity premiums to return to an average level. Once the liquidity expectation hits a turning point and the asset price experiences a quick fix, the asset bubble will burst, causing liquidity risks.

• Liquidity risks: Multiple uncertainties lead to liquidity risks
Credit, asset bubble, and external risks all may lead to liquidity risks. While credit and foreign exchange reserve risks are generally controllable, precaution is necessary against the hard-to-estimate loss from the asset bubble burst caused by shadow banking. The damages by the asset bubble burst cannot be overestimated: it might trigger liquidity risks, worsen the credit environment, be a catalyst for massive bursts of bad debt earlier than expected, and increase panic capital flight, which will drain liquidity.

• Systematic risks: Systematic risks may be triggered by any or all of the above four interconnected risks
Any of the abovementioned four types of financial risks may trigger systemic risks, and under the New Normal, financial risks are embedded and intertwined with each other. Any risk at a link of the capital flow chain will lead to a series of more devastating risks, affecting stakeholders such as local governments, enterprises, financial institutions, and individual investors. We believe that while credit risks are generally controllable, deleveraging permits no delay. It is crucial to closely watch asset bubble risks, be more alert towards external risks, monitor and analyze liquidity risks, and take precautions against systematic risks.

The weak real economy is the root cause for all the above risks. Therefore, a fundamental prescription to preventing financial risks is boosting the real economy and actively responding to the New Normal by various means. In the short and medium run, China should focus on bringing down credit risks by deleveraging in order to resolve the debt crisis, optimize credit allocation, and revitalize the real economy. In the medium and long run, China may draw experience from the United States, to improve its macro prudential regulatory system in order to prevent systematic risks and avoid a hard landing.

• Active response: Boost the real economy by various means
Faced with the reality of slowing economic growth, China should recognize that the old path leads only to a dead end. The viable path forward is accelerated shift of the economic growth model, vigorous economic restructuring, industrial upgrading, and developing new economic growth drivers. To this end, we suggest: 1) reducing government intervention, 2) continuing to advance the mixed-ownership reform in state-owned enterprises (SOEs), 3) improving market entry rules and fallback policies, 4) reducing tax burdens, and 5) breaking financial constraints.

• Active precautions: Learn from the U.S. government’s deleveraging in the crisis, reduce the “existing” leverage and keep the “incremental” leverage under control
Following the outbreak of the financial crisis in 2008, the U.S. government cut leverage by reducing “numerators” and expanding “denominators,” achieving desired effects. Drawing from the United States experience, we suggest: 1) the corporate sector should cut overcapacities and deleverage at the same time, 2) the financial sector should take active precautions against systematic risks, 3) differentiate good “existing” leverages from bad ones and tighten macro prudential regulation, and 4) the government should control the “incremental” leverage and stick to the bottom line in bailout.

• Better regulation: Learn from the United States and improve the macro prudential regulatory system
Precautions must be taken because once triggered, systematic risks are devastating to the whole financial system or even the entire economy. Drawing experience from the U.S. government in its prevention of systematic risks in the post-crisis era, we have the following suggestions for China’s macro prudential regulatory system: 1) constructing a legal framework, 2) strengthening regulatory functions and allowing for statutory mandates and administrative power, 3) maintaining full transparency, 4) conducting multi-dimensional analysis and surveillance, 5) having sound governance and organizational structures, and 6) laying the basis for effective operation of a inter-departmental committee.