The recent assessment of China’s financial stability by the International Monetary Fund highlights increasing vulnerabilities stemming from the government’s role in the lending process, and an inflexible interest rate policy. Those who regard weaknesses in the banking sector as a likely trigger for a financial collapse have railed against China’s negative real interest rates and the speculative activity this has spawned.
But focusing on emerging financial risks is a case of treating the symptoms of the problem, rather than its origins. With its responsibilities for providing a broad range of services for a mixed socialist economy, it is surprising how small China’s budgetary footprint actually is. Beijing has been using the financial system to fund public expenditure needs – many of which are not commercial in nature and would normally be undertaken through the budget. While this was unavoidable in the earlier years, it has turned out to be a politically attractive and effective option in dealing with the volatility of the global economy over the past decade.
As such, these hidden banking losses are actually quasi-fiscal deficits, rather than traditional non-performing loans. While on paper China’s does not run major budgetary deficits, these quasi-fiscal deficits in the banking system have been accumulating over the years, awaiting the time when the non-performing loans are formally recognised and written off. While one cannot dispute that China needs to act on financial reforms, the real challenge is for Beijing to recognise the importance of strengthening its fiscal system to undertake expenditure requirements in a more transparent and potentially less destabilising fashion. Continue reading »