Box B: Financial risks in China and implications for New Zealand
China’s strong economic growth in recent years has made it increasingly important to the global economy, and to New Zealand as a trading partner. However, China’s growth has recently been associated with the build-up of fragilities in the financial sector. The potential for financial instability has been brought into focus in 2014 as a result of two corporate bond defaults and losses on several trust investment products. This box discusses three main sources of financial risk in China and identifies the channels by which a financial crisis and a resulting sharp slowing in GDP growth in China could affect New Zealand.
China has experienced a rapid expansion of credit since 2008, which has helped to sustain strong growth in investment over the same period.1 A growing proportion of credit has been intermediated outside the formal banking sector (figure B1). This so-called ‘shadow’ banking sector includes informal lending between businesses, off-balance sheet activities of banks, lending by trust companies and non-bank financial institutions, and funding of local governments through special purpose investment vehicles.
Figure B1: Sources of financing in China (flow of financing as a percent of GDP)
Source: Haver Analytics.
Note: Total social financing includes foreign and domestic bank loans, trust loans, entrusted loans, private loans, corporate bonds, equity issuance, and bankers’ acceptances.
Both the banking and shadow financing sectors in China face significant risks associated with funding industries that have significant overcapacity. In addition, the risk on these investments is potentially underpriced, as one way the shadow banking sector funds these projects is through wealth management products distributed through banks. Savers may believe the banks implicitly guarantee these products. If left unsupported, shadow banking products have higher risk than traditional bank products, as the sector is less regulated and supervised than the banking sector. Weaker leverage and liquidity requirements create an incentive for riskier transactions to take place in the shadow banking sector.
A second source of risk in the Chinese financial system is associated with local government financing. Local governments have funded long-term investments with short-term debt raised via corporate entities known as local government financing vehicles (LGFVs).2 These funding vehicles therefore face significant funding and liquidity risks. LGFVs have become increasingly reliant on shadow financing to roll over funding. A recent audit of local government finances undertaken by China’s National Audit Office estimated local government debt to be 33 percent of GDP as at June 2013 – over half of which is set to mature by the end of 2015.
A third significant risk to the Chinese financial system is the potential for a sharp decline in property prices. Property prices in China have experienced several periods of rapid growth in recent years (figure B2). This growth has been underpinned by strong housing demand in large cities due to urbanisation, as well as increased speculative investment. Low returns on bank deposits encourage savers in China to invest in property. Local governments also rely on property markets and land sales as sources of revenue and as collateral for raising funds via LGFVs. A sharp fall in property prices would reduce household wealth, increase balance sheet stress for local governments and property developers, and potentially trigger more widespread asset losses in the financial system.
Figure B2: Property price inflation in China (annual percent change)
Source: Haver Analytics, RBNZ calculations.
Note: National average is a simple average of 70 cities. Tier 1 cities comprise Beijing, Shanghai, Guangzhou, and Shenzhen.
There are two main channels by which financial instability in China could impact on New Zealand: the trade channel (where China has become increasingly important), and the capital channel through the impact on offshore funding conditions.
In November 2013 China overtook Australia to become New Zealand’s most significant export partner. China has been urbanising rapidly in recent years, and urban households tend to have higher incomes and more westernised diets. As a result, Chinese consumers have greatly increased their consumption of meat and dairy products, and New Zealand’s agricultural exports to China have benefited accordingly. A contraction in Chinese demand associated with a financial crisis could have a major impact on New Zealand agricultural exports. While New Zealand could maintain export volumes by diverting products to other markets, a drop in Chinese demand for soft commodities would put significant downward pressure on New Zealand’s export prices globally. The New Zealand dollar would be likely to decline if soft commodity prices fall, cushioning the impact on prices in New Zealand dollar terms.
New Zealand exports could also be affected indirectly through other trading partners. If investment and production fall in China, reduced demand for capital goods and hard commodities would reduce export demand for Asian trading partners and Australia. Australia’s terms of trade and exchange rate could decline sharply, impacting employment and incomes. These detrimental effects could further reduce demand for New Zealand’s exports.
Turning to the capital channel, the degree of direct contagion from Chinese to global financial markets is highly uncertain. Nonetheless, serious financial disruption would likely undermine investor sentiment towards the Asian region, leading to capital outflows and posing significant challenges for policymakers in the region – particularly in those countries with high levels of foreign currency debt. Similarly, capital could withdraw from New Zealand and Australia as investors re-evaluate assumptions of strong Chinese growth underpinning growth in both countries over the longer term. Chinese outward investment has increased rapidly in recent years, although remaining small compared to global flows of foreign investment. In the event of financial crisis, Chinese investors may choose to repatriate funds invested abroad in an attempt to consolidate balance sheets.
The Chinese Government has recognised the financial risks. The Third Plenum in November 2013 proposed plans for liberalising interest rates, reforming local government finances, and improving transparency and regulation in the shadow banking sector. They also proposed to introduce a depositor protection scheme in 2014. While positive, implementation of the reforms will introduce their own risks of financial disruption in the near term. For example, interest rates may rise as a result of interest rate liberalisation, increasing the debtservicing burden, and reducing investment demand for property. Depositor protection for some saving products could reduce investor interest in un-guaranteed sectors.
The Chinese Government is well placed to act in the event of financial distress to support financial stability. The central government holds extensive assets and foreign reserves. External debts are minimal and central government debt is low. This suggests that the Chinese Government has the capacity to intervene to stabilise financial markets, and provide direct support to the banking system if necessary. Therefore, while the substantial financial stability risks in China must be monitored because of their potential impact on New Zealand, the Chinese authorities have some capacity to manage those risks.
1 A large proportion of the increase in credit is associated with the 2008-09 stimulus package which aimed to offset the large impact of the GFC on the Chinese economy. Stimulus was largely in the form of debtfunded infrastructure investment undertaken by local governments, and directed lending by banks to stateowned enterprises to support production.
2 Local governments are largely prohibited from directly raising finance from bank loans or bond issuance. To raise funds they establish special purpose investment vehicles to indirectly access funding for infrastructure investment.