Government must act prudently as any wrong move could cause risks to converge in its financial system

China's economy is now changing gear from its previously fast-paced growth to a moderately lower speed, during which the government has to continue to push forward economic structural adjustments and deal with the side effects of the large-scale economic stimulus package it adopted after the global financial crisis in 2008.

However, the country not only faces the pressures of a decelerating economy, the government also has to be vigilant, ready to address the looming risks emanating from colossal local government debts, shadow banking, industrial overcapacity, as well as the possibility that the real estate bubble will burst.

Plagued by increased pressures from the economic downturn and its economic imbalances and vulnerability, the government urgently needs to address these issues, but must ensure that it does not trigger a financial crisis.

The huge balance sheet pressures on the country's financial, real economy and public sector mean the past high debt leverage model is unsustainable, and thus deleveraging remains an irreversible trend. Given that any deviation or wrong moves in this process may cause various risks to converge in the financial system, the government should make effectively preventing the risks from triggering a systemic financial crisis a top priority.

But for an economy that has experienced extensive growth for decades, deleveraging will not be a quick or easy task.

Before to its subprime mortgage crisis, the United States also experienced a rapid credit expansion over a long period, with its debt growing faster than its nominal gross domestic product. On the eve of the subprime crisis, the size of the US debt had already risen to about 370 percent of its GDP. But owing to the dollar's hegemony in the global monetary system, the US' monetary authorities act not only as the major funds supplier but also as the major funds recipient through government bonds issuance and purchase.

China's macroeconomic conditions are more complicated. On one hand, the loose monetary and expansionist fiscal policy the government employed to stabilize the country's economic growth after the global financial crisis has resulted in ever-growing government debt. On the other hand, the country's debt risks are concentrated among banks and its financial system, given that indirect financing dominates its financing market.

The non-financial sector is an area that may cause the transmission of financial risk in China. The debt held by government is generally at a controllable level, and there is no risk of debt defaults, but a liquidity risk does exist. Considering that the government sector has to repay 6.6 trillion yuan ($1.06 trillion) in debts this year and 5.2 trillion yuan next year, that inevitably poses a big challenge to the country's liquidity and even the credit system. And the debt leverage among the non-financial corporate sector has grown even more quickly than that of local governments. The debt ratio of China's non-financial sector is now much higher than the international alert level of 90 percent. According to Standard & Poor's, China's non-financial corporations had debts of $12 trillion by the end of last year, 120 percent of the country's GDP, and the figure is expected to exceed $13.8 trillion, even higher than the $13.7 trillion debt due to be held by the US.

Overcapacity is another factor that may spark financial risk in China. With the spread of overproduction, China's real economy represented by manufacturing has become an area with concentrated bad loans, especially in its steel, photovoltaic and shipbuilding industries. The total bad loans in the country's real economy increased from 438 billion yuan in the first quarter of 2012 to 592 billion yuan at the end of 2013, an increase of 35 percent.

The continuous shadow banking expansion based on trust companies also poses a big threat to China's financial system. The credit of shadow banks now accounts for about one-third of the country's newly increased credit, up from 163.5 billion yuan at the end of 2004 to 1.9 trillion yuan at the end of 2013. The scale of the country's trust assets has also grown 30 percent over the past decade, culminating in 57.3 percent in 2008. All these loans, which are not reflected in banks' balance sheets, will unavoidably cause short-term repercussions to the country's financial system at a time of accelerated deleveraging if not handled prudently.

Real estate adjustments are another channel for the outbreak of possible financial risk in China. As pessimism continues to dominate the housing market, investment in property may fall further. Given that there exists a long real estate-related industrial chain in China, a lingering housing market slump may dampen upstream and downstream industrial development and even the country's whole fixed assets investment and GDP. The close links between real estate and financial sectors also means drastic housing market fluctuations, especially a sharp drop in housing prices, will influence the quality of financial assets and may ignite a financial crisis.

Among all these risks, how to promote deleveraging, reduce overcapacity and defuse the swollen housing bubble remain the most pressing, and must be handled with care.

The author is an associate research fellow with the China Center for International Economic Exchanges. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 06/20/2014 page12)