RBA lays out the risks of China's debt bomb

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  • RBA Governor Phil Lowe outlined the risks facing China’s financial system from rapid buildup of debt since 2009.
  • In a speech last night, he said Chinese policy makers are responding to the risks, but significant challenges remains.
  • Given the importance of China to Australia’s economy, Lowe said the RBA is watching these developments closely.

RBA Governor Phil Lowe has outlined the debt risks faced by China, highlighting the rapid buildup in debt since 2009 and its opaque financial system.

In a speech last night discussing the breadth and depth of the Chinese-Australian relationship, Lowe also pointed out that a stable China is crucial to Australia’s future prosperity.

Lowe noted that in its attempts to boost domestic demand following the global financial crisis, China’s total non-financial sector debt has risen dramatically since 2009:

Source: RBA

Lowe said the specific challenge faced by China is how to reduce overall debt levels, while also servicing the needs of its developing economy by providing finance to more small and medium size enterprises.

Noting the experience of Australia and other developed economies, Lowe said such a transition can often be a bumpy one, and there is still a lot of work to be done.

And he said Australia will be watching the developments closely. Here’s Lowe on the importance of Australia’s economic ties to China:

A stable and robust financial system in China is clearly in Australia’s interest. So too is a prosperous China as part of a rules-based international system.

As the economic relationship between our two countries broadens and deepens, developments in China are having a material impact on more and more Australian industries: it is more than just about resources.

It is therefore important that we have a thorough understanding of one another. We all have a role to play in helping build that understanding.

In view of the importance of that relationship, Lowe said the RBA now has three staff based in Beijing who work with the bank’s Asian research unit in Sydney.

His speech followed political developments yesterday which appeared to demonstrate a recent deterioration in Australian-Chinese relations.

And that raises the risk of a potential shock to the local economy, given China remains by far Australia’s largest trading partner.

Lowe highlighted that in addition to commodity exports, Australia’s service exports to China have also grown at an average annual rate of 15%.

There’s gains have been led by a rapid increase in Chinese students studying in Australia, and the continued inflow of Chinese tourists:

Source: RBA

While China’s direct investment in Australia remains relatively low (3%, compared to 30% for the US), Lowe said the RBA sees “first-hand” how Australia’s financial relationship with China has developed.

The RBA now holds 5% of its foreign currency reserves in Chinese renminbi, and has currency swap arrangement with the People’s Bank of China to help facilitate cross-border transactions.

So Lowe’s analysis of debt risk in China remains of central relevance to Australia’s economic and financial ties.

He said that while China has opened up part of its economy to capital markets, risks from its highly centralised structure still remain.

“The influence of the state and the incentives within financial institutions have almost surely distorted credit allocation and led to some poor lending decisions,” Lowe said.

That means large state-owned enterprises are likely to have been propped up, while provincial governments raise funds via opaque finance structures to meet growth targets.

“So these are reasons to be concerned about future problem loans,” Lowe said.

Lowe said such opaque finance structures — also known as China’s “shadow banking” industry — stems from the fact that centralised lending controls mean many entities have restricted access to credit issued by the large state-owned banks.

As a result, companies seek funding outside of the main financial system, via riskier business-to-business loans at higher interest rates which don’t show up on bank balance sheets.

There’s also been a proliferation of wealth management products which offer higher returns, and are implicitly guaranteed by banks but used as a way to sidestep official regulations.

Source: RBA

At the same time, Lowe multiple responses in recent months by Chinese policy makers to address risks in the financial system.

“These various measures provide a strong signal that the Chinese authorities are serious about addressing the vulnerabilities,” Lowe said.

“Consistent with this, the lower economic growth target for 2018 of 6.5% suggests some tolerance for a gradual slowing in growth.”

However, “it is too early to tell whether the authorities will be successful in managing the transition from a growth model heavily dependent upon the accumulation of debt to one where credit is less central. It is a very significant task,” Lowe said.

“China’s challenge is made more complicated by the dual nature of the task to bring down debt levels while also reconfiguring the financial system so as to better meet the needs of the people.”

“So there is still a lot to be done. At the RBA we are watching this process carefully.”

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