No financial meltdown in sight

Even if house prices fall by more than 50 percent, commercial banks can still survive. First, the share of mortgages in commercial banks' assets is about 20 percent for the country as a whole. Second, banks can recover funds by selling collateral. And as a last resort, the government can step in like it did in the late 1990s and early 2000s to take nonperforming loans off the books.

How about the liability side of the commercial banks? The structural investment vehicles in the US played an important role in causing the subprime crisis. There are no such vehicles in China. Additionally, the severity of the mismatch is not as serious as some observers believe.

China has a war chest of foreign exchange reserves that it finds difficult to dispense. When necessary, the Chinese government will not hesitate to inject capital from the reserves into commercial banks as it has demonstrated in the past.

How about liquidity shortages and a credit crunch when commercial banks are facing a crisis situation? These problems should also not happen in China. All governors of the Big Four will act swiftly to follow any instructions given by the government.

However, there is one important caveat: China has to maintain its capital controls in the foreseeable future. If China were to lose control over its cross-border capital flows it could lead to panic and so capital outflows would turn into an avalanche and eventually bring down the whole financial system. This makes current plans to liberalize the capital account deeply troubling and inconsistent with other policy priorities.

Yet the Chinese economy is fraught with serious problems and confronted with a fundamental contradiction. On one hand, due to the rampant "regulatory arbitrage", China's monetary interest rates have been rising steadily. One the other hand, the return of capital in China has fallen rapidly since 2008, due to over-investment and widespread misallocation of resources. If the Chinese government fails to reverse this trend, a financial crisis of one form or another is inevitable at some point in the future.

Finally, the Chinese government should act quickly in response to social tensions. If the government "blinks" and responds with another massive credit stimulus, instead of educating households about the concept of risk, the damage could be fatal.

For now, there is still no convincing evidence to show that China is facing an imminent financial crisis and an economic crash. Nonetheless, the Chinese government must realize that its margin for error in implementation is approaching its limits.

The author is former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. www.chinausfocus.com

(China Daily 04/15/2014 page8)

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