The IMF warned China on Tuesday it is vulnerable to asset bubbles that could damage the economy and commercial banks could see a systemic failure if hit by a combination of credit, property, currency and yield curve shocks.
But China can contain these dangers by freeing up financial markets to give investors, commercial banks and the central bank greater autonomy from government control, the fund said in its first-ever review of the Chinese financial system.
While not predicting an imminent disaster, the IMF made clear China needed to act quickly because it is vulnerable to destabilizing asset price booms.
"The existing configuration of financial policies fosters high savings, structurally high levels of liquidity, and a high risk of capital misallocation and asset bubbles, particularly in real estate," the IMF said.
The report, which was completed in June but published only on Tuesday, contains 29 key recommendations. The fund said it ran a stress test on 17 banks that account for 83 percent of China's commercial banking system.
The test, done in collaboration with the Chinese central bank and bank regulator, showed banks' non-performing-loan ratios rose by at least one percentage point for each one-percentage-point drop in gross domestic product.
Under a severe scenario where banks suffer a confluence of shocks, capital adequacy ratios — or credit safety nets — of lenders accounting for about a fifth of China's total banking assets fell below the regulatory minimum of 8 percent.
The IMF said the severe scenario assumed annual economic growth of 4 percent, sharply below the 9.1 percent posted in the third quarter; M2 (money supply) growth of around 10 percent; a property price tumble of nearly 26 percent, and a change in deposit and lending rates of 95 basis points.
But since Chinese banks would have to suffer several of those shocks all at once to face the risk of systemic failure, the fund was otherwise upbeat on their resilience, even as it noted they are lending more outside their balance sheets.
"The banking sector's basic liquidity indicators appear healthy," the IMF said, adding that banks also get stable funding from an enormous pool of low-cost Chinese deposits.
Even if non-performing-loan ratios were to quadruple in two years to around 6 percent, the IMF said no banks would see their capital adequacy ratio fall below the minimum regulatory requirement.
Equally, it said higher interest rates and a 30 percent slide in home prices would only have a "limited impact" — by shaving less than 0.25 percentage points off the aggregate capital adequacy ratio.
On China's notoriously exuberant real estate sector, where prices have clung to record highs even after nearly two years of market cooling measures by Beijing, the IMF did not judge it to be bubbly at the time of writing.
"There does not appear to be significant over-valuation of residential real estate prices in China as a whole, though there are signs of overvaluation in some market segments," it said.
To keep the house market growing healthily, the IMF said Beijing needed to liberalize interest rates and the exchange rate, develop the capital market, free the capital account and reform fiscal policy by rolling out a broad-based property tax.
The fund said a full assessment of the extent of the risks and how they could spread was hindered by data gaps, the lack of sufficiently long and consistent time series of key financial data, weaknesses in the informational infrastructure, and constraints on the team's access to confidential data.
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