No financial meltdown in sight

There will not be a banking crash, as the authorities still have policy capacity to address the problems and ensure stability

The market is always in search of a story and its corresponding trade idea. Unfortunately, so far this year, the United States, eurozone and Japan have been rather uncooperative on this matter, as their respective central banks and economies have stuck to prior trends. As a result, investors have turned to China in the hope of securing this year's story.

Indeed, the economic challenges facing China in 2014 are serious. Its growth rate has fallen from 10.4 percent in 2010 to 7.7 percent in 2013. The most recent economic statistics show that the economy is still slowing. More ominously, the black clouds of debt seem to have thickened inexorably. The high-profile corporate bond default in March, the first in many years, sent a chill through markets in the spring. China's slowdown and financial risks have led to a wave of pessimism and potential opportunity for the market: either a big "China short" is coming, or risk appetite should anticipate a major fillip as authorities have to reflate through credit and/or fiscal stimulus.

However, although the economy may slow further, it is unlikely that the decline in the growth rate will be so large that the government has to usher in a large stimulus package; financial instability exists, but the resources available to the government to ensure stability are still plentiful.

Currently, the bearish predictions of an imminent crisis in China are mostly based on the fact that China's leverage ratio is too high. It is argued that those developing countries that have had a credit boom nearly as big as China's all experienced a credit crisis and a major economic slowdown.

Yes, China's debt-to-GDP ratio is very high, but so are the debt-to-GDP ratios in many successful East Asian economies, such as Singapore, Thailand and Malaysia. The difference is that China's savings rate is much higher than most of them. All other things being equal, the higher the savings rate, the less likely it is that a high debt-to-GDP ratio will trigger a financial crisis. In fact, China's high debt-to-GDP ratio, to a large extent, is a result of China's high savings rate vis-a-vis its equally high investment rate. Certainly, the inability to repay would contribute to the high debt-to-GDP ratio, but so far the nonperforming ratio for China's major banks is still less than 1 percent.

But if one thinks that China's high debt-to-GDP ratio is indeed a great threat to its financial stability, then it should be noted that from a high debt-to-GDP ratio to a financial crisis, there are many links that need exploring. Only when all the specific links have been identified can one draw a tentative conclusion on whether a financial crisis is likely to happen.

A financial crisis, a banking crisis in particular, will only happen when the following three conditions apply simultaneously: a large fall in asset prices, a drying up of funding, and a depletion of equity capital. The government has yet to exhaust its policy capacity to work on all three fronts to prevent a financial crisis, due to its relatively strong fiscal position, large foreign exchange reserves, relative high economic growth and its effective control over the major banks.

The real estate bubble is commonly regarded as the single most important point of vulnerability in China's financial system. So let us assume the real estate bubble has burst. Will the price collapse bring down China's banks? Probably not. In China, there are no subprime mortgages or special purpose vehicles to obscure the nature of mortgages - the required downpayment for mortgages can be as high as 50 percent (or even higher). Will house prices fall by more than 50 percent? Not very likely. When house prices fall significantly, new buyers in big cities will enter the market and stabilize prices, and the country's urbanization strategy will ensure that in these cities demographics support intrinsic demand.

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.