Risks of a Chinese banking crisis are mounting, according to early warning indicators released by the world’s top financial watchdog.
The Bank for International Settlements (BIS), considered to be the central bank of central banks, announced that a gauge of Chinese debt had hit a record high. The BIS warned in its quarterly report that China’s credit-to-GDP (gross domestic product) gap hit 30.1 in the first quarter of 2016, up from 25.4 a year ago.
An early warning of a banking crisis
The BIS calculates its gap by looking at borrowing in relation to the size of the economy, and compares that with the long-term trend of the ratio. It considers a credit-to-GDP gap of 10 to be a sign of concern and warned that China could face a financial crisis in the next three years.
Studies of earlier banking crises around the world suggest that any score above ten were a bellwether of a sharp downturn in financial markets. Scores exceeded that threshold ahead of the Asian Financial Crisis in 1997 and in the U.S. in the lead up to the Financial Crisis of 2007-2008. While China has remained above the threshold for most of the period since 2009, concerns of a banking crisis are growing.
An epicenter of financial risk
The health of China’s banking sector has long been a source of concern for financial markets. Since the financial crisis of 2007-2008 there has been a boom in credit as the Chinese government has attempted to spur flagging growth. However, as bank lending soared, so has the risk of a financial crisis.
The International Monetary Fund (IMF) warned in June that debt levels in China were alarming and “must be addressed immediately”. Outstanding loans have reached $28 trillion, as much as the commercial banking systems of the U.S. and Japan combined. The scale is large enough that global financial markets are in a hypersensitive state for any sign of instability.
The state claims that its control of the financial system and limited levels of overseas debt will mitigate the risk of any banking crisis; however, its “Big Four” state-owned banks are reporting an increasing volume of non-performing loans (NPL). The IMF estimated that 15.5 percent of commercial loans to companies, an amount equivalent to $1.3 trillion, or 12 percent of gross domestic product, are potentially at risk of default.
Historical experience is not applicable
China weathered the financial crisis of 2007-2008, but the circumstances were far different, as it was still in the boom phase of industrialization and quickly adopted a strong stimulus package. This in turn was feasible because of China’s strong financial position. Fast forward to today and China is no longer hyper-competitive, its work-force is shrinking, and its financial position is weaker.