People's Republic of China
Financial System Stability Assessment
Author: International Monetary Fund
Publication Date:
14 Nov 2011
eISBN:
9781463924546
ISBN:
9781463924546
Language:
English
Keywords:
ISCR; CR; interest rate; banking system; bond market; financial system; central bank
Download PDF (2.9 MB)

This report discusses the IMF/World Bank Financial Sector Assessment Program (FSAP) exercise for China undertaken during June–December 2010. The assessment concluded that reforms in China have progressed well in moving toward a more commercially oriented financial system. Despite success and rapid growth, China’s financial sector is confronting several near-term risks, structural challenges, and policy-induced distortions. A properly composed and timely implemented set of reforms would help address these challenges. A framework to resolve weak financial institutions on a timely basis is also needed.

Abstract

This report discusses the IMF/World Bank Financial Sector Assessment Program (FSAP) exercise for China undertaken during June–December 2010. The assessment concluded that reforms in China have progressed well in moving toward a more commercially oriented financial system. Despite success and rapid growth, China’s financial sector is confronting several near-term risks, structural challenges, and policy-induced distortions. A properly composed and timely implemented set of reforms would help address these challenges. A framework to resolve weak financial institutions on a timely basis is also needed.

Table 1.

China: Key Recommendations

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Notes: NT (Near Term) means implementation completed within three years; MT (Medium Term) means implementation completed in three to five years.
Table 2.

China: Risk Assessment Matrix

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Source: China FSAP team.Note: Qualitative assessment is based on ratings of high, medium, or low for likelihood that the vulnerabilities will be exposed by shocks over a three-year horizon. Assessment of the impact on financial stability if the threat is realized is classified with ratings of mild, moderate, and severe. The assessment incorporates stress test results as well as other quantitative and qualitative elements of the FSAP analysis.

I. Overall Stability Assessment

A. The Macro-Financial Environment

10. China has maintained high growth rates over the past three decades. Since the start of reforms in 1978, growth has averaged close to 10 percent and inflation has remained relatively subdued. Productivity growth has been rapid and capacity has been expanded by very high levels of investment. The commercial banking sector has also grown rapidly and become more diversified (Figure 1). Banks’ lending to households, though low compared with other countries, has picked up sharply following the housing sector reform a decade ago (Figures 2 and 3).

Figure 1.
Figure 1.

China: Evolution of the Commercial Banking System

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.
Figure 2.
Figure 2.

China: Scale of Retail Lending in Selected Banking Systems, 2009

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; national authorities; IMF WEO; and IMF staff calculations.
Figure 3.
Figure 3.

China: Growth of Mortgage Lending

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.

11. The macroeconomic and institutional environment, however, has contributed to credit allocation inefficiencies and a build-up of vulnerabilities:

  • First, the relatively low cost of capital distorts saving-investment decisions. The low cost of capital reflects the ceiling on deposit rates and abundant liquidity, lessens foreign exchange sterilization costs, and supports investment and industrialization. It distorts real activity by generating incentives to over-invest and by suppressing household income through low returns on deposits.

  • Second, underdeveloped capital markets limit the alternatives for corporate funding and household savings. Households are limited to holding low yielding savings accounts, suppressing income and consumption. The limited availability of insurance products also creates incentives for higher precautionary savings. At the corporate level, lack of access to capital markets by small, private enterprises creates incentives for higher corporate savings. Finally, the search for higher yielding alternative investments by both firms and households adds to the likelihood that asset bubbles may develop, particularly in real estate (Box 1).

  • Third, due to incomplete interest rate deregulation and limited exchange rate flexibility, banks and other market participants lack sufficient incentives to improve their assessment, management, and pricing of risks. Banks have some flexibility in setting interest rates on loans, but most lending is clustered around the regulated benchmark loan rate (Figures 4 and 5). Also, the high levels of structural liquidity allow most banks to operate with underdeveloped internal liquidity management processes.

Figure 4.
Figure 4.

China: Benchmark and Average Lending Rates

(Percent)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: PBC; and CEIC.Note: Average lending rate prior to Dec 08 refers to the rate applied to loans with maturity between 6 months and one year.
Figure 5.
Figure 5.

China: Distribution of Lending Rates

(Multiples of Benchmark Rate)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: PBC; CEIC; and IMF staff calculations.

Real Estate Sector and Banking Sector Soundness

The sharp increase in China’s real estate prices combined with extraordinarily high bank lending to the real estate sector (Figures 6 and 7) has heightened the prospects of a negative impact of price corrections on China’s banking sector. The ongoing tightening measures, however, have slowed down loan growth to the real estate sector and the related price increases. Continuous monitoring, stress test, and a comprehensive set of policies are needed to contain the impact of a real estate price correction on financial stability.

Several fundamental factors are driving the real estate prices in China. These include rapid income growth, low return on deposits, abundant liquidity, lack of alternative investment vehicles, low cost of home ownership, and local governments’ reliance on land sales revenues.

The banking sector’s direct exposure to the real estate sector is moderate (Figure 8) but the indirect exposure is much higher. Real estate sector related loans account for some 20 percent of the Chinese banking system’s total loans, relatively low compared with, for example, Hong Kong SAR or the United States. However, indirect exposure is higher. Loan terms in China depend heavily on collateral use. In the five largest banks, 30–45 percent of loans are backed by collateral, the majority of which is real estate. A large real estate price correction would reduce collateral values, and hence loan recovery value should borrowers default. In addition, credit to industries that are “vertically integrated” with the real estate sector (such as construction, cement, and steel) are also exposed to these risks. Given the importance of the real estate sector for economic growth, an economic slowdown as a result of a real estate price correction could adversely affect the banking system’s asset quality. Last but not least, local governments’ ability to support local government financing platforms (LGFPs) via land sale and subsidies—essential for those LGFPs with limited cash flows to repay the loans—heavily depends on the real estate market.1

In the short-term, the impact appears manageable especially if the current growth momentum continues. 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. Also, the moderate direct exposure and low leverage ratio (Figure 9) would limit the impact of a real estate price correction on banks’ asset quality. Stress testing banks’ exposure to the real estate sector alone, or in combination with the “vertically integrated” sectors (Section I. D), suggests a modest impact on banks from credit quality deterioration in the real estate sector.2 However, if a growth shock materialized concurrently then the impact on the banking system and its spillovers would be severe.

Over the medium- to long-term, the risk posed by the real estate sector depends on whether the fundamentals behind the real estate price increases are addressed by policy measures. A comprehensive set of measures—including the completion of the interest rate and exchange rate reforms, further capital market development, gradual opening of the capital account, and fiscal reforms, including initiating a broad-based property tax—is needed to promote the orderly development of the real estate market. In the meantime, the authorities should monitor real estate market developments and their potential impact on the banking sector and financial stability, and take prompt corrective steps in case of real estate price overshooting.

1 On average, 29 percent of their total revenues were from the sale of land use rights in 2010 (UBS, 2011, “Measuring Property Bubble in China,” March 22, 2011). Total revenues include mainly local government revenues, transfer and tax refunds from central government, and land sales revenues.2 Due to data issues, the stress testing exercise did not explicitly take into account regional differences in real estate market developments.
Figure 6.
Figure 6.

China: Residential Housing Prices and Mortgage Lending

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.
Figure 7.
Figure 7.

China: Bank Loans to the Real Estate Sector, Year-on-Year Changes

(Percent)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.
Figure 8.
Figure 8.

China: Share of Real Estate Sector Loans in Bank Loans

(Percent)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.
Figure 9.
Figure 9.

China: A Proxy for Loan-to-Value Ratio

(Percent)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.

12. Continued reliance on credit growth targets, even if supplemented by other policy instruments, undermines the efficiency of credit allocation and disrupts monetary policy transmission. Such credit targets have meant that banks have strong incentives to expand market share to boost interest income and use off-balance sheet channels to circumvent credit targets, compromising monetary control; and that the corporate sector tends to over-borrow, knowing that at some point credit will be rationed. Controlling interest rates and determining quantities of lending also mean that policy makers cannot rely on market prices (such as short-term interest rates) to assess macroeconomic and liquidity conditions.

13. A by-product of the existing macro-financial and institutional environment is low investment efficiency. Since 2001, it is estimated that every US$ 1 of Chinese GDP growth has required, on average, nearly US$ 5 of investment, 40 percent more than in Japan and Korea during their take-off periods.1 In addition, while the share of China’s total savings and investment in G-20 aggregates is more than 20 percent, its GDP share is about 10 percent. These may be a reflection of misallocation of capital to some projects with low rates of return.

14. The state is also directly and indirectly involved in the financial sector. A large share of the banking sector is state-owned, as is much of banks’ corporate client base. As the principal shareholder, the state appoints senior management in all major banks. In the absence of an explicit deposit insurance system and a resolution framework, the state also implicitly insures all deposits. The heavy involvement by the state in many aspects of the financial system reduces market discipline, weakens corporate governance, and is likely to create soft budget constraints.

15. Such state involvement has been illustrated by the important role of the banking system in the conduct of fiscal policy. To counter the impact of the 2008–09 global financial crisis the authorities launched a stimulus package that was implemented through bank credit expansion. Local governments’ eagerness to undertake infrastructure projects coupled with revenue-expenditure mismatches and their inability to borrow directly, resulted in a rapid increase in using LGFPs to serve as indirect vehicles to collect bank loans, often using state-owned assets such as land as collateral. As a result, the contingent liabilities of the public sector from such activities increased considerably.

B. Financial System: Structure and Inter-linkages

16. China has made progress in moving toward a more commercially-oriented financial system (Table 3). This has been underpinned by reforms that included recapitalizing the banking system, creating new capital markets, introducing a prudential regulatory regime, opening the financial system following accession to the World Trade Organization, and taking steps to reform interest rate and the exchange rate policies. Reform of the joint-stock banks has boosted the commercial orientation of the banking system and reform of the rural credit cooperatives has yielded some initial results. In the securities sector, key companies have been restructured, and a resolution mechanism and investor protection scheme set up. Pension sector reform has also progressed, with National Social Security Fund established in 2000.

Table 3.
Table 3.

China: Financial Sector Reforms—Selected Benchmarks

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Note: The Big 4 banks are ICBC, CCB, ABC and BOC, which have been commercialized in recent years. The Big 4 and Bank of Communications together are referred to as large commercial banks.

17. Nonetheless, banks, particularly the largest ones, dominate financial intermediation (Tables 4 and 5, and Figure 10). The large commercial banks (LCBs) make up almost two-thirds of commercial bank assets (Figure 11) with the assets of the four largest banks each exceeding 25 percent of GDP. The fixed income market has grown as an alternative funding channel, but remains heavily concentrated in public sector securities (Figure 12). The equity market mainly meets the needs of large enterprises, in spite of recent progress in establishing a multilayer equity market to facilitate funding to SMEs. Assets under management by the insurance sector corresponded to less than 11 percent of household bank deposits. Trust, financial leasing, and finance companies have all been growing rapidly but remain small relative to banks. China also has a flourishing informal financial sector, parts of which provide funding to SMEs and small retail investors.

Figure 10.
Figure 10.

China: Credit Intermediation, 2010

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: Bloomberg L.P.; IMF International Financial Statistics; Bank for International Settlements; CBRC, CSRC, and IMF staff calculations. Note: In the case of China, private sector credit refers to domestic credit minus claims on central government and NBFIs.
Figure 11.
Figure 11.

China: Commercial Banking System Structure by Assets, 2010

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.
Figure 12.
Figure 12.

China: Fixed Income Markets in Selected Countries, 2009

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Source: Chinabond, 2010, “China’s Bond Market—the View.”
Table 4.

China: Structure of the Financial Sector, 2007–10

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Sources: PBC; CBRC; CIRC; CSRC; NBS of China; and Ministry of Human Resource and Social Security; and IMF staff calculations.

As there is no insurance company engaged in both life and non-life business, data of reinsurance companies are provided instead. In 2007 the insurance sector adopted new accounting principles which are applied to the data starting from 2007.

Proceeds raised by securities investment funds are managed by fund management companies on behalf of fund unit holders.

The table excludes assets of the four AMCs. According to the FSAP team’s calculations, the book value of the non-performing assets transferred to the AMCs amounted to about RMB2.6 trillion as of end 2006 (about 6 percent of total financial system assets or 12 percent of GDP). Comparable data for 2007-10 are not available, as the AMCs have not released financial statements since 2006.

This table does not include informal finance, the estimates of which vary.

Notes: Data for 2008, 2009, and 2010 were provided by the Chinese authorities in the context of the FSAP. Data for 2007 were collected from publically available sources, particularly the annual reports of the three financial regulatory commissions and the financial statements of the NSSF. Data on rural and urban credit cooperatives were collected from the CBRC’s annual reports.
Table 5.

China: Financial Development Indicators, 2005–10

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Sources: PBC; CBRC; CIRC; CSRC; MOHRSS; CFETS; BIS; IFS; WDI; Swiss Re Sigma; and ChinaBond.com.cn.

Including credit to public enterprises.

Labor force data for 2010 is an estimate.

Including all the A and B shares of companies listed on SSE and SZSE.

Data for government bonds are from the BIS and include both treasury securities and central bank bills/notes.

Estimates by CFETS.

18. While China’s financial markets are still in a development phase, cross-market integration has been increasing. There is distinct separation within domestic markets (for example, the domestic bond market is divided into exchange traded/retail and interbank/wholesale markets) and between Chinese markets and the international financial markets (in part, due to widespread capital controls). Nonetheless, shocks do get transmitted across different domestic markets, as illustrated by a positive correlation of yields. Connectivity between markets is likely to grow fast.

19. Linkages among the banks are mainly transmitted through the interbank repo market. The repo market is necessary for many small banks and nonbanks to fund their activities, and for larger banks to place their surplus funds. Consequently, it is the market through which a liquidity squeeze in one part of the banking system can and does spread to others (Section I.C).

20. Inter-connections between banks and nonbank financial institutions (NBFI) have begun to grow. Laws and rules permit more complex structures even though supervisors are challenged to meet the key elements of the principle of consolidated supervision. Interlinkages are increasing with the rise of FHCs, which have expanded considerably since the initiation of a pilot program on integrated financial services under the 11th Five-Year Plan (2006–10) and industrial-financial integrated groups have developed rapidly. At the same time, regulatory policies applying to shadow banking and their interconnections needs to be clarified and made transparent. A more structured oversight, regulatory, and supervisory approach is needed to prevent and to manage systemic risks via cross-market products and institutional structures.

21. Finally, the financial linkages between China and the rest of the world have historically been limited, but are growing rapidly. The growth in RMB deposits in Hong Kong SAR has been rapid (Figure 13), though the amount is insignificant relative to the RMB onshore deposits. Cross-border portfolio capital investment is subject to Qualified Domestic Institutional Investor (QDII) and Qualified Foreign Institutional Investor (QFII) programs.2 The markets for B shares, through which foreign investors are allowed to invest in China’s stock exchange markets, and H shares (China companies listed in Hong Kong Stock Exchange) are eclipsed by the markets for A shares (Figure 14). In addition, the financial transmission between A share and H share is still limited (Figure 15). While the balance sheet positions of China’s banking system vis-à-vis banks located in other countries do not yet fully match the interlinkages of the world’s leading banking centers, they have increased by 80 percent in the last ten years.

Figure 13.
Figure 13.

China: RMB Deposits in Hong Kong SAR

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.
Figure 14.
Figure 14.

China: Market Capitalization of A, B, and H Shares (RMB billions)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.
Figure 15.
Figure 15.

China: Hong Kong SAR Market Premium for Chinese Equity

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; Bloomberg; and IMF staff calculations.

C. Banking System Performance, Soundness, and Resilience

22. The banking sector’s balance sheet has expanded rapidly, in part due to the investment-driven stimulus policies of recent years. In 2009, the total amount of outstanding RMB loans expanded by 33 percent although credit growth slowed down in 2010 (Figure 16). The rapid growth in foreign currency loans is likely linked to the expectation of RMB appreciation. Bank exposure to infrastructure construction increased, driven largely by an expansion of LGFPs, while the share of manufacturing-related loans declined. The upswing in the real estate market also fueled demand for mortgage loans. Banks’ off-balance sheet exposures expanded rapidly, mostly as a result of banks’ promoting wealth-management products as the government began to limit the pace of new lending.

Figure 16.
Figure 16.

China: Loan Growth Rates

(Year-on-Year; Percent)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.

23. Banks’ funding appears stable. The sizable and low-cost domestic deposit base has contributed to stable bank funding. While household deposits remained critical to the growth of banks’ funding base for most of the reform years, the incremental growth in domestic corporate deposits in 2009 has been significant (Figure 17). Maturity mismatches have also risen. Increasing reliance on medium- and long-term loans for investment project financing has lengthened banks’ average asset maturities (Figures 18), particularly for large commercial banks.

Figure 17.
Figure 17.

China: Levels and Incremental Growth of Bank Deposits

(RMB trillions)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CBRC; and IMF staff calculations.
Figure 18.
Figure 18.

China: Loans by Maturity

(Percent)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.

24. Bank profits remain high (Table 6). The credit expansion has supported bank profitability, despite a partial contraction of the interest rate margins in 2009. Chinese banks’ limited earning diversification and strong reliance on interest income, however, makes their porfits prone to changes in regulated interest rate margins and limits on lending volumes.

Table 6.

China: Selected Indicators of Financial Health, 2005–101

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Sources: PBC; MOF; CBRC; CIRC; State-Owned Asset Administration Commission; NBS of China; IMF Global Financial Stability Report; Bankscope; and IMF staff calculations.

All data for this table unless noted otherwise were provided by the Chinese financial regulatory and supervisory commissions in the context of the FSAP. The following footnotes describe some cases in which the figures were obtained from other publically available sources or calculated by the FSAP team.

Comparability across years is limited due to differences in data coverage. Data for 2005 and 2006 refer to the total banking industry as reported in the IMF Global Financial Stability Report, whereas data from 2008 to 2010 refer to the 17 major commercial banks as reported by Chinese authorities to the FSAP team.

Capital adequacy and asset quality indicators were calculated with data from CBRC’s 2010 annual report. Capital to assets ratio is defined as equity to assets ratio. Interest rate spreads were calculated with data from PBC’s Monetary Policy Reports.

Ratios where the numerator and denominator were compiled on a domestically consolidated basis (DC).

Simple averages of 17 major commercial banks. FSAP team’s calculations based on the banks’ financial statements and Bankscope.

Available solvency margin over required solvency margin.

Number of non-financial State-Owned Enterprises (SOEs) above Grade Three. The State-Owned Assets Supervision and Administration Commission directly held SOEs are Grade One. Grade One SOEs directly held subsidiaries are Grade Two. Grade Two enterprises directly held subsidiaries are Grade Three.

Earnings before interest and tax as a percentage of interest and principal expenses.

Number of SMEs in the industrial sector.

Percent change in commercial real estate and house price indices.

CBRC’s statistics based on credit data on institution (legal person).

25. The banking systems’ nonperforming loan (NPL) ratio has been on a downward trend, reaching 1.1 percent at end-2010 (Figure 19). This decline was driven by the rapid expansion of credit, a decline in NPL levels, and a RMB 816 billion NPL carve-out from one major bank in 2008. Over a longer horizon, large scale NPL carve-outs associated with the 1999–2001 and 2004–05 state-owned bank restructurings have kept overall NPL ratios low.3 The low level of reported NPLs has also been helped by strong economic growth and some improvements in risk management in banks. The rapid credit growth, however, could result in a deterioration of bank asset quality in the coming years. In addition, about 95 percent of bank loans re-price in under one year; this could lead to higher borrowing costs and loan servicing problems for weak borrowers if the PBC moves along a tightening cycle.

Figure 19.
Figure 19.

China: Nonperforming Loans to Total Loans

(Percent)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Source: CEIC.

26. Exchange rate exposure is large at the central bank. Large current account surpluses and the management of the exchange rate regime result in the accumulation of sizeable foreign exchange reserves and a large net open foreign currency position for the central bank. Commercial banks, in aggregate, are also long in foreign assets (Figure 20) though in a much smaller scale.

Figure 20.
Figure 20.

China: Depository Corporations’ Foreign Asset and Liability Positions

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Sources: CEIC; and IMF staff calculations.

27. The near-term risks of liquidity stress appear limited. The banking sector’s basic liquidity indicators appear healthy. Larger banks typically recycle liquidity through the interbank markets to smaller banks and other financial institutions (Figures 21 and 22). The dominant share of secured interbank lending, high quality collateral, and abundant liquidity limit the prospects of market stress in the near term. Interbank markets, however, are subject to some risks. There are persistent liquidity imbalances among the banks, with small banks and non-banks particularly reliant on wholesale funding. A localized liquidity squeeze could spread from a small set of institutions that face a liquidity shock and cannot realize the face value of their pledged security to a broader liquidity shock. The PBC standing facilities should act as a liquidity backstop when liquidity is unavailable from the market.

Figure 21.
Figure 21.

China: Flow of Funds in the Interbank Market—Repos

(RMB billions)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Source: PBC.
Figure 22.
Figure 22.

China: Flow of Funds in the Interbank Market—Call Loans

(RMB billions)

Citation: IMF Staff Country Reports 2011, 321; 10.5089/9781463924546.002.A001

Source: PBC.

D. Stress-Testing Results Summary

28. To capture the key risks of the Chinese financial system, a stress testing exercise was jointly conducted by the FSAP team and PBC/CBRC team.4 The results of the PBC/CBRC team’s top-down and banks’ bottom-up calculations—based on a sample of 17 banks—were provided to the FSAP team at the aggregate level and by bank type. The FSAP team also carried out its own set of top-down calculations, based on publicly available data on the same set of 17 banks.

Caveats

29. A full assessment of the extent of the risks and how they could permeate through the economic and financial system was hindered by various factors. First, it was not feasible to fully cover all the differentiated risks confronting the banking system due to data constraints on the sectoral exposures and types of entities that banks lend to. Also, data constraints prevented an explicit analysis of off-balance sheet positions and operations, except for those relating to the direct exchange rate risk. Moreover, much of the calibration in the macro-scenario tests was based on relatively short time series of key financial data (e.g., for NPLs) with structural breaks in the series; this limited a solid econometric analysis. Full-fledged comparison, analysis, and cross-check of the results were not possible in areas where publicly available information is imprecise, insufficient, or nonexistent (e.g., exposures to LGFPs and the contagion risk exercise) due to the constraints on the FSAP team’s access to confidential data. Finally, the stress tests assumed the status quo (i.e., current macro-financial environment). As reforms begin in earnest, the banking system may face an amplification of existing risks or new uncertainties—although a properly implemented reform process and stronger risk management and corporate governance practices will help mitigate adverse financial consequences.

Table 7.

China: Stress Tests for Banks

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Source: FSAP stress testing team.

30. Keeping these caveats in mind, the stress testing results suggest that major banks can absorb moderate potential losses. This reflects improved profitability and balance sheets in recent years, which allowed banks to build up buffers. The single-factor sensitivity calculations indicate that the system would be able to withstand a range of sector-specific shocks occurring in isolation. These specific shocks include asset deterioration in bank credit to the real estate sector, LGFPs, export sector, and other sectors. The macroeconomic scenario analysis suggests, however, that the system could be severely impacted if several major shocks materialized concurrently.

Credit risks

31. The system appears able to withstand relatively sizeable aggregate increases in credit risk (Figure 23). If NPL levels were to increase by 400 percent in two years (i.e., post-shock NPL ratio reaching about 6 percent), calculations based on end-2010 data suggest that no banks would have capital adequacy ratio (CAR) below the regulatory minimum (i.e., 8 percent). The improvement in resilience from 2008 to 2010 reflects the decline in NPL levels. In addition, the buffer provided by stronger bank capital positions in 2010 helped prevent participating banks from failing to meet the regulatory minimum CAR under the most severe assumptions.

Figure 23.