International Monetary Fund identifies financial risks in China

International Monetary Fund IMF

The IMF report said authorities at the highest level had made financial stability a top priority this year and were "taking steps to address vulnerabilities" but added that some of the underlying causes of risk were yet to be fully addressed.

The reports are part of the update of the China Financial Sector Assessment Program (FSAP).

Fund identifies three areas of "tensions" within the country's financial sector. The last International Monetary Fund assessment on China was published in 2011.

The report follows a series of alerts over the debt pile which has ballooned in China alongside its rapid economic expansion.

"This level is very high by worldwide comparison, and already above levels consistent with a high probability of financial distress", the IMF said.

The report said reining in excessive growth would require China to reduce emphasis on high GDP projections in national plans, which have spurred local authorities to set high growth targets.

"International experience suggests that China's credit growth is on a risky trajectory, with increasing risks of a disruptive adjustment or a marked growth slowdown", a report said.

Abundant credit allows local governments to hit high growth figures but now each extra dollar of debt is producing diminishing returns. It pointed to the problem of moral hazard that runs through the financial system based on the widely held perception of implicit guarantees to compensate losses of investors and lenders.

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This has led to a situation in which failing companies are kept afloat, thanks to incentives for local governments to do so.

Financial institutions have been reluctant to let retail investors suffer losses, the authorities have stepped in to shore up stock and bond markets and investors believe the government stands behind debt issued by local government and state-owned enterprises, the International Monetary Fund said. The government should also put more focus on restructuring the operations of distressed companies that could survive rather than resolving their debt problems.

Increasing capital would enhance the resilience and credibility of the financial system, as well as reassure markets.

China announced the establishment of a Financial Stability and Development Committee (FSDC) in July, reporting directly to the State Council and chaired by Vice Premier Ma Kai, to strengthen supervision of the financial system, prevent system risks and formulate new laws and regulations to provide one unified regulatory framework. "Regulators should reinforce the primacy of financial stability over development objectives", it said.

More capital is justified for the largest banks due to their systemic importance and interconnectedness, the International Monetary Fund said.

"In terms of resources, the CBRC as with the other supervisory agencies under the [People's Bank of China] have been working with a headcount that hasn't changed in 10 years, a period in which the Chinese financial sector has more than doubled in size", Piris told reporters.

"The descriptions of the stress testing did not fully reflect the outcomes of the test", it said on its website.

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