The fine art of maintaining financial stability

China is facing "significantly increasing challenges in terms of financial risk prevention and tackling", but given the country's sound economic fundamentals and its pre-emptive approach to controlling financial risks, the financial sector remains well under control－that's the key takeaway from two major developments last week.

On Nov 25, the People's Bank of China, the central bank, released a report on China's financial stability, pointing out multiple challenges the country is facing in financial risk management and what it has achieved in that respect.

And on Thursday, the Financial Stability and Development Committee, the country's Cabinet-level financial regulatory body and part of the State Council, China's Cabinet, stressed several priorities: balance the relationship between stabilizing growth and preventing risks; enhance counter-cyclical adjustments; further reform the capital market as well as small and medium banks; ensure healthy development of the private fund industry; achieve financial inclusion and fair competition; encourage commercial banks, especially small and medium ones, to increase capital through multiple channels; improve the long-term mechanism to prevent, resolve and dispose of financial risks, so as to stabilize the financial system and sustain the economic and social stability.

Last Monday's PBOC report is candid in admitting the potential financial risks facing the world's second-largest economy.

According to the report, the slowing world economic growth, the fallouts of the trade frictions between China and the United States, debt risks in some major economies, the rapid development of fintech that poses challenges to financial regulators, and the uncertainties surrounding Brexit have combined to bring risks from the external front that may affect China's financial stability.

In July, the International Monetary Fund lowered its forecast for the world economic growth this year to 3.2 percent from its previous forecast of 3.3 percent made in April.

While the world economy is losing steam, the developed economies have kept their general interest rates at around zero, which, together with the high debt levels of some developed countries, will limit the room for monetary loosening if the global economy sours further.

The report also takes cognizance of the large scale of local government debt, default pressure of corporate credit securities, the downturn in some real estate markets across the country, the fraud-prone internet finance sector, and some financial institutions troubled by poor governance and bad loans. Even issues like illegal fund raising by some private-sector players like venture capital firms and online sneaker peddlers have attracted PBOC attention in recent months. Such factors may also trigger financial risks that could potentially spread and destabilize the country's financial system.

Such a frank elaboration of potential dangers in the financial market, whose security is closely related to the overall stability of the national economy, shows that the monetary authorities are fully aware of the country's financial problems and challenges.

More importantly, the country is capable of coping with those challenges. The top leadership has required that "financial stability" should be one of the country's six main policy priorities－and regulators have adopted proactive policies to tackle those financial risks and prevent them from developing into real damages.

The authorities have made a plan to "stabilize the overall situation, enhance coordination, adopt differentiated policies, and use targeted approach to tackle risks". Specifically, the regulators have vowed to effectively stabilize macro leverage level, control credit risks in some key areas, resolve the "shadow banking" problem, tackle problems of highly risky financial institutions, restore financial order, and strengthen financial opening-up, according to the central bank.

The authorities are also exploring an exit mechanism for unqualified shareholders of rural financial institutions, as well as market-based and diversified approaches for financial institutions to exit the market.

In its targeted approach, the central bank regularly sends risk reminders to local governments to urge them to closely monitor the operation of highly risky financial institutions under their jurisdiction.

The central bank also provides suggestions to such financial institutions on how to address their risks; it may suggest those institutions increase capital, reduce bad assets, lower leverage ratio, replace management or improve corporate governance, according to the report.

Such a forward-thinking and prudent approach, at least until now, has proved effective in taming risks.

For instance, in its efforts to resolve risks posed by insolvent Baoshang Bank in Inner Mongolia autonomous region, the central bank's early intervention in May had successfully prevented the risks from worsening and there had not been a run on the bank, boosting market confidence in the security of the country's small lenders.

By the end of 2018, China's macro leverage level stood at 249.4 percent, down by 1.5 percentage points compared with a year ago, according to the central bank.

At the end of the fourth quarter of 2018, non-performing loan ratio of China's commercial banks dropped to 1.83 percent from 1.87 percent registered at the end of the previous quarter, according to the Chinese Banking and Insurance Regulatory Commission.

Central bank data also showed that the capital adequacy ratio of China's commercial banks has also been on the rise.

Although some risks still remain, PBOC data indicates that the country's pre-emptive financial regulation has been largely effective and successful.

As a developing country that has only gradually established a comprehensive financial regulatory framework in the past two decades and is still exploring what the best way of financial governance is, it is crucial for Chinese regulators to step in as early as possible when serious risks loom, and act well before they develop into a substantial threat to the country's financial stability.

That said, China has accumulated quite a lot of experience in previous rounds of financial regulatory stress starting from early 1990s, making it quite capable of containing financial risks in a way that is in line with specific Chinese conditions.

In early 1990s, property prices surged in Hainan province, attracting large amounts of banking funds to the island in South China. With the local real estate bubble continuing to balloon, banks had poured loans into the province, posing serious risks of default if the bubbles burst.

Regulators, led by then Vice-Premier Zhu Rongji (who later became China's Premier), stopped banks from extending loans to Hainan's real estate sector to prevent larger risks. Consequently, local property prices tumbled, leading to mass bank loan defaults.

The banks suffered another heavy blow at the end of the 1990s, following the Asian financial crisis that began in July 1997. Against such a backdrop, the first national financial work conference was convened at the end of 1997, where regulators decided to spin off bad debts of the four biggest banks and again inject funds into the banking system to help them survive.

A higher-level market-based economic reform was then carried out, with State capital withdrawing from most of the small and mid-sized State-owned enterprises to revitalize the economy. As the market became more active and enterprises became more competitive, the banks also benefited and got financially more viable.

Then the commercial housing reform, which no longer provided free or low-priced housing for State sector employees and government workers and encouraged market forces in property transactions, was kick-started, bringing a good source of income for the banks.

As the Chinese banking sector was in a better shape, policymakers decided to allow them to get listed on both domestic and overseas stock markets to further improve their corporate governance, laying a solid groundwork for them to grow stronger and more competitive.

Then came the 2008-09 global financial crisis. The Chinese regulators were forced to resort to the colossal 4 trillion yuan ($569 billion) plan to keep the economy and its financial sector moving.

In retrospect, those measures targeted at reviving and strengthening the banking sector may not be flawless; but with very distinct Chinese characteristics, they had been largely effective in restoring financial stability. In that process, the "invisible hand" of the market and the "visible hand" of regulation were combined and balanced to achieve the best possible efficiency.

With the global economy slowing, and the debt scene in many countries worsening, and amid rising protectionism and weak domestic economic growth, the situation seems to be more complicated and harsher for China.

The positive side is that the domestic economy, in spite of a weakening trend, remains resilient and its job market remains stable. Supported by such still-sound macroeconomic conditions, policymakers, now equipped with more regulatory experience, will properly use their fiscal and monetary resources to charter the economy and the financial sector through unknown waters.

Chen Jia contributed to this article.