Regular banks, too, are trying to evade new regulations by ramping up off-balance-sheet lending. It is increasingly common for banks’ off-balance-sheet lending to exceed newly issued balance-sheet credit. From 2011 to 2012, such lending grew by 1.1 trillion yuan, reaching 3.6 trillion yuan (23 percent of total bank financing), while balance-sheet lending increased by only 732 billion yuan.
However, the former is usually implicit and uncertain, making it vulnerable to default. If faced with such losses, banks might choose to protect their reputations by using official funds for repayment, transferring the risk onto their balance sheets.
Overall, the rapid credit risk growth increases inflationary pressure and fuels the formation of asset bubbles. Conversely, when the monetary authority tightens credit too quickly, asset prices become more volatile, resulting in more non-performing loans and triggering economic shocks.
Beijing must implement macroeconomic policies now to minimize future risk escalation. Medium and long-term fiscal stability requires policies tackling the growing disparity between fiscal revenues, which are suffering from slowing GDP growth and expenditures, and will be driven up by structural tax cuts and increased social-welfare spending.
To manage growing pressure on public finances, China must establish highly efficient public-budget and fiscal-restraint systems. It must tighten financial supervision, improve budgetary management and enhance the efficiency of fiscal policies.
China also needs a new financing model for infrastructure projects. The current one relies heavily on LGIV loans and fiscal expenditures. More stable financing channels and stronger enforcement of operating standards are essential to support rapid urbanization.
As prudent fiscal and financial policies gradually stabilize China’s economy, monetary policy must remain neutral. Loosening monetary policy would significantly increase the risks stemming from local government debt and shadow banking, while tightening monetary policy would fully expose those risks, posing a serious systemic threat.
With the right balance of vision and caution, China’s leaders can tackle the buildup of fiscal and financial risk. If they fail, China’s leadership of the future global economy will hang in the balance.
Zhang Monan is a fellow of the China Information Center, a fellow of the China Foundation for International Studies and a researcher at the China Macroeconomic Research Platform.
Copyright: Project Syndicate