Moody's: China's authorities have the tools to avert a financial crisis, but erosion of credit quality is likely over the medium term

Moody's Investors Service says that China's (Aa3 negative) authorities have the tools to prevent a financial crisis from materialising in the near future, even though the country exhibits a number of pressure points associated with financial crises globally. The overarching role of the Chinese state mitigates the risk of a financial crisis, which a rapid build-up of debt, significant asset price inflation—notably in real estate—and a significant expansion of unregulated segments of the financial sector have been associated with in other countries. 

However, even in the absence of a systemic crisis, major imbalances created by rapid debt accumulation are likely to erode credit quality over time. 

"China's domestically-funded and state-backed financial system, combined with its wide range of policy tools, act as powerful mitigants to help manage systemic risks in the near term," says Michael Taylor, a Moody's Managing Director and Chief Credit Officer for Asia Pacific. 

Moody's says that these policy tools, and the authorities' willingness to employ them, significantly decrease the risk of a substantial contraction in the supply of credit, or widespread disruption to financial intermediation; factors normally associated with systemic financial crises. 

However, financial liberalization—particularly of China's capital account—could weaken the authorities' ability to manage systemic risks. 

In China's case, persistent and sizeable capital outflows would challenge banking system liquidity, reduce the ability of accommodative monetary policy to avoid widespread defaults, and increase the likelihood of a sharp currency devaluation. 

"The authorities are aware of the risks associated with rapid financial liberalization. We therefore believe they will be cautious in their approach and will continue applying existing capital controls more rigorously over a prolonged period," adds Taylor. 

Moody's analysis is contained in its just-released report titled "China Credit: Authorities Have Tools to Avert Financial Crisis, but Erosion of Credit Quality Likely". 

Moody's report says that China could face several adverse consequences even if financial liberalization is stalled and a systemic crisis is avoided. 

For example, a closed capital account contributes to the mispricing of risk and misallocation of capital by suppressing some market-pricing mechanisms. And, China's growing debt levels will lead to the persistence of large unrecognized banking sector losses, delays to the reduction in excess capacity and economic rebalancing, and a prolonged period of sub-optimal growth. 

As for the Chinese banking sector in particular, Moody's report says that if debt restructuring measures are not undertaken, the banks could be under pressure to extend further loans to already highly indebted borrowers, further impairing the banks' performance and raising their recapitalization requirements when the impaired nature of the debt is eventually recognized.