Perhaps structured financial products occupy less space on Chinese banks' balance sheets and payoffs of the Annapurna (a form of option contract) sort are less discussed in trading floors in Zhejiang province. However, that is not to say that the financial system in China is any less complex than elsewhere. In some respects, identifying the underlying vulnerabilities of a financial system that covers a large group of very diverse provinces and rapidly evolving economic structure is more challenging.

The "Financial Sector Assessment Program" (FSAP), an in-depth financial sector assessment carried out by the International Monetary Fund and the World Bank in China last year and released earlier this month, was thus a challenging task that required various provincial visits and close collaboration with key supervisory agencies.

The health of a financial system is crucial for sustaining growth. As various studies on international experiences have demonstrated, a banking crisis not only entails huge costs, but also the recovery takes much longer than from other types of crises. Thus, the main purpose of the FSAP was to identify underlying vulnerabilities and measures to deepen the financial market over the medium term.

For China, developing a robust financial system is more important now than ever before because the stakes have never been higher. China is now the world's second largest economy, it is complex, and as it drifts toward soft-landing, the threat of spillover from the global sovereign debt and banking crisis is growing.

Against this backdrop, the FSAP identifies the main short-term risk as the adverse effect on banks' credit quality of the rapid expansion of lending in 2009-10. The expansion of credit that surpasses banks' capacity to screen loan quality has raised the probability of loan defaults well above the norm.

The liquidity overhang since then - initially coupled with capped deposit rates and followed by increased required reserves ratio - has pushed liquidity into the shadow banking sector, off balance sheet products, and investment in the real estate market. Furthermore, the pricing of the quality of lending to local government financing platforms may not have fully reflected the risks.

For now, banks' balance sheets have improved, supported by rapid loan and GDP growth, that is, bank loans rose by 58 percent in 2009-10. Stress tests suggest that the banking system is generally capable of absorbing significant downside risks, including a lower economic growth, exchange and interest rate shocks, and a drop in property prices.

However, simultaneous shocks on multiple fronts could leave some of the smaller private banks with insufficient capital to meet regulatory requirements. That said, the probability of such a shock is not high, and China still has sufficient fiscal space to address any foreseeable challenges in the near term.

A greater challenge lies in the medium term. The global recovery is weakening and is likely to remain sluggish. Rebalancing is taking place in China, but it is not sufficient enough to substitute for falling net exports. Private consumption has been robust, but not nearly as significant as investment. One temptation going forward is to allocate financial resources to even more investment boosting growth over a prolonged period to buy time for private consumption to fully mature.

The cost of such a non-market-based allocation could be very large. When combined with the capital needed to address the current stock problem from the 2009-10 stimulus and the cost of maintaining an elevated growth rate, the government's fiscal space could be reduced to an uncomfortably low level.

At this juncture, a more pertinent question for China is not whether it will face a hard- or soft-landing, but as it slows, "how" it should contain the slowdown to minimize the potential cost in the long run. The weakening global recovery has shortened the time China would otherwise have had in reorienting growth to domestic consumption. A way to contain the cost is financial sector reform that ensures market-based resource allocation, to be accompanied by reorientation of the broader role of government and the fiscal framework to mitigate the build-up of contingent liabilities and sovereign risk.

Optimal resource allocation can be achieved if it is market based, and as long as there is a well-established regulatory framework and supervisory oversight. This is why the main thrust of the FSAP recommendation was to commercialize banks.

This can be induced by creating a competitive environment that includes hard budget constraints; less reliance on banks to fund government-backed initiatives, and encourage banks to enhance their risk-management capacities, credit underwriting skills and corporate governance practices. Such a market-based system will also enhance monetary policy transmission. This implies the need to develop viable alternatives to bank funding of government policy goals by better use of direct fiscal expenditures, rationalization of policy banks and reforms in intergovernmental fiscal relations.

Moreover, a market-based system requires operational autonomy of financial regulators, including formalized policies to deal with systemic risks and financial stability issues. Eventually, this would not be possible without interest rate liberalization. A gradual approach may not work well because it is not clear how much time China has left.

The author is the senior resident representative of IMF in China.

(China Daily 12/01/2011 page9)