China’s economy has grown rapidly over recent years, and its weight in the world economy has risen commensurately. China now accounts for around a tenth of world trade and around 11 percent of world GDP, double the share of a decade ago.
Its financial system has expanded even more rapidly – with a particularly marked surge since 2008. Stock market capitalisation has risen from US$1.8 trillion in 2008 to US$3.8 trillion now, and there has been an enormous increase in the size of bank balance sheets. Indeed, since 2008, the Chinese broad money supply has trebled, expanding by an astonishing US$12.5 trillion. This increase in just six years is roughly equivalent to the entire stock of US broad money.
The enormous monetary expansion since 2008 has also resulted in a significant build-up of private-sector debt, mostly in the corporate sector. The speed and scale of this build-up has led to concerns that China could suffer from a massive bad loan problem that would in turn generate a financial crisis. This risk would be especially great if the Chinese property market were to crash, given the high share of loans either connected to, or collateralised by, property.
Since China’s economy and financial system have grown rapidly in the last decade, a financial crisis there could have a much larger global impact than before.
Through trade channels, the neighbouring Asian economies would be especially hard hit and global commodity producers could also be badly affected – especially those such as Brazil and Australia which export a great deal to China. China’s slowdown over the past two years has already led to some stagnation in imports from key trading partners but a financial crisis would be much worse and mean world trade growth dipping to very low levels. Commodity currencies would be at risk of repeating the heavy losses seen in 2008-09.
The impact on regional trade would be even more marked if China responded to weak growth at home with currency depreciation. That would increase the pressure on regional currencies, especially those with weak balance of payments positions.
On the financial side, there is more uncertainty. The relatively low level of internationalization of China’s financial sector – a product of its largely closed capital account – potentially limits the global spillovers. It may also be argued that stronger capital positions of global banks compared to 2007 could limit the transmission of any spillovers from China to broader financial markets.
A best-case scenario might be that a Chinese financial crisis is largely internalized as was Japan’s 1990s banking crisis. Global financial spillovers would be limited but the heavy costs of clean-up in China would damage China’s short and medium-term growth, in turn weighing on regional and world growth. The lack of international linkages between China and the world probably means that a financial shock will impinge more on China’s domestic growth.
There would also be some positive effects: Lower commodity prices would boost real income in much of the advanced world. Overall, world equity markets would still likely be weaker and global bond yields lower as world growth and inflation expectations fell. But the impact would not be catastrophic.
The impact on global financial markets of a China crisis could be more severe than this, however. There is a significant danger that a Chinese crisis could lead to knock-on financial crises in economies closely bound to China, especially Hong Kong. And given the Hong Kong financial sector is highly internationalized it could be a conduit to transmit the Chinese financial shock globally.
Hong Kong’s banks are highly internationalized with around US$800 billion of external debt, most of it short term.
These banks have also massively increased their exposure to the mainland in recent years: claims of Hong Kong banks on the mainland have risen from 25 percent of GDP in 2007 to 180 percent in Q1 2014 (amounting to 190 percent of bank capital), with most claims on mainland banks.
In theory, much of this is supposedly low-risk lending such as trade finance but there are concerns that there has also been heavy speculative activity related to exploiting onshore/offshore interest rate differentials. Such activity is often highly leveraged and would look extremely risky in a Chinese financial crisis.
So there is a potentially very serious knock-on effect from a Chinese financial crisis to the Hong Kong financial sector, and from that to the rest of the world. Probably the main damage would still fall on Asia, because Hong Kong banks’ financing activities are centred there.
There would also be some transmission to other countries given the international nature of Hong Kong’s financial sector. European banks may be especially exposed — the Bank for International Settlements suggests the lenders have some US$425 billion of exposures to Hong Kong, with Britain accounting for the largest share of this. Moreover, as some of the exposure of Hong Kong-based banks to China reflects the activities of branches of foreign banks, some “Hong Kong” exposure may (ultimately) represent US, Europe and elsewhere.
There could also be a significant negative impact on global stock markets due to the impact of a Chinese financial crisis on world corporate earnings expectations and business confidence. This is especially the case given the large volume of FDI in China, much of which has been invested in the hope of rapid future earnings growth.
The writer is senior economist at Oxford Economics.
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