Capital outflows, surging credit expansion and slowing growth mean a torrent of headlines on China’s financial risks.
Despite those concerns, Bloomberg Intelligence Economics’ Financial Stability Index rose again in the fourth quarter of 2015, and early signs suggest it may improve again in the first quarter of 2016.
That’s a reminder that though China’s financial risks are real, they continue to lurk in the medium term, not the immediate future.
The Financial Stability Index aims to provide a comprehensive and consistent reading on risks to stability over time.
The index rose for a third consecutive quarter at the end of 2015, suggesting risks remain under control.
The increase in the index reflected rising house prices, stabilization in the stock market (at least relative to the collapse in the third quarter) and ample liquidity.
Other factors, including looser monetary conditions and low-flation, remained negatives, but not enough to prevent the overall slight improvement in the index.
Looking at the first quarter of 2016, not all the data for the index’s 10 components are yet available. However, a continued increase in home prices, signs the stock market has found a floor, and ebbing capital outflows all suggest the index could register another slight increase.
A continued slowdown in GDP growth as projected by Bloomberg’s monthly tracker, looser monetary conditions, and a further rise in the M2-to-GDP ratio will remain drags.
The moderate improvement in the index over the course of 2015 and early 2016 is a reminder that, even as signs of stress grow, China retains significant firepower to stave off problems.
Growth is lower than it was, but an economy growing at close to 7 percent continues to throw off considerable resources.
The central bank has abundant tools to manage liquidity. Lower mortgage rates and down-payment requirements have succeeded in engineering at least a temporary revival in housing. Stabilization in the yuan has stemmed capital outflows.
The price of short-term stability remains medium-term stress. Credit expansion cannot outpace GDP forever without serious consequences. But, for now, the Financial Stability Index suggests a crisis is hovering on the distant horizon, not lurking around the next corner.
In the details, the index is a composite of 10 indicators intended to capture different stability risks:
• GDP measures the pace of growth. Faster growth creates more resources that can be used to repay borrowing.
• CPI measures the level of inflation. Both high inflation, which is associated with asset-price bubbles, or low inflation, which makes debt repayment harder, are potential risks.
• Bloomberg’s Monetary Conditions Index measures the policy stance. A looser policy stance can contribute to excess lending and bubbly asset prices.
• The ratio of M2 to GDP gauges the money supply relative to the size of the economy. Rapid expansion in M2 relative to GDP points to an unsustainable expansion in lending.
• The seven-day repo rate measures liquidity conditions. A cash crunch can trigger a crisis even if financial institutions are solvent — as the US discovered in 2008.
• Cross-border “portfolio investment” and “other investment” — two categories in the balance of payments — measure cross-border capital flows. Growing share of shadow-bank lending relative to conventional lending points to an increase in risk.
• Non-performing loans measure risks in the banking system. A rise in NPLs shows deterioration in bank asset quality.
• House prices measure risks in the real-estate sector. Property prices increasing faster than inflation suggest a real-estate bubble. Price gains slower than inflation flag the chance of a bust.
• The change in stock prices measures risks in the equity markets. Increases in stock prices above inflation point to risks from an equity bubble. Falling stock prices signal investor concerns about corporate earnings.
For each of the measures, the index is based on the standard deviation of the latest score from the 10-year moving average.
For example, GDP growth of 6.8 percent year on year in the fourth quarter is 1.2 standard deviations below the 10-year average growth rate of 9.7 percent. The Financial Stability Index is the sum of the 10 component index scores.
The views expressed in this article are those of Fielding Chen and Tom Orlik, economists at Bloomberg Intelligence.
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