China conniptions: what does it mean for banks?

As ANZ China economist Li-Gang Liu explained, the intervention of the People’s Bank of China was actually supportive of broader financial liberalisation, an argument based on the thesis that an artificial peg to the USD was actually what had driven the Chinese currency higher. Not market fundamentals.

"Longer term impacts are more difficult to forecast as they depend on the interaction between government intentions, market perceptions and transmission to the real economy."
Andrew Cornell, Managing Editor BlueNotes

Such market conniptions in the volatile world are to be expected. The underlying anxiety though is a deeper uncertainty: how robust is the Chinese economy? And what are the implications for the real economy and the financial system?

More profoundly, what are the implications for economic reform, once again raised as critical in the International Monetary Fund’s latest review.

The Asian financial system is certainly better placed than during the Asian crisis of 1997-98. Central banks and national debt are less exposed to rapid depreciation against the USD and rapid inflation of their foreign liabilities.

But any slowdown in the real economy and rapid corrections in financial markets can be a challenge for banks.

For example, liquidity will be tighter in China due to the central bank actions as concerns rise of widespread capital outflows – even though the market calmed when PBoC officials publicly said they were not planning sustained depreciation or a currency war. The bank has also been acting through agents to sell USD when the RMB weakens too much.

But the longer term impacts are more difficult to forecast as they depend on the interaction between government intentions, market perceptions and transmission to the real economy.

In its latest review over the weekend, while the IMF expressed satisfaction with China’s transition to a more market oriented economy, the fund warned of a "disorderly correction" followed by slower growth if China’s reform program slows.

Meanwhile, JP Morgan put out a banking research note on Friday stressing the main question was the degree of slowdown in the Chinese economy but in the “near term, there is potential for some risk to trading and other revenues, and medium term from slower revenue growth and increased credit losses, but it should be manageable for (large banks including Citi and Bank of America)”.

“Historically, our banks, notably Citi, have managed through prior recent emerging market crises quite well but China has bigger implications,” JP Morgan said.

The firm noted the key implications of China’s devaluation and slowdown are slower loan growth; continued pressure on net interest margins (NIM); lower investment banking volumes; lower trading revenues medium term but uncertain results near term; and slightly higher credit losses.

Even less predictable though is the impact on China’s domestic banks. Significant in this regard is the global bank supervisors from Basel at the Financial Stability Board (FSB) have just published a peer review of China.

The peer review examined two topics relevant for financial stability and important for China: the macro-prudential management framework and non-bank credit intermediation.

It concluded Chinese authorities had made good progress in addressing the 2011 Financial Sector Assessment Program (FSAP) report by the International Monetary Fund (IMF) and the World Bank on both topics but warned there is additional work to be done.

“A unifying theme behind the peer review findings and recommendations is the need for closer coordination and information sharing between the authorities to handle a dynamic financial system,” the FSB said.

The west learned to its dismay communication and coordination between agencies was inadequate during the financial crisis. Australia was a positive exception. The US and UK were not.

If stresses in the banking system do appear as a consequence of current turmoil, prompt and coordinated action will be critical.

Notably the FSB recommended China needs to be clarifying the mandate and roles of different inter-agency bodies in assessing systemic risks and designing macro-prudential policies while strengthening supporting infrastructure.

It also recommended more transparency, a particular challenge, saying agencies should publish the outcome of key inter-agency meetings and deliberations periodically as a means of communicating the authorities’ macro-prudential outlook and policy stance.

The FSB noted positive steps had been taken in better understanding the role and risks of China’s “shadow banking” system and the role of this sector was moderating. More still needed to be done however.

Again, more transparency is called for with the FSB saying China should continue to “enhance efforts to collect and disclose comprehensive and granular data relating to non-bank credit intermediation (e.g. on various forms of wealth and asset management products), and routinely share them for risk monitoring purposes”.

The final message was not to step back from liberalisation: (China should) continue to promote a more diversified and resilient financial system by increasing reliance on market-based pricing mechanisms via the removal of implicit guarantees, and by further developing capital markets and an institutional investor base as an alternative pillar to bank financing.

This work obviously has a longer time frame than the short to mid-term play out of current issues. There will be impacts with the far greater connections between Asian banking systems.

A new paper for the Melbourne Money and Finance Conference by Grant Turner and James Nugent looked at the “International Linkages of the Australian Banking System – Implications for financial stability”

The paper noted the key trade and investment motivations of Australian banks, both inter and intra-Asian, weighing up the benefits of higher and more diverse earnings compared with greater operational and credit risk. There is also the risk of contagion in the home market from issues overseas.

“From a risk management perspective, the majority of exposures are shorter term and trade-related; these exposures typically pose lower funding and credit risks than long-term lending.”

The authors warn however of higher operational risk due to complexity and with businesses where there is not direct control.

Moreover “disruptions in Asia, principally China, would be expected to impart significant indirect effects to the Australian banking system (through macroeconomic and global wholesale funding market channels) at the same time as any direct financial risks are realised”.

The research also looks at the stability risks to Australia if foreign banks operating in the country get into trouble. This was a significant issue in Asia in the aftermath of the 2008 crisis with certain sectors and countries suffering credit squeezes.

However the authors say “the systemic risk posed by future external shocks being transmitted to Australia through foreign bank branches or subsidiaries is limited by their small size in Australia – the largest foreign bank accounts for only 2 per cent of domestic banking assets”.

The greater risk comes from global investment banks. “The substantial involvement of global investment banks in certain financial markets suggests that problems elsewhere in their banking groups could have a larger adverse effect on the Australian economy,” the research says. “It would be hard for others to replace some of their financial market activity at short notice because it is specialised and/or complex.”

For the banks operating in the region, including the Australian banks – and their subsidiaries in New Zealand – the greatest risk at present is to revenue. A slowing China may slow activity in the region and while the banking being done is relatively low credit risk, it is also dependant on volume.

The Australian banks, for better or worse, are far more connected with what’s happening in Asia today than in 1997.