China’s Gray Rhino Financial Risks

In the financial sector black swan events are those which are unlikely to happen but, if they did, would have a huge impact on the country and they are nearly impossible to predict. The elephant in the room is an event that everyone is aware of but no one wants to address. A new animal has recently been added to the list of financial risks – the gray rhino. A gray rhino risk is an event that is highly probable and high-impact that officials have neglected to address. China is currently facing just such a risk as debt has built up in Chinese banks and firms due to the unregulated shadow banking system.

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China’s economic growth is founded on a system of credit and the growing debt levels have surged China’s non-financial debt-to-GDP ratio to over 250%. Having neglected to curb bank borrowing previously, President Xi has now begun efforts to prevent a financial crisis which could negatively effect the domestic economy and result in social unrest. However, the current situation presents somewhat of a catch 22. Tackling debt levels would result in a sharp drop in growth, meaning a large portion of the population could find themselves without employment. If left as it is with no attempts to solve the issues, the financial situation could lead to the banking system crashing.

As the government begins to address this long-standing issue, investors are worrying that risky assets, such as small stocks, may bear the brunt of the damage, as many of them are purchased using credit. The Shenzhen, China’s small-cap index, fell by 4.3% on the 17th July while the tech-focussed ChiNext index closed the day at 5.1%, its lowest point since 2015. The government’s expansion of regulation into more aspects of the economy, rather than just financial sector excesses as before, has prompted many investors to sell off their domestic stocks. If Chinese stocks suffer as a result of efforts to rectify the gray rhino risk, the effects could be felt in other countries. In a global market, if a country as influential as China experiences problems other areas will follow.

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Despite the issue of bank debt finally being addressed by the Chinese government, the country’s growth in the second quarter of 2017 was still 6.9%, a faster rate of growth than predicted. While this puts China back on track to meet its growth target this year, it means that the country is still heavily relying on debt-fuelled investments to develop GDP. To target the gray rhino risks, China should address problems that could arise from liquidity, shadow banking, credit, and avoid falling victim to price bubbles in the insurance and property markets. The outcome otherwise could be negative for China’s economy.