An almost two-year long study of the Chinese financial system by the International Monetary Fund found three major tensions that could derail the world's second-largest economy.
Those tensions emerged as China moves away from its role as the world's factory to a more modern, consumer-driven economy, the IMF said. The financial sector is critical in facilitating that transition, but in the process it evolved into a more complicated and debt-laden system.
"The system's increasing complexity has sown financial stability risks," the fund said in the 2017 China Financial Sector Stability Assessment report released on Thursday morning Asia hours.
The report was a culmination of the fund's several visits to China between October 2015 and September 2017. The assessment is intended to identify key sources of systemic risk in the financial sector so that policies can be implemented to enhance resilience to shocks and problems that could spread across the globe.
The first tension in China's financial system, according to the IMF, is the rapid build-up in risky credit that was partly due to the strong political pressures banks face to keep non-viable companies open, rather than letting them fail. Such struggling firms have, in recent years, taken on more debt to achieve growth targets set by the authorities.
The overall debt-to-GDP ratio in the Asian economic giant grew from around 180 percent in 2011 to 255.9 percent by the second quarter of 2017, data by the Bank for International Settlements showed. The rise coincided with a slowdown in productivity growth and pressures on asset quality in the banking system — increasing the risks faced by the Chinese economy.
The second tension identified by the IMF is that risky lending has moved away from banks to the less-regulated parts of the financial system, commonly known as the "shadow banking" sector. That adds to the complexity of the financial sector and makes it more difficult for authorities to supervise activities in the system, the IMF said.
And the third issue identified by the international organization is that there's been a rash of "moral hazard and excessive risk-taking" because of the mindset that the government will bail out troubled state-owned enterprises and local government financing vehicles. An example is the "implicit guarantees" that financial institutions offer when selling products to retail investors. That is a situation where the financial product sold are not guaranteed, but banks almost always compensate investors for principal losses by dipping into their own capital.
The People's Bank of China, in response to the IMF assessment, said in a statement on its website that it disagrees with some points in the report but the fund's recommendations are "highly relevant in the context of deepening financial reforms" in the country.
One of the points the Chinese central bank said it disagrees with is the conclusion that many banks lack the ability to withstand shocks. The IMF's stress tests found that 27 out of 33 banks studied were under-capitalized. But the PBOC said the Chinese financial system is resilient.
The IMF report was released at a time when China is showing greater resolve to contain financial risks. Over the past year, authorities have strengthened regulatory oversight and closed loopholes in the country.
Major steps taken include the setting up of a "super financial regulator" to coordinate the oversight of the banking, securities and insurance sectors. The government has also proposed prohibiting issuers of wealth management products from offering implicit guarantees to investors.
China's efforts have paid off, with the international investing community now recognizing the country's lower systemic risks.
"System risks from China have faded a little bit over the last year. There are less China bears out there. Over the last year economic data has surprised on the upside, but more importantly, the quality of economic growth has improved," said Joep Huntjens, head of Asian debt at NN Investment Partner.
The IMF said it acknowledged what China has done and welcomed President Xi Jinping's commitment to ensuring financial stability in the country. However, some gaps remained and the fund has five main recommendations for further improvement:
"Supervising one of the world's largest and most complicated systems is a challenging task. The Chinese authorities have worked hard to keep pace with growth and innovation but, as in all countries, many gaps remain," the IMF said.