Until roughly three years ago, many outside commentators argued that China’s state-driven financial mechanism, which funnelled cheap credit to state-owned industrial enterprises with little regard to efficiency or return on capital, would inevitably generate a huge pile-up of non-performing loans leading to a financial crisis.
To generate sustainable long-term growth, they contended, China would have to adopt the vastly more efficient capital-allocation mechanism of western banking systems and capital markets.
The problem with this argument was that efficient capital allocation matters a lot in mature economies at the technological frontier with structural growth rates of 2-3 per cent.
In contrast to western regulators, who put bank regulation on auto-pilot via the model-driven and extremely pro-cyclical Basel II capital adequacy system, Mr Liu made a persuasive case for the enduring value of old-fashioned bank supervision tools such as limits on single large exposures, a conservative 75 per cent loan-to-deposit ceiling, limits on simple leverage ratios, and “window guidance” on exposures to specific companies and sectors.
There is certainly plenty of garbage hidden in China’s banks, and new garbage is being created at a rapid rate through the vast expansion of lending under the government’s economic stimulus programme. But strong balance sheets and the sensible regulatory framework suggest that financial crisis risk in China remains low.
Mr Liu concluded with several recommendations for regulatory redesign that western governments would do well to heed:
#monetary policy must take account of asset prices as well as consumer-price inflation;
#the capital markets should never be the primary source of funding for banks;
#traditional prudential ratios should be used where appropriate to supplement capital-adequacy ratios;
#and regulators should use judgment and discretion to modify the actions suggested by their models.