Bank risks can create system risks

CHINA FINANCIAL - In Brief 02 Dec 2015 by Michael Pettis

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Why does an open capital account reduce Beijing’s ability to control refinancing risk? Because part of reason that what looks like liquidity mismatches between shorter-term liabilities and longer-term assets are a lot less risky than they seem for China is that liabilities may be liquid at the institution level, but they are really not that liquid at a systemic level. If you take your money out of Bank A, in other words, your only alternative, often enough, is to put it back into Bank B, so that it remains within the system and subject to re-allocation from Bank B to Bank A by the PBoC. That’s why we don’t see runs on Bank A. While I still think China is fairly unlikely to see a financial or banking crisis, and that we are far more likely to see a long but stable slowing down of the economy as debt is slowly ground out of the system, the longer we see rapid credit growth, the greater the risk of a financial disruption, or even crisis. If this were to happen, I wonder if in retrospect we might not point, ironically, to this week's SDR membership change as the beginning of the unraveling. It is too early to say, but over the next few quarters we will have to watch how China addresses capital flight and capital controls. I have long argued that it is only ideology, and not history, that makes so many of us so sure that an open capital account is a good thing for developing countries. The more distorted the national balance sheet, the riskier I think capital account liberalization is likely to be. If SDR membership ends up tying Beijing’s hands on the issue of capital flows, I don’t think it will be a good thing. However if it succeeds in reducing net outflows on the capit...