NYU Stern Professor and Nobel Laureate Rob Engle was recently interviewed by the China Economic Review. In response to the question of China’s global financial stability, Engle responds:
“In Asia, risk is increasing, and has been increasing for a decade. The financial crisis did not show up very much in Asian banks, but they look substantially riskier today than they did five years ago. And in China, the rate of increase is very high. Its banking sector is taking on a risk at a very rapid rate. This is by publicly available accounting numbers. So, my feeling is, at the moment, that China is big enough, strong enough that they could recapitalize the banks.
However, as the economy slows, which appears to be the case, there are going to be a lot of competing demands for these resources, and the banks, because they are effectively guaranteed by the government, have little incentive to reduce their risk. How do you not increase your risk? You loan only to state-owned enterprises, who are themselves guaranteed, or at least indirectly to the municipals, which you sort of think are guaranteed. My feeling is that investors probably feel like they are guaranteed to some extent by investing in the banks.
Consequently, things are probably worse than they look.
What I am thinking is that this measure is based on how capital markets value the banks. And so my feeling is that investors, even though they have discounted the Chinese big banks, may not have discounted them as much as they would if they did not have these government guarantees. And consequently, our measure of risk is maybe a little bit optimistic about the strength of the banks. In which case, it seems an even bigger concern.”
Read the entire interview.