Although the vast amount of comment around the world is that China is the boom economy and that, while there may be adjustments, it has such large foreign reserves it is insulated against the sort of financial crisis that rocked Asia about ten years ago.

Nevertheless all economists love playing a game which is ‘what if’ and they tend to be on the gloomy — which is to say the safe — side with their predictions.

The questions are asked: What if China’s export engine suddenly seized up? What if the resulting overcapacity exposed a new crop of bad bank loans? What if share and property prices plunged, sapping confidence and triggering capital flight that rattled banks and hit the renminbi?

This is a most unlikely scenario but economists love dabbling in this area.

One dramatic view: Stephen Jennings, head of the Russian investment bank Renaissance Capital, said in Moscow that China’s double-digit growth and soaring equities could drop so hard that it would make the 1998 emerging markets crisis look like a storm in a teacup.

He said, ‘The 8.5 earthquake on the Richter scale that will affect all of us — to me it’s China.’

Economists agree that the longer imbalances and liquidity build up because of the renminbi’s semi-fixed exchange rate, the greater the risks.

Nouriel Roubini, head of Roubini Global Economics and a New York University economics professor, suggests that if in the United States there is a a hard landing this could act as a trigger for a possible China crisis.

The ensuing slowdown in China’s growth could lead to a surge in bad loans, while a slump in share and real estate prices could wipe out enough wealth to dent residential construction.

He said, ‘The risks are that these things at some point — not in the very short term — get out of hand and then become a serious macro and financial problem to manage.’

China has spent as much as $500 billion since 1998 beefing up its banks, and its public finances are strong enough to rescue them again.

Nouriel Roubini agrees with this. He said recently in Beijing, ‘Of course fiscal resources could be used to help the banks. But at that point the risk is you get a credit crunch that has negative effects on the financial system and on the real economy regardless of the ability of the government to bail out the banks.’

Eswar Prasad, a professor at Cornell University in Ithaca, New York, argued that China’s ‘dysfunctional’ financial system might not be robust enough to withstand a big shock.

Prasad, a former International Monetary Fund researcher, identified a sudden reversal of capital inflows — caused perhaps by a loss of confidence in the banking system or social instability generated by rising inequality — as a vulnerability.

Monetary policy is a country’s first line of defense in the event of an economic shock. But Eswar Prasad said, ‘It’s a potential risk. One wouldn’t want to overstate the case. But, in terms of thinking of scenarios, it’s illustrative of the fact that even a small change in people’s preference for holding banking deposits could, because of the fragilities of the system, become something much larger.’
Source: International Herald Tribune