By Gao Zhanjun

Pressure for monetary policy normalization is gradually increasing, economic performances are uneven and economic

What is the most important topic in the financial sector? In my view the top priority is how to maintain financial stability,specifically how to deleverage and defuse financial risk. In short, the aim is to prevent the arrival of a "gray rhino"- or an obvious danger that we ignore.

People are more familiar with so-called “black swan” events, the unexpected developments that could trigger a crisis. Unlike the black swan,the "gray rhino" refers to a high probability of risk. There is a warning sign before disaster strikes, but it is often overlooked or neglected.Michele Wucker, an American economic and crisis policy researcher,first proposed the concept in her book, The Gray Rhino, published in 2016. The financial risks discussed in this article are, to a large extent,those gray rhino issues - seemingly far away but actually looming.

Defusing financial risk is an issue that is important to China and the world. China's current debt burden, which requires deleveraging through monetary policy, regulatory coordination and structural reform,has created a consensus on how to reduce financial risk. However,leverage is high not only in China, but also elsewhere around the globe.

According to the Institute of International Finance (IIF), in the third quarter of 2017 total global debt was US$233 trillion, which was up US$88 trillion compared with a decade ago,accounting for 318% of global GDP.Excessive debt was seen as one of the triggers of the 2008 financial crisis.And now global debt is higher than it was then. Is the problem worse?Debt is high and so far this has not caused a new crisis. Is it because the ability to manage risk has increased,or is global debt allocation more reasonable than before? Or is it just our good fortune that one has not yet arrived? At the moment, global asset prices are not low. The world economy is improving but could still falter. Pressure for monetary policy normalization is gradually increasing,economic performances are uneven and economic and financial policies remain divergent. Meanwhile, political risks remain. These factors underscore the difficulties in dealing with significant financial problems such as elevated levels of debt.

Source: BIS credit-to-GDP gap statistics.

On October 5, 2017, Christine Lagarde, managing director of the International Monetary Fund (IMF),spoke at Harvard University. The theme of her speech, “Mend the roof when the sun shines," was that the global economy has made a gentle recovery,the banking sector has stabilized, and financial conditions have improved.So it's time to take appropriate policy measures to make structural reform and reduce excessive debt. In response to my question, "Will high global debt levels trigger another financial crisis,"Lagarde replied that this problem is not a cause for alarm, but certainly of concern. The IMF's Global Financial Stability Report, released in mid-October, also highlighted the debt issue.

So what about that overwhelming debt? I want to emphasize three points here:

First, on the other side of these debts are assets. To improve economic efficiency and enterprise profitability is to solve the debt problem from the asset side. If the profitability of the asset is strong and efficiency is high, then the increase in the denominator will help reduce the leverage ratio itself. Higher profitability and efficiency make higher debt levels affordable.Second, there is a need to allocate existing debt to more efficient sectors. Debt itself is a resource in some sense. Different industries and different sectors in the same industry are different in terms of efficiency.State-owned enterprises are often less efficient than private ones. The resources should be tilted to the ones with high efficiency.

Third, when we talk about leverage, it is not just about the real economy, but also the financial sector. It is difficult to solve the problem when not shrinking the huge financial system, not changing the complicated situation of the financial sector, and not strengthening the risk-bearing capacity of the financial sector. This is the focus of this article.

China's Financial Complexity

To gain a deeper understanding of financial risk, we need a vantage point from which we can observe the entire economy and financial system and take a global view. Considering the following factors, we must remain highly vigilant against the financial risks that may appear in China.

Sources: Wind database and author's calculations

First, China's debt burden is heavy,and if this does not change, the pressure will be hard to bear. In 2014,to describe a typical phenomenon of China's economy, I put forward a point of view, which I call "the impossible triangle of debt." The socalled "triangle" is high leverage, low efficiency and the fact that credit expansion cannot drive effective economic growth. It is difficult for these factors to co-exist for an extended period of time. High leverage will continue to aggravate inefficiencies and make a transition out of this environment difficult to achieve. Low efficiency worsens as a result of high leverage, and that makes leverage a greater threat. In an economic slowdown, if we continue to use high leverage to maintain low efficiency, the problems will be aggravated and a long-term trend will be formed. The answer is to reduce leverage or improve efficiency.There is no alternative. The use of loose monetary and credit policies to keep the economy running will have to come to an end.

Fortunately, China is carrying out supply-side structural reform. One of its core measures is to deleverage,reduce overcapacity, improve resource allocation and improve economic efficiency. That's the right direction. We have confidence in the success of the supply-side structural reforms, but we must also recognize that it requires sustained effort and much time. We need to attach great importance to financial risks and ensure they are not treated lightly.

Second, the bond market has expanded considerably. When credit expansion does not lead to effective economic growth, capital flows into the financial sector rather than the real economy. Bond markets are at the heart of financial and debt problems. China's bond market is large -- the balance has increased from less than 30 trillion yuan three years ago to nearly 70 trillion yuan at present. Bond trading volume has increased from 40 trillion yuan to 120 trillion, money market financing volume has increased from 230 trillion yuan to 800 trillion yuan --which mainly consists of overnight financing. In the face of these significant market changes, we need to adopt a completely different vision,manner and philosophy. The situation is becoming more difficult to control and a slight move in one area may affect the overall picture.

Third, China's financial system is a large and tightly linked network.Total social financing has reached 171 trillion yuan and total assets on bank balance sheets exceed 230 trillion yuan. The ratio of social financing to deposits has increased by 30% in the last three years, indicating that a large share of bank assets is not supported by deposits. The off-balance sheet assets of banks are 100 trillion yuan,and the proportion to total assets continues to rise. Interbank assets have reached 60 trillion yuan. The outsourced amount from the banking system is 15.7 trillion yuan and is growing rapidly. Banks' claims on non-bank financial institutions have risen from less than 10 trillion yuan to 27 trillion yuan in the last three years,reflecting the growing relationship between banks and non-banks. Assets under management in the whole society are as high as 112 trillion yuan(78 trillion yuan after adjusting for double counting), involving almost all financial institutions, financial markets and financial products. From the perspective of management, the business model is complex and highly interconnected.

Deleveraging on Two Sides

In 2017, to squeeze out financial bubbles, carry out deleveraging and prevent risks, China adopted a neutral monetary stance and strengthened regulation. This policy shift was part of a global phenomenon that included China, although the timing and starting point for each economy was different. Major economies are now recovering from their difficulties compared with 2016, and deflation is no longer a global challenge.Against this background, the US has entered a period of normal monetary tightening. In October last year the Fed even began to shrink its balance sheet. The European Central Bank's stimulus campaign is drawing towards a close, and the central bank has cut back its bond-buying program.The monetary policies of the world's major central banks are differentiated but resonant. The linkage of monetary policy between China and the US is particularly obvious: The Fed has raised interest rates several times since December 2016, and the PBOC has closely followed and increased its short term interest rates. In addition to the consideration of deleveraging,the spread between domestic and US interest rates has remained fairly constant to stabilize expectations for the renminbi exchange rate and slow outflows of capital.

During this period of strict regulation and neutral monetary policy, the initial focus has been monetary policy. The PBOC has tightened short-term funds and loosened long-term funds by means of its open market operations since the beginning of August 2016. In 2017 it raised policy rates several times. Additionally, it incorporated off-balance-sheet financing into its Macro Prudential Assessment. These have all had a significant impact on conditions overall. Many institutions had to make adjustments, and this has played a positive role in the process of financial deleveraging.

Since March 2017, regulators have released new policies and guidance to put in place special administration over the financial sector. This was to avert arbitrage and improper behavior and prevent financial activities from turning to the virtual area so that the financial sector can focus on its key objective of serving the real economy.The scope and intensity of policy and guidance is unprecedented.

As regulators have focused on neutralizing monetary policy, financial institutions have begun to deleverage.This has already produced results,and can be seen clearly from two aspects. From the perspective of the market, the duration of short-term financing has been extended, the trading volume of bonds has shrunk,the bond turnover rate has dropped significantly, and the credit spread has widened. From the perspective of business structure, the pattern of asset management has undergone positive changes. The channel business - or the channeling of funds from banks to non-bank financial institutions - has been reduced,banks' off-balance sheets have been compressed, and the outsourced funds from banks have been redeemed. Although progress has been made, we are still a long way from reaching our targets, however.The process is at a crossroads, both for investors and regulators.

Financial institutions are under pressure to deleverage. Compressing assets and reducing debt is essential,and it is important to adjust the strategy under the pressure of passive deleveraging. This is a wise choice. It is unsustainable to use interbank liabilities to maintain financial plans. The proportion of offbalance sheet assets is too large and should be compressed appropriately.Outsourcing and channel operations are too aggressive, and this should be addressed in an active manner.

For regulators, in order to deleverage, it is natural for financial institutions to experience some pressure in order to squeeze their assets and liabilities. This is a move in the right direction. But regulators should also be aware of priorities and help give markets a stable outlook.While maintaining this high pressure,regulators should take the whole situation into account and plan accordingly, control the pace of their actions and make progress gradually,so as to avoid excessive adjustments and a loss of control.

An Assessment of the Debt Overhang

People who hold a bearish view of China's economy have once again been disappointed. Over the past year, China's capital outflows have been effectively controlled. Foreign exchange reserves have reversed their decline and started to edge higher.Meanwhile renminbi exchange rate expectations have stabilized and the local currency has even appreciated against the dollar. GDP grew by 6.9%last year, industrial capacity utilization increased sharply, and the deflation risk decreased. The contribution of consumption to GDP has risen,the service sector has continued to expand, scientific and technological progress has achieved remarkable results, and air quality has improved.

Moreover, it is important to note that the pace of credit expansion has finally slowed, overall leverage has fallen and the financial system has become less complex. According to the Bank for International Settlements(BIS), there has been a narrowing of China's credit-to-GDP gap -- defined as the difference between the creditto-GDP ratio and its long-term trend-- captures the build-up of excessive credit in a reduced form. It has been found to be a reliable early warning indicator of impending financial crises. The indicator, which tracks data starting from 1995, peaked at 28.8 in March 2016 and then fell to 16.7 in the third quarter of 2017, the lowest level since 2012. (See Chart 1: China's credit-to-GDP. A reading of 10 or higher is considered to be in the alert area).

According to central bank statistics, the growth of M2 in 2017 slowed markedly, partly reflecting the result of deleveraging. In addition,the asset-liability ratio of enterprises declined, profitability was enhanced,and solvency improved.

Looking back at the stock crash of 2015, the renminbi depreciation and capital outflows between August 2015 and the first quarter of 2017,and the bond slump in the fourth quarter of 2016, we can now see much less market pessimism. Some optimistic people have even begun to look forward to a new economic cycle.

That's a good thing. But at the same time, it is necessary to keep a clear mind to ensure our more favorable vision comes true. It is important to note that although the leverage ratio has declined and solvency has improved, this is partly due to a real estate boom, rising prices of raw materials and higher household leverage ratios. Financial risks are far from being eliminated,and new challenges have emerged.Sustained efforts are needed to achieve a fundamental solution to problems associated with China's long and ongoing credit boom.

The IMF has been concerned about China's debt and financial risks in recent years. To find analogues for China, the IMF identified 43 cases of credit booms in which the credit-to-GDP ratio increased by more than 30 percentage points over a fiveyear period. (See IMF Working Paper WP/18/2, January 5, 2018) Among these, only five ended without a major growth slowdown or a financial crisis in the immediate aftermath.

According to IMF estimates,China's non-financial sector leverage increased by 48% in the five years between 2008 and 2012,and increased by 55% after 2012.Moreover, the recent increase has come from a high starting point; the leverage ratio was 131% in 2008 and 179% in 2012, both above the 100%threshold. Despite the high starting point and a huge increase over a 10-year span, there was no crisis or severe recession, which seems inconceivable to many researchers.

There are five exceptions to the IMF's 43 cases. But these five are not comparable to China: New Zealand had a one-off, low-start credit expansion after 1988; Hong Kong had a similar expansion while it was developing into a global financial center in the 1980s; Finland's credit expansion was the result of a massive deleveraging in the late 1990s.Indonesia and Switzerland temporarily avoided risk for the first time in 1990 and 1985, but a crisis finally occurred after further credit expansion.

China's economy and financial system are still intact, and this is a result of many factors including a high savings rate, a current account surplus, limited foreign debt, a significant net worth of assets from various companies and countries,high foreign exchange reserves and the high bank reserve requirements ratio. But China cannot maintain its current status forever, and must stick to deleveraging and making structural reforms.

What's more, the recent stabilization of leverage is only structural. M2has slowed, but total social financing and other broad credit indicators are still growing fast.In addition, there is a new challenge from the investment fever linked to the real estate sector. Residential leverage levels are rising and local government debt is climbing.

The surge in household debt is particularly worrisome. Since 2006,household loans from financial institutions have grown at an average annual rate of 24%, and by the end of 2017, total loans had reached 40.5 trillion yuan, equivalent to 48.97% of GDP. (See Chart 2: China's household loans. ) Without any controls, the total could reach 80 trillion yuan by 2020.It would be ironic if the household sector, once seen as China's financial risk firewall, would become another risky factor and the focus of a new round of deleveraging. People who believe that China has further room for the household sector to increase leverage, need to be careful.

Deflecting “gray rhino” risks requires vision and a willingness to take comprehensive measures. The root of credit risk is a high leverage ratio, excess capacity, resource mismatches, “rigid payments” to cover debts of uncompetitive market participants and a lack of proper default disposal mechanisms. All of these issues must be addressed.The current liquidity situation reveals a number of weaknesses,in which the money supply chain often breaks down. It is important to reduce financial risk but also control the pace of change, as well as forming real market interest rates and reconstructing money supply channels. The key to resolving the risk spillover effect is to maintain the continuity of policy and value the construction of a regulatory system,letting the market mechanism play a role and strengthening supervisory coordination. Regulators should be vigilant in coping with "gray rhino"issues, which refer to risks that are visible to all but not necessarily occurring soon or capturing the attention they deserve. They need to make plans in advance according to different scenarios and move in a timely manner to prevent risks from increasing.

In particular, in order to achieve the expected effects and avoid extreme situations, it is important for policy makers to reach a consensus on the following four aspects or the four policies for resolving financial risk.

Maintaining Policy Continuity

We should keep a steady and neutral monetary policy, avoid a rapid expansion of credit and prevent money flowing from the real economy to the virtual area as that usually increases leverage. At the same time, regulators should strengthen supervision, block unnecessary links within the financial sector, control the scale of bank offbalance sheet lending and regulate the asset management business. At the same time they need to raise the threshold for market participants,encourage sustainable business models, reduce leverage in the bond market and establish effective regulatory standards.

In the process, it is more important to recognize that policy continuity should be maintained.Otherwise, there may be three unfavorable situations:

The market may experience more volatility and ultimately regulators back off from their policy objectives. This could lead to the reappearance of old, unresolved problems. One example is that the regulation of shadow banking was effective in 2014, but in 2015 this was no longer emphasized. That led to a reappearance of the same old problems, erasing some of the past achievements.

There is a potential for undermining the authority of regulation. This may affect the confidence in regulation, and result is an endless "cat and mouse" game between regulators and some market participants.

There is a possibility that systembuilding and attention to market mechanisms will be ignored. In this unfavorable situation, it is difficult to grasp the key points and to focus on the more urgent target, let alone make gradual progress.

Implement Market-oriented Supervision

Preventing risk spillover effects relies on laws and regulations,which will solve problems in a systematic, considerate and durable way. Regulators should also avoid too much administrative intervention, which could easily lead to a cycle of "problems reappearing when supervision is loose and then leading to rules becoming tight." This could leave market participants and regulators at a loss.Effective supervision will focus on implementation after regulatory rules are and institutional arrangements are in place. Then the violators of the rules need to be punished. Many problems need to be solved, including those exposed by the money market fund squeeze that roiled the market in December 2016 and the problem that same month with bond holding entrustment agreements as revealed by the Guohai Securities incident. (Such agreements, a form of financing whereby one party finds another company to hold a bond and promises to buy it back in future,can entail considerable counterparty credit risk). On October 1, 2017, the implementation of the Regulations on Liquidity Risk of Public Offering Open-end Securities Investment Funds was a significant effort in this respect aimed at limiting customized money market funds, requiring risk reserves and insisting on improving asset allocation requirements and collateral qualification.

Strengthen Supervision Coordination

China has a mixed mode financial system though supervision is divided into different regulatory areas. In the context of serious departmental interests and increased regulatory competition, systemic risks may increase. That is one reason why the US subprime mortgage crisis erupted and turned into a once-in-a-century event. Coordination of supervision must be strengthened to reduce decision-making costs and eliminate information fragmentation and unnecessary mutual suspicion among regulators. Regulators should also need to accurately identify and judge risks, and take timely and effective measures to avert them.

At the moment, China's monetary and regulatory policies are becoming tight which is the right direction for a period of deleveraging, reducing financial bubbles and preventing risk. But if regulatory rules are not coordinated the probability of an accident may increase at times of heavy financial stress. At present,participants trust the supervisors'coordinating ability. They have deep faith in the regulators' ability to promote risk prevention and disposal in the event of a crisis. Therefore,the threat of a situation slipping out of control can be averted, but still requires attention. In 2013, China set up a financial supervision and coordination mechanism (the interministerial conference system for financial regulation and coordination),which can be viewed as an attempt to make progress in regulatory coordination. At the Fifth National Conference on Financial Work held in July 2017, the establishment of the financial stability development committee of the governing State Council was also put forward, with high expectations from all circles.

Regulators should further modify and improve existing laws and regulations. The current law and regulation system was designed for separate supervisory operations, but the financial industry has developed from the original separate operation to actual mixed operation. Without a change of rule when situations have changed, participants may not make proper adjustments and legal loopholes may emerge, and that in turn could conceal risks.

Regulators Need a Plan to Respond to Major Risks

When the financial markets are volatile, risks may be more apparent.But direct actions of the central bank and regulatory authorities are not always necessary in these situations.Normally, markets are able to digest risks themselves, and these risks should be handed over to the markets. However, when markets are volatile and risk spillover occurs,authorities are required to respond appropriately.

The collapse of the bond market at the end of 2016 is a classic case.At that time, bond yields spiked sharply and the money market froze up. The market panic reached a peak on December 15, when the main contract on the treasury bond futures market reached limit down, and a circuit breaker went into effect after only 15 minutes. That was the first time this had occurred. The cause of the event was very complex but it could be linked to four aspects:one was fundamental and policy factors, including the central bank's tightening of monetary policy, the Federal Reserve raising interest rates,disappearing deflation expectations and better economic prospects (in China and globally). Second, the bond market was highly leveraged,so it was easy to magnify the effect of a market setback. The third is the unexpected events, including the Guohai Securities incident, as well as a large redemption and the breakdown of the money supply chain. Fourth,the risk of corporate bond defaults was concentrated in a short span of time.

In this latest bond market storm, market risks, liquidity risks,counterparty risks and credit risks have emerged simultaneously. This has spread to other markets, leading to a stock market slide and expectations of a depreciating currency. In a word, the risk spillover effect has occurred. Market mechanisms failed in this crisis, and authorities needed to come forward to restore market confidence and order. Fortunately, the central bank and relevant regulatory authorities took timely actions. One response was to provide necessary liquidity support and window guidance. The second was to play an important role in guiding the negotiations of the Guohai incident and reaching a solution. This was very timely and necessary for market confidence, because if not, the market might have collapsed and risk would have spread further.

Black swans are hard to predict,but "gray rhinos" should be easier to spot. Regulators need to remain vigilant, prepare response plans in advance and take firm action when necessary.