In the China Financial Stability Report 2019 recently released by the People's Bank of China ("PBC") the stability of China's financial system since 2018 was comprehensively evaluated. In general, China's financial risks have gradually shifted from rapid accumulation to high-level mitigation in the past few years. The exposed financial risks are being dealt with in an orderly manner and the bottom line of the nonoccurrence of systemic financial risks has been maintained. However, various structural, industrial and regional financial risks will continue to emerge. Therefore, under the complicated internal and external environment of the Chinese economy, the pressure of potential financial risks still needs to be taken seriously.

It can be seen from the central bank's report that China's biggest financial risk is still the problem of debts, or "de-leveraging". Judging from the situation in 2019, although China's macro leverage was contained in 2018, the level of macro leverage has increased again under the pressure of steady growth. This is also the "grey rhino" in China's financial risks. According to the report, the overall level of China 's macro leverage at the end of 2018 was 249.4%, decreased by 1.5% from the end of 2017, and the rapid growth of macro leverage has been initially contained. However, macro leverage has risen again this year. The report released by the National Institution for Finance and Development of the Chinese Academy of Social Sciences shows that macro leverage has increased to 251.1% at the end of the third quarter of 2019. Wu Ge of Changjiang Securities believes that the impact of de-leveraging on private enterprises is reflected in a significant increase in financing costs, which has also caused a sharp deterioration in the financing environment for private enterprises in the past two years. Monetary credit continued to shrink under the de-leveraging measures, and the increasing pressure on private companies' debts restrained their asset-side investment expansion, which led to a decline in economic growth. Li Xunlei of Zhongtai Securities further pointed out that the de-leveraging policy did not remove the leverage, but the pressure of the debts had shifted. Therefore, the risks remained and caused restrictions on policies. Hence, from the perspective of financial risks, the issue of leverage is the ultimate manifestation of various financial risks. Short-term mandatory contraction is not a solution for de-leveraging; rather a series of financial policies and reforms are required to resolvethe issue systematically.

The huge debts and credit scale have caused credit risk to become a prominent problem in the banking industry. The central bank's report shows that in the systemic stress test on banks, credit risk is the main source of risk for the 30 participating banks. Under severe impacts, about 80% of the total losses of the 30 participating banks come from credit risk losses. The key factors are the deterioration of loan quality and the increase in non-performing loan ratio under stress scenarios. Under mild and severe impacts, the overall non-performing loan ratios of the 30 participating banks increased from 1.46% to 5.42% and 7.38% respectively, and the losses of loan credit risk caused the overall capital adequacy levels to fall by 2.2% and 3.92% respectively. Not only that, from the perspective of the rising defaults in the bond market and the issues of exposure of collateralized financing in the stock market, credit risks are also continuously exposed in the financial market, and the impact on the entire financial system cannot be neglected.

According to the report, the stress test results of macro scenarios show that the 30 participating banks posses higher overall capital adequacy level, and their overall operations are stable, which can withstand downward economic pressure. Market risk has a limited impact on the 30 participating banks. Compared to credit risk, market risk has less impact on the capital adequacy level of the participating banks. The banking system has a certain resilience to the overall deterioration of credit risk. At the same time, the participating banks' overall profitability is relatively strong, thereby alleviated to some extent the pressure of the decline in capital adequacy levels during the stress period. However, risks in some key areas deserve attention. Solvency sensitivity stress test results show that risks in areas such as customer concentration, local government debts, real estate loans, and off-balance-sheet businesses should be issues of concern. At the same time, the regulatory side is also introducing various policies to help banks replenish their capitals in various ways. Since the beginning of this year, the bank's convertible bonds alone have a scale of nearly one trillion Renminbi. The risk-resistance of the banking system has also been continuously improved. Therefore, the bank's overall resistance to impacts is strong, and the likelihood of overall systemic risks is low.

PBC's report shows that the liquidity risk of the banking system cannot be overlooked, and the stress capacity of banks needs to be further enhanced. The stress test results show that, under mild and severe stress scenarios, 90 out of 1,171 participating banks failed the test, accounting for 7.69% and 13.58% respectively. Under the severe stress scenario, 10 out of 30 large and medium-sized banks were still unable to make up the gap after exhausted all the available qualified high-quality liquid assets and failed the test. Individual banks need to strengthen their off-balance-sheet business management. From the test results, some of the participating banks that failed the test have a large scale of off-balance-sheet businesses. In extreme cases, it is necessary to pay attention to the adverse impact of capital loss on banks due to contingent financing obligations, and strengthen off-balance-sheet business management. Generally speaking, the liquidity crisis is the concentrated exposure to credit risk, which will cause a series of problems. This is a financial risk problem that needs to be guarded against nowadays. The interbank market turmoil caused by Baoshang Bank this year shows the harm caused by liquidity stratification. This requires the central bank's monetary policy to emphasize the support in the liquidity of the financial system. Otherwise, systemic problems will easily occur.

From the perspective of structural de-leveraging, the high level of residents' leverage, which resulted from the rapid development of internet financing and inclusive financing, is also a complication. The report points out that, the sharp increase in household purchase expenditure in recent years has reduced the consumer expenditures to a certain extent, which has caused the growth rate of total retail sales in 2018 to slow down to 9.0%, which is 1.2% lower than the previous year. On the other hand, the credit risk of residents caused by the rapid development of Internet financing and other fields is also expanding. The report also pointed out that, with the downward pressure on the economy, more than 1,000 online lending platforms have collapsed, especially when the outbreak of some risk events. These have caused a huge negative impact on the industry reputation, and imperiled social and financial stability. Besides, due to the relatively relaxed internet regulatory environment, some Internet financial businesses are free from financial regulations or taking advantage of the existing gaps in the separate supervision of different lines of financial business for arbitrage. This has also led to the strict supervision of the internet financing and fintech fields, as well as severe rectification of financial markets since 2019. Nowadays, the risks in this area are still gradually emerging, which not only create a great disruption to the online financing institutions, but also the traditional banking systems and the real economy.

The central bank's report acknowledged that the financial turbulence sources and risk areas of the global economy are still increasing. The downward pressure on the domestic economy has intensified, and potential hidden risks are difficult to eliminate in a short period. Financial risks are showing some new characteristics and evolutionary trends, which require close attention. First, risks in key areas remain high. The scale of the local government's hidden debt is huge, and corporate credit bonds are under greater pressure of default. Real estate market risks may appear in some regions and the risks may be passed to the financial institutions. Second, even though the incremental risks of key institutions and various types of illegal financial activities have been effectively controlled, the existing risks remain relatively prominent. The risks of individual finance holding groups and rural financial institutions may be exposed. Internet financing, especially the risk of online lending, still requires close monitoring, and the situation of illegal fundraising remains complicated. Third, the risk of abnormal fluctuations in financial markets should not be neglected. Financial markets are highly sensitive to external impacts. The stability of the renminbi exchange rate and foreign exchange reserves are under pressure; the likelihood of the cross-impacting of risks between financial markets is increasing as well. These issues are the "black swans" that need to be addressed in the future.

Final analysis conclusion:

China's economy continues to decline. Cyclical and structural problems of the economic operation still exist, and financial risks continue accumulating. In general, the root cause of various financial risks is still the debt problems. Structural adjustment and deepening of financial supply-side reforms should be taken as the first step to improve prolonged structural contradictions. At the same time, monetary policy support is required to avoid concentrated exposure to problems.