The U.S. Congressional Research Service published a detailed report on "China's Banking System: Issues for Congress" in February 2012, showing the importance of China's banking risk to the global economy. A lot has changed in the Chinese banking system since the publication of that report, but the world's concern about China's systemic risk has not faded, especially when its accumulated debt has accelerated while its asset quality has deteriorated.
Nevertheless, the focus on China's rising debt level and worsening asset quality exaggerates fears about a debt crisis. China's financial risk is still localized in nature because the current system set-up distorts rational domestic creditors' behavior and, ironically, reduces systemic risk. But we cannot ignore the risk of local financial accidents which could turn viral and systemic when the system set-up changes over time. This risk stems from the rapid expansion of small and regional banks that rely on wholesale funding and abuse financial innovation for regulatory arbitrage.
International credit-rating agencies have been warning about the danger of a Chinese banking crisis for quite some time. Fitch Ratings even boldly warned that China's bad loans in the banking system might be ten times the official estimates of 1.8 percent of total assets. That China's banking system has a non-performing loan problem is nothing new. The predictions of a Chinese banking crisis have been proven wrong for more than three decades because pessimists treat China as an open-market system with a liberalized capital market and an open capital account, which is clearly not the case. This is not to deny any financial risk in China. But concern should focus on other areas the system, rather than in a systemic blow-up.
A SYSTEMIC FINANCIAL "BOMB" THAT WON'T DETONATE
Financial risk in China is still localized in nature rather than systemic, though this will change as China continues to liberalize its financial sector and capital account. As long as the current system set-up remains, or changes very slowly, an increase in bad assets per se is probably not enough to trigger a financial crisis. This is because the government still owns the major banks, which are funded by stable retail deposits. Its implicit guarantee policy is the linchpin that holds the system together by, ironically, distorting creditor behavior.
If China were an open and mature market, which is how most western analysts see China, and given its non-performing loan problem, the creditors would lose...