Brad Setser Asks if a Chinese Banking Crisis Could Trigger a Currency Collapse

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Former US Treasury economist as well as Nouriel Roubini associate Brad Setser asks whether a crisis in China’s banking sector could lead a collapse in the Renminbi.

In a blog post for the US Council on Foreign Relations Setser notes that banking crises and currency crises often go hand in hand in an era of cross-border capital flows.

If foreign lenders demand their money back from domestic banks who have borrowed in a profligate manner from outside creditors, repayments can lead to an exhaustion of foreign exchange reserves and a sharp devaluation of the currency.

Setser points to the collapse of the Thai baht during the Asian Financial Crisis as a salient example of how a banking crisis can lead to currency collapse.

In China’s case this particular form of risk is almost entirely absent, given that Chinese banks have used domestic savings to fuel a boom in credit, as opposed to borrowing from abroad.

Despite spending copious amounts to keep the yuan afloat last year, China also have a large volume of foreign reserves that continue to exceed external debt.

Setser notes, however, that China could be vulnerable to several other forms of bank-triggered currency crisis.

Chief amongst them in his opinion is a mass withdrawal of funds by Chinese residents from the domestic financial system in the case of a banking crisis, and an exodus to offshore safe harbours.

Despite the existence of capital controls Setser contends that “this no doubt could happen,” and that China “doesn’t have enough reserves on hand to cover all its domestic bank deposits, let alone the shadow banking system’s analogue to deposits.”

This is a key reason why Setser believes that China should exercise caution when it comes to the liberalisation of its financial account.

Setser makes the caveat, however, that in the case of an imminent banking collapse regulators would likely recapitalise the system in advance a major run, or depositors might simply flee from shadow banks and smaller lenders to the implicitly guaranteed big state banks.

There is also the possibility that the Chinese government will lack the ability to recapitalise the banking system on its own and need to make recourse to financing from the People’s Bank of China.

The government could also avoid interfering  with the central bank balance sheet and recapitalise the bank with government bonds in lieu of cash, which lenders could  then use as collateral to borrow money  from PBOC.

A fourth and final way in which a banking crisis in China could trigger currency collapse is by means of a slowdown in growth, compelling the central bank to loosen monetary policy, which would lead to depreciation of the yuan.

In this case, however, China would still have the option of responding to the growth slowdown by easing fiscal policy in lieu of monetary policy, and keep interest rates at levels that would encourage depositors to keep funds in the country.

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