China's Zhou Xiaochuan Warns on Rising Financial Risk in Blunt Article

BEIJING, BLOOMBERG -- China's financial system is getting significantly more vulnerable due to high leverage, according to central bank governor Zhou Xiaochuan, who also flagged the need for deeper reforms in the world's second-biggest economy.

Latent risks are accumulating, including some that are "hidden, complex, sudden, contagious and hazardous," even as the overall health of the financial system remains good, Zhou wrote in a lengthy article published on the People's Bank of China's website late Saturday. The nation should toughen regulation and let markets serve the real economy better, according to Zhou. The government should also open up financial markets by relaxing capital controls and reducing restrictions on non-Chinese financial institutions that want to operate on the mainland, he wrote.

"High leverage is the ultimate origin of macro financial vulnerability," wrote Zhou, 69, who is widely expected to retire soon after a record 15-year tenure. "In sectors of the real economy, this is reflected as excessive debt, and in the financial system, this is reflected as credit that has been expanding too quickly."

Zhou's comments signal that policy makers remain committed to a campaign to reduce borrowing levels across the economy. Concern that regulators may intensify the deleveraging drive after the twice-a-decade Communist Party Congress has helped push yields on 10-year government bonds to a three-year high.

Still, measures of credit continue to show expansion, with aggregate financing surging to a six-month high of 1.82 trillion yuan ($274 billion) in September. China's corporate debt surged to 159 percent of the economy in 2016, compared with 104 percent 10 years ago, while overall borrowing climbed to 260 percent.

Zhou's article was included in a book that was published recently to help the public and party members to better comprehend the spirit of the 19th Party Congress, according to the official Xinhua news agency and information on the PBOC's website. Here are some of the other points he made:

On risks and regulation

China's financial system faces domestic and overseas pressures; structural imbalance is a serious problem and regulations are frequently violated.

Some state-owned enterprises face severe debt risks, the problem of "zombie companies" is being solved slowly, and some local governments are adding leverage.

Financial institutions are not competitive and pricing of risk is weak; the financial system cannot soothe herd behaviors, asset bubbles and risks by itself.

Some high-risk activities are creating market bubbles under the cover of "financial innovation".

More companies have been defaulting on bonds, and issuance has been slowing; credit risks are impacting the public's and even foreigners' confidence in China's financial health

Some Internet companies that claim to help people access finance are actually Ponzi schemes; and some regulators are too close to the firms and people they are supposed to oversee.

China's financial regulation lags behind international standards and focuses too much on fostering certain industries; there's a lack of clarity in what central and regional government should be responsible for, so some activities are not well regulated.

China should increase direct financing as well as expand the bond market; reduce intervention in the equity market and reform the initial public offering system; pursue yuan internationalization and capital account convertibility.

China should let the market play a decisive role in the allocation of financial resources, and reduce the distortion effect of any intervention.

China should improve coordination among financial regulators.