Sovereign debt default and bank risk in China

Abstract

Following the 2008 global financial crisis, sovereign default risk has become an important issue in Europe, as many Eurozone countries such as Greek and Portugal fell into serious debt problems. The sovereign default problem in these countries not only negatively impacts the overall economy of the countries, but also slows down the recovery process or even endangers the financial system of the Eurozone as a whole.

Some researchers have studied the sovereign default problem in Eurozone countries. For example, Reinhart and Rogoff (2010) tested the relationship between government debt and bank crisis, and found a strong link between them. In addition, Gennaioli, Martin and Rossi (2014) claimed that public default weakens the balance sheets of banks which hold public bonds. Further Reinhart and Rogoff (2010) confirmed that the run-up in debts acceleration is an important signal of a bank crisis.

The debt issue is not confined to Eurozone countries. Based on JP Morgan reports, at the end of 2012, the total Chinese government debt (central and local government debts) in terms of GDP ratio was 187%, reaching 282% in 2015. This high government debt level can potentially endanger the financial stability of China and its overall economy. In addition, it may result in a bank crisis in China. This study tests a potential sovereign debt problem and bank risk in China’s financial market. This includes the origin of the sovereign debt problem (what factors contribute to sovereign default), the negative impact of sovereign debt issues (for example the impact on economic growth and the financial system) and the interaction of sovereign debt and bank sectors (that sovereign default can negatively impact the banking system. On the other hand, banking factors also impact the sovereign debt problem).

This study tested the sovereign debt dynamics of China. The results confirmed a sovereign debt problem in China since 2009, which could be the result of the massive government expenditure since 2008. Secondly, this study estimated the sovereign risk of China based on macroeconomic fundamentals. The results found significant impact of macroeconomic fundamentals (debt burden, government revenue, debt interest rate, economic growth and inflation) on the sovereign risk in China. This provides a potential mechanism for the Chinese government to make concerted decisions to control the sovereign debt risk. Finally, this study investigated the impact of sovereign risk on bank risk in China. The results showed strong link between sovereign risk and bank risk especially for government-owned banks in China, which warn banks and government of China to pay attention to the spillover effect between sovereign risk and bank risk.