Significant distress in China could spill over to US and global markets: Federal Reserve

The US Federal Reserve on Friday said a prolonged, rapid credit expansion in China has rendered its corporate sector highly vulnerable to a sharp downturn and warned that adverse developments in China also could spill over to the US and other global markets.

“Because of the size of the Chinese economy, significant distress in China could spill over to the US and global markets through a retrenchment of risk appetite, US dollar appreciation, and declines in trade and commodity prices,” said US Federal Reserve in its latest edition of the Financial Stability Report.

“A prolonged period of rapid credit expansion in China has rendered its nonfinancial corporate sector highly vulnerable to a sharp downturn in addition to poor asset quality and notable interconnections between banks," the Federal Reserve said, adding  developments in domestic and international markets could pose a number of near-term risks to the financial system.

According to the Federal Reserve, trade frictions -- centered on the US–China dispute -- remained the most widely cited potential near-term shock.

“Respondents generally expected higher tariffs on Chinese imports to persist well into next year and noted that the tariffs had started to affect US economic activity,” it said, referring to a survey it did as part of the report.

Some contacts worried about a deterioration in broader US–China relations, rooted in technology and national security issues, said the report adding they were also concerned about the regional geopolitical risks in Hong Kong, Taiwan and North Korea that may amplify bilateral tensions.

In its report, the federal Reserve said poor asset quality and notable interconnections between banks and the large and weakly-regulated shadow banking sector leave the Chinese financial sector vulnerable.

In this context, near-term risks such as an escalation in the trade conflict with the United States, a rapid adjustment in property prices, or a high-profile corporate default may trigger financial instability that could be transmitted globally, it said.