No financial meltdown in sight

China has a war chest of foreign exchange reserves that it finds difficult to dispense. When necessary, the Chinese government will not hesitate to inject capital from the reserves into commercial banks as it has demonstrated in the past.

How about liquidity shortages and a credit crunch when commercial banks are facing a crisis situation? These problems should also not happen in China. All governors of the Big Four will act swiftly to follow any instructions given by the government.

Government won't resort to short-term stimulus

Financial reform 'one of China's easiest'

However, there is one important caveat: China has to maintain its capital controls in the foreseeable future. If China were to lose control over its cross-border capital flows it could lead to panic and so capital outflows would turn into an avalanche and eventually bring down the whole financial system. This makes current plans to liberalize the capital account deeply troubling and inconsistent with other policy priorities.

Yet the Chinese economy is fraught with serious problems and confronted with a fundamental contradiction. On one hand, due to the rampant "regulatory arbitrage", China's monetary interest rates have been rising steadily. One the other hand, the return of capital in China has fallen rapidly since 2008, due to over-investment and widespread misallocation of resources. If the Chinese government fails to reverse this trend, a financial crisis of one form or another is inevitable at some point in the future.

Finally, the Chinese government should act quickly in response to social tensions. If the government "blinks" and responds with another massive credit stimulus, instead of educating households about the concept of risk, the damage could be fatal.

For now, there is still no convincing evidence to show that China is facing an imminent financial crisis and an economic crash. Nonetheless, the Chinese government must realize that its margin for error in implementation is approaching its limits.

The author is former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. www.chinausfocus.com