Financial Instability In China: An Econometric Study

The outbreak of the international financial crisis has triggered a reflection on the traditionalmicro-prudential supervision based on capital regulation, and the academia and governments havestarted to reconsider whether the monetary policy targeting controlling inflation is sufficient tomaintain the stability of the entire financial system. To prevent systemic financial risk andmaintain financial stability and economic growth, macro-prudential supervision is becoming themajor trends of financial regulation in the countries of the post-crisis era. Strengthening themacro-prudential supervision and cooperating with the micro-prudential supervision are majorrestructuring of the financial regulation. However, with regard to financial instability, financialcycle and systemic financial risk, there has not yet been a clear and consistent understanding. Theevolutionary mechanisms for the financial risk, the quantification of financial instability and thecreation of financial-economy model should be further studied, and more attention should be paidto the development and implementation of macro-prudential supervision tools.Although China has not yet experienced the financial crisis triggered by internal risk,instability in the financial system is increasing and the financial risk is accumulating, meaning thatit is urgent to study China’s financial instability and its spillover effects on the real economy. Themeasurement of financial instability and the characterization of the financial cycle could providesupport for the design of effective macro-prudential tools and the implementation of financialregulatory policies. The aspects and main findings of the studies in this paper are the following:First, the theoretical analysis of the financial instability is given. In Chapter2, after reviewingthe previous studies, the connotation, the causes, and the essential nature of the financialinstability are elaborated. From the static and the dynamic perspective, the clear connotation of thefinancial instability is given. The evolution of the financial instability is divided into three stages,i.e., financial fragility, financial stress and systemic financial risk. The characteristics of thefinancial risk in each stage are introduced. Both the traditional financial contagion theory and theendogenous financial instability theory are used to explain the generation of financial instability.The essential nature of the financial instability, including the characteristics, dimensions,regulations, and economy costs, are discussed. Finally, the pre-crisis and post-crisis policies forfinancial instability are introduced.Second, the quantitative analysis of the financial instability is given. In Chapter3,4and5,the three main stages of the financial instability, namely the financial fragility, the financial stress,and the systemic financial risk, are measured and analyzed using econometric models respectively.In the quantitative analysis of the financial fragility in Chapter3, state-space model with Markov regime switching is used to model the co-movement of financial variables, and thetraditional maximum likelihood approach and Bayesian approach are used to estimate the modelrespectively. The common factor of the state-space model which is called the financial fragilityindex is extracted as a measurement for the financial fragility in financial system. Further analysisof the financial fragility and its switching features in China’s financial system are given. Moreover,the leader-lag relationship between financial instability and macro-economy is studied using linearand non-linear Granger test. Analysis results show that: two regimes of the financial fragility,“high financial fragility” and “low financial fragility”, exist in China’s financial system, and thetwo regimes are asymmetric, with the persistence probability being bigger and the persistenceduration being longer in the “low financial fragility” regime; the magnitude of the financialfragility cycle is affected by financial policy, fiscal policy, and monetary policy, and unusuallyhigh financial fragility is followed by much lower financial fragility; financial instability inChina’s financial system will have an effect on the macro-economy, but the transmissionmechanism and channel are complex and nonlinear.In the quantitative analysis of the financial stress in Chapter4, based on the characteristics ofthe financial stress, financial stress indicators are selected from the banking sector, the stockmarket and foreign exchange market, and they are constructed into a financial stress index as wellas three sub-index, namely bank stress index, security stress index, and foreign exchange stressindex. Duration-dependent Markov regime switching autoregressive model is used to characterizethe duration-dependent feature and regime switching feature of the financial stress in China’sfinancial system. Analysis results show that: China’s financial system has two regimes of thefinancial stress,“high financial stress” and “low financial stress”, and it is more likely to transferfrom the “high financial stress” regime to the “low financial stress” regime; positive durationdependence exists in both regimes, that is to say, the financial system is more likely to transfer tothe other regime as one regime lasts longer.In the quantitative analysis of the systemic financial risk in Chapter5, the extremal quantileregression method based on extreme value theory is used for the measurement of the systemicfinancial risk of33financial institutions and their contributions to the systemic financial risk.Through the panel data regression model, factors contributing to the systemic financial risk offinancial institutions are analyzed. Analysis results show that: the value-at-risk approach may bebiased in measuring the financial risk of the institutions, since it cannot measure the correlationbetween financial institutions and the financial system; systemically important financialinstitutions in China are mainly from the bank sector, and joint-stock commercial banks haverelatively higher systemic risk contribution; the larger the size of the financial institution, thehigher leverage and the higher beta of the stock, the higher its risk contribution to the financial system, however, financial institution with a higher stock volatility does not necessarily have ahigher systemic financial risk contribution.Third, the quantitative analysis of the financial cycle is given. In Chapter6, the scrolling H-Pfiltering method is used to analyze the macro-economy and financial environment before and afterthe period of high financial stress. By comparing the financial fragility and financial stress inChina’s financial system, the characteristics of the financial cycle are given. Through the turningpoint analysis of the financial variables and the studies of their cyclical features, China’s financialcycle is determined. Furthermore, by comparing with the business cycle, the relationship betweenthe financial cycle and the business cycle is analyzed. Finally, multivariate linear regression modelis used to assess the predictive power of the financial instability measures given in this paper forthe economic growth. The findings are: before the occurrence of the high financial stress, theeconomy is in a high-growth path, with the loans of financial institutions increasing, and the realestate market and stock market booming; however, when the high financial stress occurs,everything reversal, the economic growth declining to a lower level, the loans reducing and theasset prices declining rapidly; from the first quarter of1999to the fourth quarter of2013, China’sfinancial system has gone through three major recessions, i.e.,1999Q2to2000Q3,2006Q1to2007Q4and2012Q2to2013Q2, and China’s financial cycle shows an asymmetrical feature with ashorter duration of recession but a longer duration of recovery; the financial cycles lead thebusiness cycles generally, and after the recession of the financial cycle, there will always be one ormore downturns of the business cycle; the financial fragility index and the financial stress indexhave good predictive ability for the economy growth, especially in the medium-term andlong-term; the financial fragility index has better predictive power than the financial stress indexin the medium-term, while the financial stress is better in the long-term.