Blog Post

Are financial conditions in China too lax or too stringent?

The pronounced slowdown in China’s GDP growth in recent years has raised the important question of what might be its principal causes.

By: Date: August 5, 2014 Topic: Global Economics & Governance

The pronounced slowdown in China’s GDP growth in recent years has raised the important question of what might be its principal causes. The usual suspects are many and might include rebalancing pains associated with China’s domestic and external imbalances, less favourable demographics resulting in a stagnant labour force, fewer low-hanging fruits in market liberalisation, a less-accommodating global economy that no longer serves as a ready outlet for China’s surplus savings, and even the ongoing anti-corruption campaign that might have slowed government outlays and hit sales of luxury goods.

Could tighter Chinese financial conditions be another, unusual suspect contributing to the marked growth slowdown in recent years? If the recent economic slowdown was primarily structural, lax financial conditions would not help and might even worsen the structural problems that dragged down economic growth in the first place. Indeed, China over the past few years has witnessed concurrently weaker growth and rising credit as a ratio to GDP, in contrast to a ‘creditless recovery’ in the euro area.

I recently made a case for China to ease its monetary policy in the face of slowing economic growth and benign inflation. Moreover since the global financial crisis, the Chinese central bank until recently maintained a tighter monetary policy relative to its international peers such as the US Fed, the European Central Bank, the Bank of Japan and the Bank of England, on the basis of both the real policy rate and the real effective exchange rate.

However, whether a different monetary policy is to have a meaningful effect on economic agents depends in part on transmission channels. Europe’s half-asleep banking sector is a case in point.

To better assess the financial environment that actually influences economic behaviour in China, I construct a crude ‘financial conditions index’ (FCI) that is a weighted sum of five key financial asset prices — policy rate, one-year treasury yield, ten-year treasury yield, effective exchange rate and benchmark stock market index. Higher readings denote tightness for the first three rates and the effective exchange rate, so I use the inverse of the stock market index to capture changes in equity prices.

I place an equal weight of 20 percent on each of the z-scores of these five financial prices. Thus, increases in interest rates, the effective exchange rate and the inversed stock market index all result in a rise in the FCI, indicating a tightening of financial conditions. I will focus on the post-crisis period from January 2007 to March 2014 before the latest Chinese monetary easing. A positive FCI reading suggests tighter financial conditions than the period average.

Let’s consider two versions of the FCI, one based on nominal interest rates and the effective exchange rate and the other on their real (ex post) counterparts. It is also useful to construct the FCIs for the US, euro area, Japan and Britain using the same consistent methodology, so that the Chinese FCI can be compared both over time and to its peers.

The central message from these FCIs is that China’s financial conditions have tightened the most among the major economies since the global financial crisis (Graph 1). Also, China started with relatively lax financial conditions, but post-2011 tightened considerably, at least until the second quarter of 2014. By contrast, financial conditions in the G4 generally became less stringent over the same period, as shown by both the nominal and real alternatives.

Moreover, all of the five asset prices underlying the Chinese FCI indicate an unmistakable financial tightening over this period — rising short- and long-term interest rates, a strengthening renminbi and a languishing Shanghai stock market that lost 27 percent of its value during this episode.

Finally, the paths of the nominal and real FCIs have differed somewhat for these big five economies in the post-2007 period, but all indicate tighter financial conditions in China both over time and relative to its international peers. While the real FCIs of the five major economies have shown noticeable swings, their nominal counterparts except China’s display steady, large and synchronised declines, indicating considerable easing of the financial conditions outside China.

In sum, China’s financial conditions have become unmistakably tighter since the global financial crisis. Intuitively, this revealed financial tightening, both over time and relative to its international peers, could have meaningfully contributed to China’s recent slower economic growth. Puzzlingly, our price-based FCI seems to sharply contrast with the observed Chinese credit boom in the wake of the global financial crisis.

In any case, Chinese policymakers ought to take notice of such marked, sustained and broad-based tightness of the financial conditions. A good starting point would be to better understand the underlying causes behind the tighter Chinese financial environment. For instance, a rigid 75 percent regulatory cap on the bank loan-to-deposit ratio and a punitive 20 percent reserve requirement both might have added to financial tightness, prompting policymakers in Beijing recently to tweak these rules in an attempt to loosen the domestic financial conditions.

Assistance by Giulio Mazzolini and Noah Garcia is gratefully acknowledged.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Opinion

Japan must boost R&D to keep rising Chinese rivals at bay

As China shifts into a more advanced industrialised economy, Japan has slowly but surely lost to some of its comparative advantages to its rival. One possible solution to help the government keep pace would be to concentrate research and development efforts on a few key sectors where Japanese players still hold a large competitive lead.

By: Alicia García-Herrero Topic: Innovation & Competition Policy Date: September 20, 2018
Read article More on this topic More by this author

Podcast

Podcast

Backstage: Developing the EU-China relationship amid rising global trade tensions

Bruegel director Guntram Wolff is joined by Alicia García-Herrero, senior fellow at Bruegel, and Zhang Weiwei, director at The China Institute of Fudan University, following up a Bruegel conference focused on the potential for closer economic links between China and the EU.

By: The Sound of Economics Topic: Global Economics & Governance Date: September 20, 2018
Read article More on this topic More by this author

Opinion

China Made Two Promises in Africa. Can It Keep Them?

China has committed to a market-driven relationship with Africa, as well as a new $60 billion investment plan on the continent, following the recent China-Africa summit. In this light, the author assesses the China-Africa economic relationship, suggesting those new objectives may not be so easy to achieve.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: September 19, 2018
Read article More on this topic More by this author

Opinion

China real estate developers: a grey rhino in the jungle of financial risks

The author assesses the Chinese real estate industry’s liquidity concerns and its leverage, which is estimated to be four times higher than its global peers.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: September 18, 2018
Read about event

Past Event

Past Event

China's digital economy

How to measure China's digital economy?

Speakers: Alicia García-Herrero, Claudia Vernotti and Reinhilde Veugelers Topic: Global Economics & Governance, Innovation & Competition Policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: September 17, 2018
Read about event More on this topic

Past Event

Past Event

Perils and potential: China-US-EU trade relations

We are hosting a number of Chinese and EU experts to discuss trade relations between the three forces.

Speakers: Miguel Ceballos Barón, Alicia García-Herrero, Wei Jianguo, André Sapir, Herman Van Rompuy, Zhang Weiwei, Guntram B. Wolff, Zhou Xiaochuan, Zhang Yansheng and Ruan Zongze Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: September 17, 2018
Read about event

Upcoming Event

Oct
11-12
20:00

Policy responses for an EU-MENA shared future

In the third edition of the "Platform for Advanced & Emerging Economies Policy Dialogue" we will discuss trade flows and trade policy between Europe and MENA, integration of developing economies into global value chains, and regional energy relations.

Speakers: Mounssif Aderkaoui, Karim El Aynaoui, Marek Dabrowski, Uri Dadush, Giuseppe Grimaldi, Badr Ikken, Joanna Konings, Zahra Maafiri, Pier Carlo Padoan, Visar Sala, Nicolò Sartori, Nathalie Tocci, Simone Tagliapietra and Guntram B. Wolff Location: Rome
Read about event More on this topic

Upcoming Event

Oct
17
10:00

Asia-Europe Economic Forum 2018 - Closed-door

This year's Asia-Europe Economic Forum (AEEF) will be held in Brussels on 17-18 October

Speakers: Franco Bruni, Zsolt Darvas, Andreas Esche, He Fan, Michael G. Plummer, Thomas Grjebine, Kiyoto Ido, Sébastien Jean, MA Jun, Moonsung Kang, Stefan Mair, Yung Chul Park, Choonsung Park, Sayuri Shirai, Guntram B. Wolff and Naoyuki Yoshino Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Oct
18
08:30

Asia-Europe Economic Forum 2018 - Public

This year's Asia-Europe Economic Forum (AEEF) will be held in Brussels on 17-18 October

Speakers: Matthias Helble, Jyrki Katainen, Jin Keyu, Jae-Seung Lee, Yoichi Otabe, Jean Pisani-Ferry, Rintaro Tamaki, Amb. Karsten Warnecke and Guntram B. Wolff Topic: Global Economics & Governance Location: Solvay Library, Rue Belliard 137, 1000 Bruxelles
Read article More by this author

Opinion

US-China trade war: What’s in it for Europe?

To help evaluate whether the market response is warranted or exaggerated, the author measured the trade impact of additional import tariffs based on standard economic theory, namely two key parameters—the tariff pass-through rate and the price elasticity of demand. The end of multilateralism seems clear, at least for trade.

By: Alicia García-Herrero Topic: European Macroeconomics & Governance, Global Economics & Governance Date: August 23, 2018
Read article

Opinion

Goodbye deleveraging: Fiscal and monetary expansion to support growth in China

China has opted for a renewed fiscal and monetary stimulus to address the risk of the US-led trade war. The dual policies send a clear signal that economic growth is the priority, but such measures do not come without a cost. Deleveraging efforts will have to be put on hold for the time being.

By: Alicia García-Herrero, Gary Ng and Jianwei Xu Topic: Finance & Financial Regulation, Global Economics & Governance Date: August 23, 2018
Read article More on this topic More by this author

Opinion

Can Multilateralism Adapt?

Global governance requires rules, because flexibility and goodwill alone cannot tackle the hardest shared problems. With multilateralism under attack, the narrow path ahead is to determine, on a case-by-case basis, the minimum requirements of effective collective action, and to forge agreement on reforms that fulfill these conditions.

By: Jean Pisani-Ferry Topic: Global Economics & Governance Date: July 3, 2018
Load more posts