Do Financial Shocks Drive Real Business Cycle Fluctuations in China?


Over the past several decades, China has enjoyed one of the world’s fastest-growing economies and succeeded in rebounding quickly from historical recessions, especially the global financial crisis of 2008-2010. This paper studies the extent to which financial shocks, shocks that originated from the financial market, can shape business cycle fluctuations in China. First, I document the business cycle properties of China’s economy from 1994 to 2017 and show the procyclicality of dividend payout and the countercyclicality of debt repurchases with real GDP, respectively. To account for these features, I develop a real business cycle model that allows firms to raise funds via debt and equities to understand the role of financial shocks in generating macroeconomic dynamics. In the model, I assume that payments to labor need to be made before the realization of revenues, so a firm might need to raise funds to fill liquidity shortages between two periods. However, when both financing and liquidating capital assets become challenging to a firm, especially during recessions, it must cut budget constraints by laying off workers. This paper finds that financial shocks contribute significantly to the growth of output, investment, hours worked, and debt repurchases, and thus are the main driving force of macroeconomic fluctuations in China through the real economic factor, labor.