Do financial shocks drive real business cycle fluctuations in China?

Abstract

This paper concentrates on identifying the potential origin of business cycle fluctuations in China during the 2007-2009 recession. First, I document that domestic loans are countercyclical to GDP in China, revealing a link between the financial market and the real economy. Next, I employ a standard real business cycle model that allows financial asset trading between firms and households and imposes restrictions on firms’ credit constraints. Specifically, I measure the financial shocks as the residuals of a firm’s enforcement constraint. As assumed in the model that payments to labor need to be made before the realization of revenues, firms might need to raise funds with intra-period loans to fill liquidity shortages in between two periods. However, during recessions, firms can neither obtain enough indirect finance from banks nor convert capital assets into liquidity within a short time horizon. As a result, firms have to cut budget constraints by laying off workers. To calibrate key parameters fitting characteristics in China’s economy, I combine macroeconomic data from the National Bureau of Statistics of China (NBS) and financial data in the China Stock Market and Accounting Research (CSMAR) database. Then, I solve systematic equations of the dynamic stochastic general equilibrium (DSGE) model analytically and quantitatively with Dynare. This paper finds that financial shocks can explain about 66% of GDP fluctuations during the 2007-2009 recession. Therefore, financial frictions are the main driving force of macroeconomic fluctuations in China during the recent Financial Crisis through the real economic factor, labor.