Monetary Policy Uncertainty Credit Risk and Chinas Macroeconomic - PowerPoint PPT Presentation

Monetary Policy Uncertainty ， Credit Risk and China’s Macroeconomic Fluctuations Li Li Guanghua School of Management, Peking University 2018.10

Road map • Institution background • Literature review • Model • Bayesian VAR evidence • Conclusion

Background • In 2017, Zhou Xiaochuan,former chief of China’s central bank, warns of ‘ Minsky moment ’. • Economic policy makers led by President Xi made preventing financial risk an economic priority for the next three years after annual Central Economic Work Conference in 2017. • Chinese Prime Minister Li Keqiang said preventing financial risks was one of the country's "three fundamental battles" along with fighting poverty and pollution.

• Why China’s leaderships are so serious about financial risks? • The International Monetary Fund has repeatedly warned of risks stemming from China's high debt-to-GDP ratio and called for speedy deleveraging. • In 2017, Moody’s downgrades China’s sovereign credit rating since 1989, which raises the worry about the alarming risk of financial instability in China.

When it comes to China’s Financial risks • Downgrade of GDP growth • Massive shadow banking • High corporate debt and household indebtedness • Local government Debt • Housing sector • Huge Financial market fluctuations • Capital outflows

• Why should study Chinese government's policy uncertainty? China News-Based EPU(Baker et al.,2016) 800 700 600 500 400 300 200 100 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

• Policy uncertainty (also called policy risk) is a class of economic risk where the future path of government policy is uncertain, policy uncertainty may refer to uncertainty about monetary or fiscal policy. • China offers an excellent place to study policy uncertainty • Dual track or gradualist approach • Crossing the river by feeling the stone • Launching the circuit breaker in the China stock market is a vivid example of how to depict policy uncertainty. • This hurried implementation and with-drawal of the circuit breaker revealed that the government still has a long way to go in improving scientificity in policy making.

Why China’s monetary policy uncertainty? • Multiple tools, intensively intervention and various work all lead to the increase of China’s monetary policy uncertainty. • 1. Multiple tools • Open Market Operations (OMO) • Reserve Requirement Ratio (RRR) • Interest rates • Rediscount • Window guidance • SLF 、 MLF 、 SLO 、 PSL 、 TLF… • Individuals may feel ambiguous about the orientation, effect size and persistence of those tools.

• 2.Intensively intervention and various targets • changing benchmark interest rates to regulate funding cost • changing required reserve ratio • developing macroprudential framework • managing the stock market and real estate sector • RMB exchange rate intervention • ... • The intensive intervention and dominant role of Chinese Central bank in financial system indicate that slight changes in monetary policies could produce significant uncertainty shock.

Monetary policy uncertainty index of US(Sun Bo et al.,2016)

Link the credit risks with monetary policy uncertainty • Song and Xiong(2017) —Risks in China’s Financial System • Debt Crisis Risk • Housing Risk • Capital Outflow Risk • Stock Market Risk • Policy Risk • Active government interventions have profound impacts on the financial system. Policies and regulations can deliver unintended consequences, some of which may be entirely counterproductive. This may eventually reduce the efficiency of the financial system and exacerbate the systemic risk.

Main contribution • Provided the first direct evidence that China’s monetary policy uncertainty exacerbate its financial risks . • Developed a specific proxy for China’s monetary policy uncertainty. • Measured China’s credit risks by using large -scale factor models

Literature review • Uncertainty shocks in business cycles • Bloom (2009), Bloom et al.(2012),Villaverde et al. (2011) • Empirical evidence for uncertainty shocks • Baker et al. (2016) ,Ng et al. (2015) • Policy uncertainty • Villaverde et al. (2015), Born and Pfeifer (2014),Bianchi and Melosi(2017)

Transmission mechanism from uncertainty to real economy • Real option channel • Bloom (2009),Bloom et al. (2012),Bachmann and Bayer (2013) • Precautional saving channel • Gourio (2012),Basu and Bundick (2012) • Financial friction channel • Gilchrist (2012),Alfaro et al. (2016) • Labor market friction(Leduc and Liu, 2016) • Imperfect information and uncertainty(Wang et al.,2018)

China’s policy uncertainty • Hachem and Song (2017) • stricter liquidity standards and unintended credit booms • Cai et al. (2017) • tripling of stamp tax and speculative bubble in warrant market • Xiong and Song (2017) • active government interventions and financial risks • Xiong et al. (2017) • gradualist approach and misallocation

• We constructed the DSGE model with credit risks based on Bernanke et al.(1999) and Christiano et al. (2014), and introduced monetary policy uncertainty shock by augmenting the Taylor rule with stochastic volatilities. • We estimated the uncertainty of monetary policy in China by using the Bayesian MCMC method, and applied the time-varying dynamic factor model to measure financial risks in China’s bond market, stock market and credit market respectively, based on a large macro and financial dataset of China. • We further provided some empirical evidences of the impact of China’s monetary policy uncertainty documented in the theoretical model by using Bayesian VAR model.

Main findings • the increase of China’s monetary policy uncertainty could bring about negative effects on economic activity and exacerbate the credit risks. • Credit risks could spill over to the real economy and amplify negative impact of the monetary policy uncertainty on the output. • Credit risks currently make the greatest contribution to China’s whole financial risks.

• This paper is linked with different streams of literature in macroeconomic concerning uncertainty shocks and frictions. • The model can well duplicate the traditional channels documented in the literature through which the uncertainty shock can tighten the economic activities. eg. Precautional saving channel (Gourio,2012), Real-option channel (Bloom et al. ,2012),and financials friction channel (Gilchrist ,2012). • The main conclusion is also in line with the literature focus on credit risks and business cycles.(Gilchriste t al.,2012;Miao and Wang,2010) • This paper is also associated with the growing literature on China’s policy issues provides the findings offer direct evidence to support the analysis of Song and Xiong (2018).

Model outline • New keysian DSGE model based on BGG model and Christiano et al. (2014) • Habit formation, investment adjustment cost, price stickness,financial friction • We depart from them by introducing monetary policy uncertainty shock Tax Deposit Government Household Banks Interest Loan Consumption Government purchasing Labor Wage Entrepreneur Retailor Wholesale goods Capital Final goods Capital producer

1.Household Representative household choose consumption and labor to maximize its lifetime expected utility function: 1−𝜏 − 1 1+𝜃 1 + 𝜃 ∞ 𝐷 𝑢 − 𝑐𝐷 𝑢−1 − 𝜔𝑂 𝑢 ൗ 𝛾 𝑢 𝑛𝑏𝑦𝐹 𝑢 ෍ 1 − 𝜏 𝑢=0 𝑡. 𝑢 𝑄 𝑢 𝐷 𝑢 + 𝐶 𝑢+1 = 𝑋 𝑢 𝑂 𝑢 + 𝑆 𝑢 𝐶 𝑢 + 𝛲 𝑢 − 𝑈 𝑢 We can get the following first-order condition: −𝜏 −𝜏 1+𝜃 1+𝜃 𝐷 𝑢 − 𝑐𝐷 𝑢−1 − 𝜔 𝑂 𝑢 𝐷 𝑢+1 − 𝑐𝐷 𝑢 − 𝜔 𝑂 𝑢+1 𝜇 𝑢 = − 𝛾𝑐 1 + 𝜃 1 + 𝜃 𝑄 𝑢 𝜇 𝑢 = 𝛾𝐹 𝑢 ቊ 𝜇 𝑢+1 𝑆 𝑢+1 ቋ 𝑄 𝑢+1 −𝜏 1+𝜃 𝑋 𝐷 𝑢 − 𝑐𝐷 𝑢−1 − 𝜔 𝑂 𝑢 𝑢 𝜃 𝜇 𝑢 = 𝜔𝑂 𝑢 𝑄 𝑢 1 + 𝜃

2.Entrepreneur According to Bernanke et al. (1999), entrepreneurs manage the production sector that produces wholesale goods and sell it to the retailor firms .Entrepreneurs purchase capital from the capital producer and employ labor force from the household: 𝛽 𝑂 𝑢 1−𝛽 𝑍 𝑢 = 𝐵 𝑢 𝐿 𝑢 At the end of period of 𝑢 ,Entrepreneurs issue debt contracts with financial institution to fund for new capital purchasing : 𝑑 𝐶 𝑢+1 = 𝑅 𝑢 𝐿 𝑢+1 − 𝑊 𝑢 Entrepreneurs begin production and observe idiosyncratic productivity shock 𝜕 𝑢+1 Entrepreneurs decide default or non-default thus determine their net worth Period 𝒖 Period 𝒖 + 𝟐 Period 𝒖 + 𝟑 End of period 𝑢 ,entrepreneurs use the End of period t+1,a fraction of net worth 𝑊 𝑢 and sign debt contracts γ e ntrepreneurs can survive, they use net 𝑑 with bank to get 𝐶 𝑢+1 for their new worth 𝑊 𝑢+1 and sign new debt contract to capital purchasing 𝐿 𝑢+1 𝑑 get 𝐶 𝑢+2 for purchasing 𝐿 𝑢+2