Skip to main content

China’s Gradualistic Economic Approach and Financial Markets (Brunnermeier, Sockin, Xiong, AER P&P, 2017)


"A key approach successfully employed by China to reform its economy in the past 30 years is the so-called "crossing the river by touching the stones" approach, a gradualistic method that optimizes policy through experimentation. The government will start with an initial (usually small) policy change, and gradually modify the policy based on the reaction from the economy to this change." BUT, "Can China continue to use its gradualistic approach in the presence of active financial markets?"

 In Brunnermeier, Sockin, Xiong, (AER P&P, 2017), they provide the theoretical rationale for potential ineffectiveness of gradualistic policy approach with the existence of an active financial market. In align with the well-known time-inconsistency problem (Kydland and Prescott (1977) and Barro and Gordon (1983) ), incentives of front-run by private agents in expectation of ex post non commitment of the policymaker renders the gradualistic approach ineffective. 

 The policymaker faces the tradeoff between informativeness of the signal and magnitude of the output. A policymaker uses investment decisions taken by private agents in the economy as a signal to infer their information about economic fundamentals, and more gradual investment reduces the noise in this signal. This motivates the policymaker to adopt gradual policy changes.  However, the ex post efficient policy change (the change after knowing the action of private agents) is a change of full magnitude. Without an active financial market, private agents are forced to make investment decisions after the policymaker moves. The availability of financial markets gives private agents greater financing flexibility and allows them to choose investment ahead of the policy maker. If the policymaker cannot commit to a policy rule ex post, which means the policymaker will adjust to the full magnitude change ex post, private agents have incentives to make investment decisions before the policymaker take actions. 

They use a simple game theory model to explain  the quicker expansion of infrastructure investment, faster growth of a shadow banking sector, more rapid increase rate of leverage across the economy. In particular, they use the breakdown of a policy instrument in China's stock market, the introduction of circuit breakers, as an example for the dramatic responses from private investors and inadequate time for gradual adjustment on the policy market side. The introduction of circuit breaker itself is a  failure and shows the potential of over reaction from private investors. I agree on that for the circuit breaker instrument itself, the policymaker cannot apply gradual adjustments to keep the stock market in stable condition.

 However, it would be exaggerated to say that it proves that the gradualistic reform of the stock market is determined to be ineffective. In fact, in my view, the introduction of circuit breaker is one small step, though proven to be wrong afterwards, in the whole reform scheme. It is an experiment of the circuit breaker in a different environment (large amount of retail traders, T+1 trading, and daily limit) from the western stock market.

 Reference
Brunnermeier, Markus K., Michael Sockin, and Wei Xiong. 2017. "China's Gradualistic Economic Approach and Financial Markets." American Economic Review, 107 (5): 608-13.
Finn E. Kydland and Edward C. Prescott, Journal of Political Economy Vol. 85, No. 3 (Jun., 1977), pp. 473-492
Barro, Robert J., and David B. Gordon. "Rules, discretion and reputation in a model of monetary policy." Journal of monetary economics 12.1 (1983): 101-121.
Labels:

Comments

Post a comment

Popular posts from this blog

Shadow Banking in China (Chen, Ren and Zha 2018 AER)

Shadow Banking in China receives rising attention from both the press and the academia. In  The Nexus of Monetary Policy and Shadow Banking in China  (2018 AER, NBER WP23377,  NBER WP21890), Chen, Ren and Zha discuss the interplay between China's quantity-based monetary policy and commercial banks' reaction in terms of shadow banking activity. In this blog, I highlight their theory and  findings on shadow banking in China.

One feature in China's banking system is an institutional division of state and nonstate commercial banks. State banks are state owned and the remaining commercial banks, as a whole represent almost half the size of the entire banking system, are nonstate banks. State banks adhere to the government's own policy against actively bringing shadow banking products into their balance sheet. This is not true of nonstate banks, however. As found in the paper, nonstate banks take advantage of regulatory arbitrage by bringing shadow banking products into a sp…
Post a comment
Read more

Dividends and expropriation, Faccio, Lang, and Young (2001 AER)

The failures in East Asian corporate governance are blamed for the East Asian financial crisis.  In East Asia, the predominant form of ownership is control by a family, termed as "crony capitalism", and the top managers are often from the family. In Faccio, Lang, and Young (2001 AER, citation 1861), they document ownership and control structures among East Asian corporations and analyze the salient agency problem, namely the expropriation of outside shareholders by controlling shareholders, by looking at dividend behavior.

To start with, they show an extraordinary concentration of control in East Asia, whereby 6 groups control more than 20% of the corporations in the 9 most advanced East Asian economies. This control is obscured behind layers of corporations, hence insulated against the forces of competition on less-then-transparent capital markets. However, family control is also predominant in West Europe, though the group sizes are smaller, with 5 groups control about 10%…
Post a comment
Read more

Competition, Policy Burdens, and State-Owned Enterprise Reform, by Lin, Justin Yifu; Cai, Fang and Li, Zhou, The American Economic Review 1998

Started in late 1978, reform of state-owned enterprises (SOE’s) is a long lasting cause in China. In the paper Competition,Policy Burdens, and State-Owned Enterprise Reform (AER P&P, 1998,681 citations), Lin, Cai and Li argue that the key for successful SOE reforms is to create enough a sufficient level of market competition and remove the policy burdens. In a less competitive world, the separation of ownership and controls makes managers’ incentives incompatible with those of the state. Various state-imposed policy burdens are often criticized to give a chance for soft-budget constraints.
In 1996, SOE’s employed 57.4 percent of urban workers and possessed 52.2 percent of total investment in industrial fixed assets. However, over 40 percent of SOE’s are losing money. By definition, SOE’s are owned by the state. However, the state needs to delegate their control rights to the enterprises’ managers. The separation of ownership and control is a common feature of any large modern corp…
Post a comment
Read more