The Impact of China’s Fiscal and Monetary Policy Responses to the Great Recession: An Analysis of Firm-Level Chinese Data
One sentence summary: Employment and investment by larger Chinese firms have benefited more from bank loans following Chinese financial and fiscal policies during the Great Recession.
The corresponding paper by Jason Taylor, Wenjun Xue and Hakan Yilmazkuday has been accepted for publication at Journal of International Money and Finance.
The working paper version is available here.
Abstract
This paper investigates the effects of Chinese financial and fiscal policies designed to counter the worldwide Great Recession of 2008. We examine how policies designed to increase bank credit and health (i.e., asset liquidity, capital adequacy ratio, profitability, and bad loan ratio) influenced firm-level output, employment and investment. We also explore the impact of China’s expansionary fiscal policy with regard to these firm-level variables. We find that the policy effects varied based on firm-level characteristics such as size, liability ratio, profitability, ownership and the industry in which the firm operates. With respect to the dynamic effects, our results suggest that Chinese financial and fiscal policies were generally effective in the short run, but their positive impacts ceased within two years.
Non-technical Summary
The economic crisis of 2008 began in the United States but soon affected almost all developed and developing countries worldwide. In response, the United States enacted fiscal stimulus via the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009 (ARRA). Additionally, the Federal Reserve reduced the federal funds rate to near zero and engaged in several rounds of “quantitative easing” programs that sought to facilitate credit flows and reduce the cost of credit. The European Union likewise undertook large-scale fiscal stimulus via the European Economic Recovery Plan (EERP) and the European Central Bank also acted aggressively by cutting interest rates and insect liquidity into the economy.
While global output was curtailed in the aftermath of the crisis, China’s economy continued to expand, albeit at a far slower rate than it had in the years prior to the crisis. Specifically, China’s reported GDP growth rate fell from around 15 percent in 2007 to around 9 percent in 2008. Its growth rate would almost certainly have declined much further had the nation not adopted aggressive countermeasures that were similar to those enacted in the United States and Europe. While the effects of countercyclical policies in Western nations have been widely analyzed, far less attention has been paid to the impact of such policies from the world’s largest emerging nation.
China’s central bank (The People’s Bank of China) relaxed the credit constraints faced by commercial banks, most of whom are state owned, by reducing reserve requirements, cutting the prime lending rate, and relaxing credit limits. To be specific, during the last quarter of 2008, China’s central bank reduced reserve requirement ratios from 17.5% to 13.5% for small and medium-sized banks, and from 17.5% to 15.5% for large banks, and it reduced the prescribed one-year lending rate (commercial banks are typically allowed to set interest rates within a pre-specified range of the prescribed rate) from 7.47% to 5.31% (Cong et al., 2018). The credit limits faced by commercial banks were also eliminated in 2008. As a result of these actions, bank credit in China more than doubled from 4.7 trillion RMB (688 billion US dollars) in 2008 to 9.6 trillion in 2009, and it continued to grow in the years that followed.
In addition to aggressive monetary policy, the Chinese government also launched a 4 trillion RMB (US$586 billion) fiscal stimulus in November of 2008—an amount more than 12 percent of China’s GDP. In comparison in the United States, the American Recovery and Reinvestment Act of 2009 allocated around $800 billion, which was around 5 percent of the size of its GDP. While the stimulus programs of Western nations were largely funded through federal government debt, nearly three quarters of China’s stimulus was funded by local governments. These governments secured loans via Local Government Financing Vehicles (LGFVs), which were state-owned enterprise, whereby the corresponding local government was the dominant shareholder.
While there were differences in the nature of the policy responses of China and other major geopolitical areas such as the European Union and the United States, they were united in their attempts to stimulate aggregate demand via the credit channel. Still, the broader financial literature has shown that it is not just the quantity of credit, but also its quality (i.e. the efficiency of financial intermediation) that affects economic growth. In light of this literature, our focus is not just on the impact of quantitative monetary factors (money supply and quantity of credit), but we also focus heavily on the effects of qualitative factors affecting bank health (e.g., asset liquidity, capital adequacy ratio, profitability, and bad loan ratio). Given the nuances of the Chinese system highlighted above, it will be interesting to determine the extent that quantity and quality of credit affected China’s economic performance during the Great Recession and the subsequent recovery period.
In this paper, we employ firm-level data in an attempt to identify the effects of China’s fiscal and monetary responses to the crisis of 2008. Our work expands earlier studies by examining the determinants of firm-level output, employment, and investment It is important to note that these three variables have significant dynamic interactions. Specifically, an increase in a firm’s employment and investment positively affects firm output. At the same time, an increase in firm output promotes the growth of employment and investment. Thus, we employ a panel vector autoregression (VAR) analysis which allows for these relationships. We find that key variables related to banking health such as asset liquidity, capital adequacy ratio, profitability, and bad loan ratio, as well as credit supply, are important determinants of a firm’s output, employment, and investment. We also find evidence for government spending positively affecting these three firm activities. Our results suggest that China’s fiscal and monetary response to the Great Recession helped mitigate the effects of the Great Recession and promoted faster economic recovery in the years that followed that event.
Because we employ firm-level data, we also investigate which types of firms were most impacted by China’s financial and fiscal policies. We examine firm size, liability ratio, profitability, ownership, and industry, and we find that a healthy banking system and enhanced credit supply have positive and significantly stronger effects on larger firms and SEOs than they do on small and privately-owned firms. Regarding a firm’s liability ratios, a healthy banking system and a larger supply of credit have the most impact on the high- and medium-liability firms. Additionally, we find that expansionary monetary policy was most beneficial to those Chinese firms that had the highest profitability. With respect to fiscal policy, increases in government expenditures positively affected firm-level output, employment, and investment, regardless of the size, liability ratio, profitability, ownership and the industry to which firms belonged, although the magnitude of these effects varies based upon firm characteristics.
We also find that, consistent with China’s “top ten industry revitalization plan” of 2009, some industries benefited more than others from China’s policy response. Agriculture, utilities, manufacturing, transportation, and warehousing industries, which are heavily supported by bank credit in China, benefited the most. Additionally, our results suggest that the increased credit was funneled disproportionately to the real estate and construction industries, which contributed to overheating in the Chinese housing market. We also show that changes in net exports and the financial market performance of the United States differentially affected Chinese firms based on their characteristics.
Our final step is to employ impulse-response functions to explore the dynamic interaction of firm-level output, employment, and investment and the dynamic effects of financial and fiscal policies between 2008 and 2014. Our results suggest that firm-level output, employment, and investment responded positively to the shocks created by financial and fiscal policies, however, these positive shocks end within two years.