The Impact of Financial Crisis on Real Economy in China and Russia

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1 The Impact of Financial Crisis on Real Economy in China and Russia Mengjia Gao Abstract Five years after the eruption of 2008 financial crisis, global economic growth is fraught with further challenges and risks. The Euro crisis and US fiscal shock brought a shrinking international trade, and thus posed challenges and risks to transitional economies. This paper examines how financial crisis in developed economies affected the real economies of China and Russia. Based on analysis of real economy and inflation, FDI, labour market and industrial policy, it was stated that financial fragility in developed markets spread to the real economies via monetary channel, credit channel, capital cost channel and exchange rate channel of China and Russia, although these two economies have different economic fundamental scenarios. The implication of risk transmission theory holds that the policymakers need to support financial stability and maintain stable noninflationary growth. While financial and international trade are deepening the synchronized risks, industrial policies could adopt economic divarication incentives to moderate risk transmission over the medium and long term. Introduction Five years after the eruption of financial crisis in 2008, global economic growth is fraught with further challenges and risks. The developed economies were weakened due to sovereign debt distress, caught in the double-dip recession, with high unemployment, tightened fiscal austerity, significant public debt as well as the financial uncertainty. In

2 the major transitional economies, growth has also decelerated significantly. For example, emerging markets development slowed down, indicating not only external vulnerabilities but also their domestic challenges. Graph1: World Real GDP Growth Source: International Monetary Fund According to the empirical analysis financial crisis are synchronized with real economy downturn. However, comparable analysis of the economic scenario as well as the updated data on China and Russia is limited. Among the BRICs countries (emerging markets, Brazil, Russia, India, China and South Africa), China and Russia transcend from planned- economy to market oriented economy, and benefited from their trade with the developed markets. What are the effects of 2008 financial crisis on real economy in China and Russia? How does the financial sector transmit the risks and returns to labour market, industrial Research and Development, and Foreign Direct Investment in China and Russia? Thus this essay will compare and contrast the linkage between financial crisis and real economic growth, in order to analyse the effects of 2008 financial crisis on real economy of China and Russia. 58

3 The essay will begin with literature review of theoretical studies of transmission mechanism. Based on the transmission channel theory, the role of financial sector in Chinese and Russian real economies will be evaluated. Furthermore, this essay will examine and discuss the implication of transmission channel theory in qualitative case studies. Literature Review The correlation of the financial crisis theory with the real growth of an economy is one of the main reasons why it attracts economists attention. Literature review in this paper will be focused on the mechanism of financial crisis on real economy. There are four main mechanisms: monetary channel, credit channel, exchange rate volatility channel, and capital cost channel. 1. Monetary Transmission Friedman and Schwartz (1963) tested monetary factors in real economic cyclical fluctuations. According to Friedman and Schwartz, the money stock illustrates a systematic behavior. The economic interrelationship could fully explain how monetary changes can produce cyclical fluctuations in real economy s income and expenditure. Alternatively, Minsky (1991) argued that each success in prevention of a financial crisis led to further risk taking and hence a more fragile economy. Furthermore, decision making in investment and finance is the critical factor that will cause income and employment in real economy to fluctuate. 2. Credit Transmission In light of the credit channel theory, credit demand and credit supply are analyzed: For credit demand, Bernanke and Gertler (1995) explained the tight-money 59

4 periods would depreciate the value of financial assets and hence change firms ability to obtain credit. Moreover, Klyotaki and Moore (1997) further linked the financial asset depreciation with negative investment and consumption change. For credit supply, due to economic uncertainty, financial institutions would contract their credit supply. Credit restriction would depress the investment and consumption. Furthermore, the domestic economic multipliers would lower aggregate income, according to Bayoumi and Melander (2008). The analysis conducted by Greenlaw et al (2008) concluded that the linkage between real economy decline and credit market is a negative loop. Firms have difficulty to repay their deposits, which increased the defaults. Banks have difficulty to maintain their liquidity and are forced to strain their lending standards. Thus, the credit demand and supply would be worsened during financial crisis. 3. Exchange Rate Transmission Financial crisis could transmit currency turmoil to real economy. In theory, the exchange rate volatility will lead to dramatic currency depreciation, resulting in deterioration of real GDP growth, employment, and consumption. Moderating the currency vulnerability could therefore stabilize domestic trade, Mckinnon (2000). In accordance to Goulas and Zervoyianni (2013), maintaining a lower exchange rate fluctuation could generate investment incentives and long-term growth. 4. Capital Cost Transmission One of the most crucial parts in financial- crisis economy is to rebalance reduce the negative impact of fluctuation on the cost of capital. McKinsey Global Institute (2010, December) analyzed the post-crisis capital cost. The adjustments of international and domestic factors in real economy are determined by the capital cost channel during financial crisis. 60

5 China and Russia Real Economy Case Study Most economists agree that the definition of real economy is opposite with financial economy. The real economy is compound of aggregate service and product output (Cochrane, 2005). While macroeconomic cycle is evaluated in output, investment, and employment, this essay will explore aggregate output (GDP) and inflation, foreign direct investment (FDI), industrial Research and Development (R&D), as well as labour market in post-financial crisis period. 1. GDP and Inflation The economic depressions of the financial sectors are surging to real economies in transition. Business cycles are synchronized with weaker demand for exports, elevated vulnerability of FDI and heightened volatility in commodity prices in China and Russia. Graph 2 and Graph 3 not only show the output decline in Russia and China during the financial crises 2008, but also illustrate the dramatic market dip in China and Russia, compared with world s average standard. Compared to Chinese, Russian economy has a higher volatility, for its higher dependence on natural resource export as well as its domestic economy scale. Alternatively, measurement of the inflation is crucial to assess the household purchase power in transitional economy (Arthur and Sheffrin, 2003), such as China and Russia. The inflation rate in China was 2 percent in January 2013, according to the National Bureau of Statistics of China (2013). The most important components of the CPI basket are Food (31.8 percent weight) and Residence (17.2 percent), which are the basis on household maintenance in China. During the financial crisis, the inflation rates in both China and Russia was volatile, while Russia has a higher fluctuation comparatively. China experienced the highest inflation rate of 8 percent in 2008, when the output dropped to the dip meanwhile. From 2010 Chinese inflation rate stabilized at 61

6 the range between 2 and 6 percent. Comparably, the inflation rate in Russia was 7.10 percent in January of 2013 (Federal State Statistics Service, 2013). In Russia, food and non-alcoholic beverages (30 percent weight) as well as transport (14 percent) are recorded as the most substantial category in the Costumer Price Index. The peak of inflation rate during business cycle was 15 percent in 2008, but it dropped to 6 percent in the mid-2010, and maintained above 4 percent with lower fluctuation. The illustrations on GDP and inflation of China and Russia thus show a high correlation of aggregate output and financial crisis. First, the business cycle in the Europe and the United States is spilling over to transitional economies, such as China and Russia. While China and Russia are significantly relying on exports, the weaker demands from the EU and US decelerated China s output of manufacture and Russia s export of commodity. Secondly, a higher volatility in capital flows and commodity prices in the global financial markets are affecting the further growth of China and Russia economies. Also, external financial fragility triggered the home economic problems in China and Russia, for example the domestic fiscal policy and industrial imbalances. To further analyze the relevance, the foreign direct investment (FDI), industrial Research and Development (R&D), and labour markets are studied in the following parts. Graph2: China and Russia GDP Growth Source: International Monetary Fund 62

7 Graph3: China and Russia GDP Growth Rate Source: International Monetary Fund Graph4: China and Russia Inflation Rate Jan Jan 2013 Source: National Bureau of Statistics of China and Russian Federal State Statistics Service 2. FDI in China and Russia The financial crisis starting from the developed markets led to capital out flows in most emerging markets. According to the UNCTA data (2012), the inward FDI change rate in Russia fluctuated significantly over , with the lowest at minus 56%, while inward FDI in China inclined steadily at an estimated rate of 10%. 63

Graph 5: Annual FDI Inward Stocks (US Million Dollars at 2012 exchange rate) in China and Russia over 2001-2011 Source: UNCTA Graph6: Percentage Change of Annual FDI Inward Stocksin China and Russia

8 Graph 5: Annual FDI Inward Stocks (US Million Dollars at 2012 exchange rate) in China and Russia over Source: UNCTA Graph6: Percentage Change of Annual FDI Inward Stocksin China and Russia over Source: UNCTA For Russian economy, the capital flow vulnerability as well as monetary policy spillovers from developed markets led to a high imbalance of global commodity price. Since 15.3% of the FDI in Russia was concentrated in energy fields (Russian Federal State Statistics Service 2010), vulnerability of FDI caused sharp price drop of 64

9 commodity (including cruel oil and natural gas). In global market the commodity depreciation affected the wealth generation in Russian economy, through not only the exchange rate channel but also the capital cost channel, and thus financial crisis in developed economies transmitted credit risks to Russian commodity markets. A dramatic deceleration in fuel exports was a crucial factor in Russian economy recession and wealth depreciation. Cyclically, the real economy was losing its attraction for further inward capital from abroad. Although the inward FDI growth rate maintained steady in Chinese market, the synchronized risk was transmitted from global commodity markets to China, due to its considerable rate of reliance on fuel commodity. Estimated 60% to 80% of Chinese domestic output relied on oil energy (according to the US Energy Information Administration Analysis, 2012), volatility and uncertainty in global commodity markets brought higher production cost to Chinese economy. Further, as oil-importing country, Chinese economic output weakened, due to higher import costs from exporters and declining external demands from the developed markets. For example, the Quantitative Easing (QE) policy from developed markets fueled the fragility in China- US currency exchange rate. Speculators increased their expectations in Chinese currency return, fueling an increase of exchange rate in China, while Chinese exchange reserve depreciated and exports weakened. High fluctuation in commodity (food and oil) prices could transmit downside risks by depressing Chinese domestic demand and contracting the space of monetary policies to stimulate growth. In global markets, inflation expectations have remained well stabilized, supported by relatively anchored food prices. However, in China and Russia economies there could be budgetary volatility in fuel and food subsidies, for their significant share in CPI baskets. 65

10 Graph 7: Global Commodity Price Index (measure price index in 2000= 100) Source: Source: UNCTA 3. Labour Market Trade-channel effects exerted a powerful downward pull on China and Russia labour markets. The vulnerability of trade impacted aggregate investment and employment in export-oriented sectors, in the scenario of euro crisis and US fiscal cliff. However, effects of financial crisis on employment situation vary between China and Russia. Although both China and Russia witnessed high elevated unemployment rates during 2008, the rise of unemployment rate settled at the range between 4% and 5%, while Russian unemployment rate fluttered from 5% to 9%. In accordance to the United Nation Global Economic Outlook (2013), the skills of unemployed population deteriorated in China and Russia during financial crisis. Aggregately, the higher percentage of unemployed worker is impacting the Russian and Chinese productivity in the long term. Due to the shrink of manufacture industry, unemployment rate in export-related sectors rose significantly. While China is utilizing the domestic stimulus policy to create job opportunities, the trade-off between unemployment rate and local government debts 66

11 created risks for long-term economic growth. Alternatively, Russian government spending was increasing due to its notable job creation. Graph8: Unemployment Rate in China and Russia over Source: National Bureau of Statistics of China and Russian Federal State Statistics Service 4. Government Expenditure and Industrial Transformation Economic slowdown led to noticeable government spending in China and Russia over In the fiscal stimulus package, Chinese government spent 4 trillion RMB for infrastructure investment, which formed short-term economic growth engine. Meanwhile, the large-scale government expenditure also increased inflation rate, government debts and concerns over real estate bubbles. In 2011, Chinese government started to put its efforts on industrial transformation, rather than domestic demand stimulus. The fiscal policy and monetary policy spillovers started to rebalance the real economy via the monetary channel, accordingly. 67

12 Graph9: Government Debt/GDP Ratio in China and Russia over Source: National Bureau of Statistics of China and Russian Federal State Statistics Service Through fiscal and monetary channel, China and Russia economy are restructuring their economy after The fiscal policy in China got re-oriented to the linkage between job-creation and green-growth, while its aggregate economy slowed down. Meanwhile, Russia joined the World Trade Organization and implemented economic reform policy. Governments in China and Russia enhanced public spending on health, education, R&D, and green energy to create energy sustainable growth incentives. Furthermore, industrial policies in both China and Russia are employed to support the economic diversification and to moderate risks of economic dependence on manufacture and fuel energy export in China and Russia, respectively. Conclusion This paper examined how financial crisis in developed economy was transmitted to real economies in China and Russia. The Euro crisis and US fiscal shock brought a shrinking international trade, and thus posed challenges and risks to transitional 68

13 economies. Based on analysis on real economy and inflation, FDI, labour market and industrial policy, it is found that financial fragility in developed markets was spread to the real economies via monetary channel, credit channel, capital cost channel and exchange rate channel in China and Russia, although these two economies have different economic fundamental scenarios. The implication of risk transmission theory holds that the policymakers need support financial stability and maintain stable noninflationary growth. Since financial and international trade are deepening the synchronized risks, industrial policies could adopt economic divarication incentives to moderate risk transmission over the medium and long term. 69

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15 The Risk of Economic Crisis. Chicago: University of Chicago Press P Minsky H. P., Ferri P. Market Processes and Thwarting System. Working Paper No. 64.The Jerome Levy Economics Institute, New York: Annandale-on Hudson McKinnon, R. The East Asian Dollar Standards, Life after Deaths? // Economic Notes Vol. 29. No. 1. P McKinsey Global Institute. Farewell to cheap capital? The implications of long-term shifts in global investment and saving. URL: 13. US Energy Information Administration Analysis "China Energy Analysis", URL: 71

UN: Global economy at great risk of falling into renewed recession Different policy approaches are needed to address continued jobs crisis

UN: Global economy at great risk of falling into renewed recession Different policy approaches are needed to address continued jobs crisis New York, 18 December 2012: Growth of the world economy has weakened