Study Of The Context Of Financial Globalization, Financial Instability Factors Generating Mechanism

Financial Crisis can ignite new financial theories. The reason that I choose this as my dissertation title is that China faces the freedom of the financial market. If we implement it well, it can increase the economic growth, otherwise it will do harm to the economy. What role does the finance play in the Japanese and German economy after the World War Two? What role does the financial freedom play in the process when Korea and Singapore became to be a developed country? Why other Southeast Asian and Latin American countries strived to free the finance, but get the financial crisis in the end, not to say economic growth? It is wrong to resist the market reform of finance, but it is also wrong to step too fast. U.S. subprime loan crisis informs us that the western economic theory has defects. So the Chinese financial freedom should combine the reality and the financial reform under the basis of foreign financial freedom theory.In a word, we should understand the financial freedom in the process of financial freedom development. We should not just use one method to analyze this explicated task. This is the direction of financial freedom theory. The dissertation uses this as a starting point to utilize related theories and models to analyze the financial instability factors under the background of financial globalization and financial innovation. How to impose active impact on the financial market and release the financial instability factor is of great importance to China.Choosing this as my dissertation can develop a theory for developing countries, including China, to avoid financial crises in the process of financial development. In the mean time, it can inform us some policy suggestion to resist the economic crises. What the dissertation wants to do is the problem of development mode and the financial stability.Financial instability research has several niches. The dissertation analyzes the forming mechanism problem of financial instability. The structure as follows:Introduction states the problem, dissertation choice meaning, contents and innovation points.The last part of every chapters sum up the whole chapter. There is no sum-up in Part 2, Part 3 and Part 4. There will be a sum-up in Part 5.The first part includes Chapter 1, which reviews the papers for financial instability.The main part of dissertation analyzes it from three levels of effect analysis, endogenous system arrangement and exogenous fund shock. This dissertation studies several issues in the field of financial instability.The second part includes Chapter 2 and Chapter 3, analyzing the economic environment and effect of financial stability.In Chapter 2, I argue that systemic bankruptcy of firms can originate from coordination failure in an economy with investment complementarities. I demonstrate that in such an economy, a very small uncertainty about economic fundamentals can be magnified through the uncertainty about the investment decisions of other firms and can lead to coordination failure, which may be manifested as systemic bankruptcy. Moreover, my model reveals that systemic bankruptcy tends to arise when economic fundamentals are in the middle range where coordination matters. High financial leverage of firms greatly increases the severity of systemic bankruptcy. Optimistic beliefs of firms and banks can alleviate coordination failure, but can also increase the severity of systemic bankruptcy once it happens.Chapter 3 studies how coordination failure in a country's new technology investment dampens a country's economic growth. I establish a two-sector Overlapping Generation model where capital goods are produced by two different technologies. The first is a conventional technology with constant returns. The second is a new technology exhibiting increasing returns to scale due to technological externalities, about whose returns economic agents have only incomplete information. My model reveals that coordination failure in new technology investment can lead to slower economic growth. More interestingly, the model generates a positive correlation between economic growth and volatility.The third part includes Chapter 4 to Chapter 6, analyzing the endogenous system arrangement forming mechanism of financial instability.Chapter 4 presents a general equilibrium model of intermediation designed to capture some of the key features of the modern financial system. The model incorporates financial constraints and state-contingent contracts, and captures the spillovers associated with asset fire sales during periods of stress. If a sufficiently severe shock occurs during a credit expansion, these spillovers can potentially generate a systemic financial crisis that may be self-fulfilling. Our model suggests that financial innovation and greater macroeconomic stability may have made financial crises in developed countries less likely than in the past, but potentially more severe. The financial system has been changing rapidly in recent years. Resale markets for capital have deepened, and sophisticated financial products and contracts, such as credit derivatives and asset-backed securities, have mushroomed. At the same time, macroeconomic volatility has fallen in developed countries. This chapter examines the implications of these developments for the likelihood and potential scale of system-wide financial crises.I develop a theoretical model of system-wide crises in which instability is associated with distress selling of assets (the forced selling of assets at a low price). The set-up attempts to capture the key features of intermediation in the modern financial system. Though the model also applies to traditional banks, it is especially relevant to the activities of hedge funds, private equity firms, and other non-bank financial institutions.Consumers channel funds through financial intermediaries to firms who manage investment projects in the productive sectors of the economy. Intermediaries have financial control over projects and form equity-type contracts with consumers. But these contracts are subject to potential default. This imposes financial constraints on them which limit the ability of intermediaries to insure against bad outcomes for investment projects.The results suggest that if an adverse economy-wide shock hits the productive sectors, intermediaries may be forced to sell assets to less-productive sectors of the economy to remain solvent. This distress selling causes the asset price to fall. In turn, this creates a feedback to net worth which affects the balance sheets of all intermediaries, potentially leading to further asset sales. Since intermediaries do not account for the effect of their own sales on asset prices, the allocation of resources implied by the market is inefficient. For sufficiently severe shocks, this spillover effect is capable of generating a system-wide financial crisis that may be self-fulfilling.The model suggests that recent developments in the financial system may have made crises less likely as they widen access to liquidity and allow assets to be traded more easily. But by relaxing financial constraints facing borrowers, they imply that, should a crisis occur, its impact could be more severe than previously. We demonstrate how these effects may be reinforced by greater macroeconomic stability. As would be expected, our model predicts that reductions in volatility make crises less likely since severe shocks occur less frequently. However, greater stability also makes mild downturns less likely. As a result, consumers are more willing to lend, allowing intermediaries to increase their borrowing and investment in firms. But if a crisis does then ensue, losses will be greater. Overall, the findings thus make clear how financial innovation and increased macroeconomic stability may serve to reduce the likelihood of crises in developed countries, but increase their potential impact.Chapter 5 shows under which conditions loan securitization, e.g. collateral debt obligations (CDOs) of banks can increase the systemic risks in the banking sector. We use a simple model to show how securitization can reduce the individual banks' economic capital requirements by transferring risks to other market participants and demonstrate that systemic risks do not decrease due to the securitization. Systemic risks can increase and impact financial stability in two ways. First, if the risks are transferred to unregulated market participants there is less capital in the economy to cover these risks. And second, if the risks are transferred to other banks interbank linkages increase and therefore augment systemic risks. We analyze the differences of CDOs (true sale) and credit default swaps (synthetic) in contributing to these risks.Chapter 6 introduces a framework for analyzing the role of financial factors as a source of instability in small open economies. Our basic model is a dynamic open economy model with a tradable good produced with capital and a country-specific factor. We also assume that firms face credit constraints, with the constraint being tighter at a lower level of financial development. A basic implication of this model is that economies at an intermediate level of financial development are more unstable than either very developed or very underdeveloped economies. This is true both in the sense that temporary shocks have large and persistent effects and also in the sense that these economies can exhibit cycles. Thus, countries that are going through a phase of financial development may become more unstable in the short run. Similarly, full capital account liberalization may destabilize the economy in economies at an intermediate level of financial development:phases of growth with capital inflows are followed by collapse with capital outflows. On the other hand, foreign direct investment does not destabilize.The fourth part includes Chapter 7 to Chapter 9, analyzing the exogenous fund shock forming mechanism of financial instability.The U.S. is currently engulfed in the most severe financial crisis since the Great Depression. A key structural factor behind this crisis is the large demand for riskless assets from the rest of the world. In Chapter 7 we present a model to show how such demand not only triggered a sharp rise in U.S. asset prices, but also exposed the U.S. financial sector to a downturn by concentrating risk onto its balance sheet. In addition to highlighting the role of capital flows in facilitating the securitization boom, our analysis speaks to the broader issue of global imbalances. While in emerging markets the concern with capital flows is in their speculative nature, in the U.S. the risk in capital inflows derives from the opposite concern:capital flows into the U.S. are mostly non-speculative and in search of safety.As a result, the U.S. sells riskless assets to foreigners, and in so doing, it raises the effective leverage of its financial institutions. In other words, as global imbalances rise, the U.S. increasingly specializes in holding its "toxic waste."The rapid growth of international reserves---a development concentrated in the emerging markets---remains a puzzle. In Chapter 8 we suggest that a model based on financial stability and financial openness goes far toward explaining reserve holdings in the modern era of globalized capital markets. The size of domestic financial liabilities that could potentially be converted into foreign currency, financial openness, the ability to access foreign currency through debt markets, and exchange rate policy are all significant predictors of reserve stocks.The explosion and dramatic reversal of capital flows to emerging markets in the 1990s have ignited a heated debate, with many arguing that globalization has gone too far and that international capital markets have become extremely erratic. In contrast, others have emphasized that globalization allows capital to move to its most attractive destination, fuelling higher growth. Chapter 9 re-examines the characteristics of international capital flows since 1970 and summarizes the findings of research of the 1990s on the behavior of international investors as well as the short-and long-run effects of globalization on financial markets and growth.Non-foreign direct investment capital inflows in China were particularly strong these years. They have led to a rapid accumulation of international reserves and they may have provided excess liquidity to the Chinese economy. Chapter 9 investigates how the central bank of China managed the rapid build-up of international reserves. The relationship between real international reserves and real domestic credit is examined with a Vector Error Correction Model (VECM), estimated on monthly data. Empirical results show that this relationship was negative, which suggests that the central bank succeeded in slowing down real domestic credit when real international reserves increased. Direct and indirect Granger causality tests are implemented to show how the central bank of China proceeded to control domestic credit.Part 5 is Chapter 10. It sums up important conclusion. It also presents the future research direction.