Measuring And Analyzing China’s Macro-Financial Risk

The purpose of this paper is to measure and analyze China’s macro-financial risk for the period of 2000Q1-2008Q4. To quantify the risk exporues in China’s financial system, contingent claims approach is used to calculate the risk-adjusted balance sheets of the main sectors of the economy. The paper then illustrates and analyzes how the value of implied assets, implied asset volatiltiy and risk indicators, like DD, PD, and EL, had evolved during the period.The CCA approach is further applied to analyzing and quantifying the strong non-linearities that are characteristic for the accumulation and transmission of risk in financial system. Sector-level market leverage, market value of implied assets and asset volatility are highlighted as key factors that drive rapid increase in macro-financial risk and risk transmission between interlinked sectors. The analysis then show how risk indicators change with the above-mentioned key factors. And a sensitivity analysis is conducted to examine the effect of multi-factors on the risk indicators. Further discussion suggests sector-level market leverage and implied asset volatility are interacting factors that play an important role in the increase of sectors’ vulnerability to shocks and contagion.Then, based on China’s 2007 and 2008 flow of funds data, the paper develops the sector-level network of bilateral balance sheet exposures and proves that the cross-sector financial linkages through all types of financial instrument categories constitute the shock propagation channels. Moreover, the network models of instrument-specific bilateral exposures facilitate simulations and stress testing to demonstrate shock transmission process and measure the balance sheet contagion.After empirical evidence of risk contagion is provided based on China’s financial balance sheet data, a risk-based network of bilateral exposures is constructed to explore in detail how and how fast a local shock can cause a general increase in financial vulnerabilities. Through simulation excercises, the paper examines how balance-sheet contagion affects the risk indicators of all sectors and how increased financial market volatility further drives systemic risk higher. The simulations also show how increase in sector-level risk exposures causes drop in risk-based value of bilateral sector-level exposures and thus demonstrate the transmission of risk along the network of bilateral CCA balance sheet exposures. Finally, following the comprehensive analysis of the transmission of shocks in a network of inter-linked CCA balance sheets, a CCA countercyclical macro prudential policy supporting monetary policy is briefly discussed.