The Research Of Financial Instability Hypothesis And Chinese Business Cycle

This dissertation tries to interpret China’s business cycle from the perspective of financial instability. We start our research from the irrational investment in fixed assets by the entrepreneurs, and then it transmits through the path of the credit and capital market mechanisms. Lastly it causes the instability of whole financial markets, as well as the business cycle.Due to their incomplete rationality and the impetuous incentive to invest, the entrepreneurs with high operative revenue would try to expand their investment especially the operative investment on fixed assets. Besides, even the owners of enterprises in deficit would try to follow the step. But as the operative investment could hardly bring positive profits and cash flows to them, they would try to invest more on speculative fixed or financial assets, especially on the real estates. The large amount of investment flowing in the industries of finance and real estates would inevitably lead to prevalence of the asset foams in such industries. When the economy turns to the unfavorable side, or when a negative shock takes place, the illusion of the foams in these industries would burst and the financial crisis tends to loom. Coming first would be the credit crisis, when the entrepreneurs in debts have to commit credit defaults due to the lack of cash liquidity. The banks would try to call in the inferior loans in advance of time in order to cover the present loss and avoid future deficits. The debtors would be forced to undervalue and sell their fixed assets, or the banks would call in the assets for collateral and sell them at auctions to cover the loss, leading to the burst of the financial foams in both ways. In the next step, the lack of cash liquidity would spread to the creditor banks, and because of the interdependence between the financial institutes through the credit market mechanism, or the banks in the financial market would be involved in the liquidity crisis. At last, the lack liquidity in the financial market would dramatically raise the financing cost of the entrepreneurs, and the real economy would suffer from the recession due to the depressed incentive of the entrepreneurs to invest.We choose five quarterly indicators related to the topic in the Chinese financial market from 2004 to 2013, they are:the capital adequacy ration of the commercial banks, the nonperforming asset ratio of the commercial banks, the current ratio of the financial institutes, the proportion of the credit market size taking up of GDP and the proportion of the capital market size taking up of GDP. By the combination of the positively-standardized indicators based on the max-min nondimensionalizing method, we estimate the financial stability index during the time period of the past ten years. Two combined simultaneous equations are set up to input the fixed investment by the entrepreneurs, the financial stability and the business cycle in macro economy into the model so as to test the main theses of the dissertation. The empirical results by using the two-stage least square estimation method could be summarized into two main aspects of conclusion. Firstly, the irrational fixed assets investment by the individual entrepreneur could explain most of the volatility of financial instability. Secondly, financial instability could explain 48 percent of the business cycle in China in the past ten years, which means that nearly half of the cycle effects could result from the financial factors.