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"International approach"
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
57


high unemployment, tightened fiscal austerity, significant public debt as well as the
financial uncertainty. In 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 1991-2013


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.
The essay will begin with literature review of theoretical studies of
58


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 economys
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
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
59


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.
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


60


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 worlds 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 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 Chinas output of manufacture and Russias export of commodity.
61


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 1990-2012


Source: International Monetary Fund

Graph3: China and Russia GDP Growth Rate 1990-2012


Source: International Monetary Fund

62


Graph4: China and Russia Inflation Rate Jan 2005- 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 2007-2010, with the lowest
at minus 56%, while inward FDI in China inclined steadily at an estimated rate of
10%.

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

63


Graph6: Percentage Change of Annual FDI Inward Stocksin China and
Russia over 2001- 2011
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 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
64


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.

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.
65


Due to the shrink of manufacture industry, unemployment rate in exportrelated 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 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 2005-2013


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 2008-2009. 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.

66

Graph9: Government Debt/GDP Ratio in China and Russia over 2000-2013


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 2009. 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 economies.
Based on analysis on real economy and inflation, FDI, labour market and
67


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.

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