Financial Market Development and Economic Growth: the Case of China

Financial Market Development and Economic Growth: the Case of China

 

Introduction

Over the past decade, global equity markets have experienced explosive growth. The emerging equity markets, such as China, have experienced a much rapid growth (Mohtadi and Agarwal, 2001). The growth takes an increasingly significant amount of shares in the global market boom. For instance, globally, the total capitalization rose from $4.7 trillion to $15.2 trillion. The emerging market share rose from below four to 13 percent during this period. China is the second largest economy and second largest stock market in the world. Chinese stock markets reached USD 3.21 trillion in 2009 (Zhang and Wu, 2012). The economy of China has sped up in the last decade. In July to September 2013, the economy expanded at 7.8 per year as estimated by the official gross domestic product calculations (Talking Business with Linda Yueh, 2013)

In this paper, the financial market development and economic growth will be studied in line with their driving forces. The paper will delve into the relation between relevant principles and theories supported with contemporary instances in the Chinese immerging yet world’s the second largest economy. The importance of problem solving and decision-making and  will be discussed. Results from previous research will be analysed to explain the sudden boom in the Chinese stock market. The paper will be organized into three sections namely financial market development in China, economic growth and theories and principles of economic growth in China’s economy. The financial development and economic growth in China will be compared to with the global economic and financial market development as an indicator of a growing economy. The discussion will form the starting point for solving the challenges China is facing in the financial market development and economic growth.

Financial Market Development in China

Financial asset exchange takes place in the financial market. The market is classified according to different standards such as physical versus OTC, money versus capital market, primary versus secondary markets. Financial securities are places to buy and sell financial securities. The basic financial securities include debt and equity.  Debt securities are for borrowing money while equity securities are for stock finance or investments. The two stock markets in China are Shanghai Stock Exchange and Shenzhen Stock Exchange. These market stock trades more than just stocks. The Chines financial market operates under financial repression. The financial market in China has survived the 2008 financial out bust (Maria, 2013) to emerge the second largest financial economy. The resilience in the market is attributed to high saving rates. The aggregate ratio of the total rate of saving to gross domestic product in China is over 35% in the past twenty years.

Under financial repression in which Chinese stock market operates, the shareholdings and bank deposits are substituted in a domestic portfolio (Zhao and Gao, 2010).  The decisions of the Chinese household investment between depositing money in the banks and purchasing shares have a great impact on the financial market development. The decisions also have a critical impact on the economic growth in China. The booming financial market induction of investors switches from stock purchase to deposit saving will eventually lead to a reduction of bank deposit. The Chinese stock market is now flooded. For instance, the first four months of 2007, the financial market was already flooded (Zhang and Wu, 2012). The impact of this effect is evident when the financial market leans towards one side creating an imbalance in the whole system.

The relationship between the domestic savings and purchasing of shares shows a negative affiliation. Studies show the links between the relationship and the disadvantage in it (Redfern and Burdekin, 2009). The studies explored the significant sentiment effects on the allocation of assets in China. The reported a growing negative financial market sentiment and its impacts on the savings account growth in China over a period between 2003 and 2007. According to Redfern and Burdekin, the Shareholder sentiment also employed constantly significant effects on the reductions attached to Chinese H-shares, B-shares, and ADRs by extraneous investors. The data though limited in the period shows the effect of the shifting to share market in the banking system, in China. The effect is more significant to the control of relative stock market performance, expected exchange rate shift, and liquidity level.

The Chinese investors shifting from banking to purchasing shares reduces the cash in the banks. The shortage of money makes the stock market the worst of this year. Millions of small investors have been affected by this change and are now dependent on the government policies. A liquidity crush sparked worries booming Chinese economy in June and December of 2013. This squeeze affected the stock market. The sudden change is attributed to the authorities. The whole shift was seen as a mechanism of the authority to impose tighter financial disciplines over the banking system. The stock market now dreads the resumption of new share offers that are flooding the market. For instance, the stock index in Shanghai closed at 6.75 per cent over the year.  The volatility in the financial market was caused by the expectations that the authority would maintain a tight balance in the financial policy and instability in the financial system (Business Recorder, 2014).

Despite the challenges in the developing financial market, there is hope as shown in Zhang and Wu (2012) and Wong (2006) studies China saw a marriage of the capitalism and socialism in the 1980s. This paved way for the development of the stock market. The financial market development has seen a series of difficulties and success. The success of the stock market now lies in the hands of Beijing. The ability of Beijing to overcome the various oppositions and challenges and to create an appropriate market oriented platforms and institutions will save the market (Wong, 2006). China as an emerging market and developing economy will take time to be the same level with the well financially developed economy in the stock market. The high saving rate in the key catalyst of the fast growing economy despite is banking challenges. It the financial market will continue to maintain the high domestic saving and enhancing the banking system, and it is bound to rise (Zhang and Wu 2012).

The Chinese Economic Growth

China is the second world largest economy in the world. The growth of the economy of China took off in the 1980s. This is the period the government of China saw the marriage of the capitalism and socialism systems. The union paved way for growth that have brought China this high a ranking. With the union, then government of China, developed with reforms in its economic policy. The collectivized agriculture was phased out and a new system of agriculture, which provides more household responsibility, was introduced. The prices of the products were initiated later, and this made the change more possible. Private enterprise in a diversity of industries such as services and light manufacturing developed and grew, after this denationalization was allowed. Currently, investments in the largest state banks in the country by investors from international companies and the bond market and foreign exchange changes have allowed more room for development (Janicki and Wunnava, 2011).

In the year 2007, china has a gross domestic economy of over USD seven trillion. The key drivers of growth of the economy of China over the past three decades can be attributed to the opening of the foreign direct investment (FDI) and reforms. These drivers are inactive and unreliable. The inactivity of these driving factors does not prevent China from emerging the second in the world economy (Yan, 2013). According to Yan, the current developing urbanisation and the strengthening domestic consumption are the current and future principle drivers of the growth of the economy of China. Despite the fact that the economy of China is facing numerous challenges externally and internally, it has continued to grow at the fastest rate and shown a willingness for growth in the future.

The Chinese economy is facing numerous challenges. The economic boom in China, foreign direct investment and export are currently unreliable. It is indisputable that export is no more the leading main driver in the economic growth internally and externally as it used to be. The labour cost in China will never go lower than it is. Workers are demanding higher pay. It means that the cost of production will increase with time. The current appreciation of China is weakening competitive advantage of export compared to other countries. The weak economy growth of the US and the Euro crises affects the export in China than before. After the 2008 crisis, the Foreign Direct Investment, which was the key driver of the Chinese economy, has been decreasing. Acquisition and Cross-border Merger are the drivers of the multinational Foreign Direst Investments that have declined vastly. Since most of the multinational corporations based in North America are suffering from both international and domestic economic downfall, the divers will not rebound for years (Yan, 2013).

On the contrary, China’s Foreign Direct Investment to other countries has been growing for many years. Conversely, as most of China’s Foreign Direct Investment to other countries made before going to establish countries in west Europe and North American, the return can be diminutive. Essentially, China commercially lost quite much through Euro crisis the going on right now and during the 2008 financial crisis in America. As the two significant drivers of China’s economic boom are unreliable, some people argue that China’s economy will not grow anymore. Another believes that the economy will pull through the crises to yet higher heights in the global ranking than it is now (Yan, 2013). Since China has a large population, it has a market for its goods and services, a factor that will see the economy grow (Iqbal, Masood & Ramzan, 2013).

Several factors affect the China’s Foreign Direct Investment. The economic activities of China affect the FDI. The positive conditions of the economic activity have positive impacts on the FDI. The GDP of China shifted for purchasing power parity, which helps in the economic growth. China has well established, immense and organized market as well as more liberalization oriented policies and had huge numbers of consumers for inviting foreign direct investment (Khaja, 2013). Infrastructure affects the FDI. It plays a significant role in attracting foreign investors. Another factor is a legal and political system. Political instability in terms of illegal capital flight, civil wars, corruption and financial market instability affect FDI negatively. Business environment in the host country will directly affect FDI. A good business environment will attract investors while a negative environment will demotivate the investors (Iqbal, Masood & Ramzan, 2013). The future of the Chinese economy growth depends on how the country handles the challenges. The republic of China should provide good infrastructure, diversify its economic activities, and streamline the legal and political system. This will attract the foreign investors and the economy will continue to grow just as it has for the last three decades.

Theories and Principles of Financial development and Economic Growth

Portfolio Theory

Portfolio theory claims that a country can reduce the risk by diversification. This is the spread of the income as much as possible. Also according to the theory, the total risk of the future returns can be categorised into company risk and market risk. Diversification can only solve the company risk (Hassan, Sanchez and Safa, 2012). Market risk cannot be solved or eliminated by diversification. Following this theory, Chinese financial market development and economic growth can be saved by holding a well-diversified portfolio rather than individual stock. China only needs to hold a limited number of stocks to gain impact of diversification and reduce the idiosyncratic instability (Xu, 2003). According to Xu, developed capital markets understand the benefits of holding a diversified portfolio. He notes that the Chinese market is still premature despite their twelve years in the market. In china, most of the investors focus on the short-term gains rather than focusing on the long term benefits. The market has limited institutional investment, a factor that makes it volatile. In such a market, diversification is needed for its survival (Loh and Singh, 2009)

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For most investors, the risk they involve with while buying stock is lower than expected during the return. This is a deviation from the expected average return. Standard deviation of each stock varies from the mean. For portfolio theorist, this is a risk. This shows that when stock is high, there less the risk. This means that holding a single stock is riskier that holding diverse stock. This is true if the risks of different stocks are not directly related. The Chinese stock market for it to escape the challenges it is facing now should diversify its stock. Various stocks should not be directly related since this means that they will share the risk. China, which is the future economic superpower, will have short-term diversification opportunities rather than long term (Singh and Loh, 2009).

The International Fisher Theory

According to the Fisher international theory, monetary valuables determine the interest rate of a given economy (Modest, 1983). The theory argues further that the economy with lower interest rates will have a lower inflation rate. In addition, the country with the higher interest rates will have a higher inflation rate. This will make the value of the currency in the country with low inflation rates rise over time. An over-generalized international fisher theory argues that the interest rates of all countries should be similar.  China’s economy rose when it pegged its currency, the Yuan to the Unit state dollar in the 80s a situation referred to as the Renminbi (Rahman and Islam et al., 6).  Another factor is the instituting trade between the two countries. China appears that it benefited more from the union than American did. By then, china was a small economy with low interest. America had been an already big economy with high interest rates. According to the international fisher theory, the country with  low interest rate will have its currency rise over time and have lower inflation. This explains why the economy of China has had such a boom. Now China is a big economy and the International fisher theory applies to it. According to Fisher, the expected future spot FX rate of China should be determined by the interest rate of another country such as the United States. The future of the financial market development and economic growth can be determined using the Fisher’s formulae (Markowitz, 1991).

The Chinese financial market can be saved from the challenges in the stock market and the economic growth by diversification. The government of China should rely on the research done on the stock market and the economy growth in their decision making process (Blume, 1970). Many scholars have dedicated their time and knowledge to solve the challenges of the coming. The economy, though, volatile has the power to overcome the challenges. Using the portfolio theory and the international Fisher theory the contrary can determine the future course of the economy as they did in the 1980s (KANE and LJUNG, 1983)

Conclusion

In sum, China has witnessed a boom it its economy in the past decade. The rise in the economy and financial market has seen China rank the second in the global economy and financial markets. China is a young and emerging market. The aggregate ratio of the aggregate rate of saving to gross domestic product in China is over 35% in the past twenty years. The impact of this effect is evident when the financial market leans towards one side creating an imbalance in the whole system. Under financial repression in which Chinese stock market operates, the shareholdings and bank deposits are substituted in a domestic portfolio. In the past decades, the economic boom in China was attributed to foreign direct investment and export, which are no longer reliable.

According to the portfolio theory, diversification is the key to the success of the economy. How the country will tackle the challenges facing Foreign Direct Investment will pay part in reviving the volatile economy. The International Fishers Theory may also be used to determine the future on the China’s financial market development and the economic growth. Comparing the relationship between the economy of China and that of United State, economist can use the Fisher’s formulae to calculate the cause of the economy in the future. The Chinese government should make use of the current research to make a decision in the matters of economic growth. While some scholars and economists felt that the Chinese market will not grow further, others are convinced that it will pull through the economic imbalance as it did in the past.

 

 

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