Abstract:

A rapidly growing macro-leverage ratio, measured by M2 to GDP ratio or private debt to GDP ratio, has provoked heated debates on increasing financial risks and the stance of macroprudential policies in China. Drawing on cross-country data between 1990 and 2010, we explore the explanatory factors for financial crises, using a panel logit model that considers variables such as GDP growth, external debt, savings rate, capital market openness, etc. We find that the private debt to GDP ratio has a strong explanatory power for the probability of financial crises, while the M2 to GDP ratio is not significantly correlated to financial crises.  If the private debt to GDP ratio goes up by 1 percentage point in China, the probability of a banking crisis will increase by 0.40-0.68 percentage points. The following policy implications can be drawn from our research. Although policymakers must be cautious with financial risks stemming from an excess deleveraging process, it is important to understand that an increasing macro-leverage is the key warning indicator for financial crises.  Given the high private debt to GDP ratio in China, a tightening policy stance that aims to deleverage the Chinese economy should be always in place in the medium to long run.

Full Text(PDF): Early Warning Indicators of Financial Crisis