China's Output Volatility Decline

The study begins by establishing a historical context, noting that prior to 1978, China experienced ten business cycles marked by significant volatility. The introduction of Deng Xiaoping’s market-oriented economic reforms and opening to the outside world in 1978 initiated a period of exponential economic growth accompanied by a noticeable decline in GDP growth rate volatility. Macroeconomic control policies implemented in the 1980s further mitigated these fluctuations. A key observation is the strong correlation between output volatility and inflation volatility; both surged in the third and fourth quarters of 1994 before experiencing a sharp drop after 1996. Analysis using standard GDP decomposition indicates that this decrease in overall output volatility stems from reduced volatility in consumption, investment, and net exports, particularly rural consumption expenditure and residential investment. This initial section sets the stage for a deeper investigation into the causes and nature of this dramatic shift in China's economic stability.

This section presents empirical evidence supporting the occurrence of a 'Great Moderation' in China. The analysis focuses on the period from 1987 to 2007, examining the four-quarter growth rate of real GDP. A clear decline in the rolling standard deviation of the quarterly GDP growth rate is observed, falling from approximately 4.5 percent in the late 1980s to less than 1 percent in the late 2000s. While this trend is not entirely continuous, with increased volatility between 1993 and 1996, the overall reduction in volatility is significant. The study also notes that periods of excessive economic growth, like that seen in 2003, prompted government intervention through tighter macroeconomic policies to maintain stability and prevent inflation. This section firmly establishes the existence of a marked decrease in macroeconomic volatility in China, prompting further analysis into the underlying factors.

To gain a more granular understanding of the decline in overall output volatility, the study delves into the volatility of individual GDP components. Using a standard decomposition of GDP into consumption, investment, government spending, and net exports, the analysis reveals significant decreases in the volatility of most components from 1997, with investment and consumption contributing most prominently to the overall reduction in volatility. Government spending, however, showed a different trend. The relationship between the rolling standard deviation of growth rates and growth contributions is explored to assess the stability of component shares over time. Specific attention is given to the volatility of net exports, which shows a sharp decrease after 1998, a trend attributed to changes in China's international trade policies and its accession to the World Trade Organization. This detailed breakdown of GDP components highlights the multifaceted nature of the decline in macroeconomic volatility and its diverse origins.

The study concludes by comparing China's experience with the Great Moderation in other countries, especially developed economies. The findings reveal that while China’s experience mirrors the trend observed globally, the timing differs. The reduction in volatility in the United States and other G7 countries occurred in the early to mid-1980s, while China's Great Moderation shows a later onset. The study underscores the importance of several factors in achieving this reduced volatility including improved monetary policy leading to lower inflation, sustained stability in consumption and investment, and the positive impacts of the WTO accession on net exports. The final section concludes with the suggestion that sustaining this stability requires continued prudent monetary policy, maintaining stable international trade policies, and ensuring sustainable economic development. The question of whether the observed moderation is permanent or temporary is posed, indicating an area for future research.

This section of the research focuses on identifying structural breaks within China's real GDP growth rate data using econometric techniques. The primary methods employed are the CUSUM squares test and the Quandt-Andrews breakpoint test, both designed to detect unknown shifts or changes in the underlying data generating process. These tests are applied to the time series data of China's GDP growth to determine if periods of increased or decreased volatility are statistically significant and to pinpoint the precise timing of these shifts. The application of these methods aims to isolate periods where significant changes in economic stability occurred, providing a more rigorous understanding of the dynamics behind the observed 'Great Moderation'.

The study utilizes time-series econometrics to analyze the data. Given the nature of the time series data, autocorrelation is considered and tested using Durbin-Watson statistics. Additionally, the Dickey-Fuller test is employed to check the stationarity of the real GDP growth rate before further analysis. The Quandt-Andrews breakpoint test is used to determine the precise dates of any structural breaks, which is done by performing a series of Chow breakpoint tests at various points in the time series. From each individual Chow test, likelihood ratio and Wald F-statistics are extracted to identify periods of significant changes in the underlying model parameters, offering a precise timeline of economic shifts in China's GDP growth rate. The non-standard distribution of these test statistics is addressed by referencing the work of Andrews (1993) and Hansen (1997) for appropriate p-values and interpretation. This rigorous approach enhances the reliability and precision of identifying the timing and nature of structural breaks in China’s economic trajectory.

The application of the CUSUM squares test and the Quandt-Andrews breakpoint test reveals two significant structural breaks in China's real GDP growth rate. The first break occurs in 1994:Q1, signifying a move toward destabilization characterized by increased volatility. Conversely, the second break, detected in 1998:Q1, indicates a shift toward stabilization with reduced volatility. Further analysis of the autoregressive (AR) model shows that the variance reduction is primarily attributable to smaller error variance—smaller external shocks—rather than changes in the autoregressive coefficients themselves. This implies that the decrease in output volatility is more likely due to a reduction in the magnitude and frequency of external economic shocks, rather than a fundamental alteration in the inherent dynamics of the GDP growth process. The precise identification of these dates provides crucial markers in China's economic history, highlighting critical junctures affecting macroeconomic stability.

This section examines the role of monetary policy in influencing output volatility in China. The study notes a strong historical relationship between movements in output and inflation volatility. The findings suggest that improvements in monetary policy, leading to a decline in inflation volatility, played a significant role in reducing output volatility indirectly. This is consistent with observations in other countries where stricter monetary policy regimes and increased central bank independence have been associated with a decrease in macroeconomic volatility. The research also notes that while the decline in inflation volatility and stable monetary policy contribute to reduced output volatility, this is not a complete explanation because output is an aggregate variable requiring further disaggregation for a complete understanding.

To understand the decrease in output volatility, the analysis extends to the individual components of GDP. The study employs standard GDP decomposition into consumption, investment, government spending, and net exports. The results indicate that from 1997, volatility decreased significantly in most components, except for government spending. Investment and consumption are highlighted as the key contributors to the overall decline in output volatility. Further analysis compares the rolling standard deviation of growth rates with the rolling standard deviation of growth contributions for each component. This disaggregated analysis reveals that the stability of the GDP components plays a key role in the overall decline of macroeconomic volatility in China.

The study gives special consideration to the volatility of net exports. It observes a high level of net export volatility before 1998, followed by a dramatic decrease after that year. This change is attributed to China's shifting international trade policies and its eventual accession to the World Trade Organization (WTO) in 2001. The period before the economic reforms and opening up is characterized as a largely closed economy with minimal external trade, contributing to the initial high volatility. The bilateral market-access agreements with the U.S. and the EU, as well as the subsequent multilateral WTO accession, are identified as key factors in smoothing this volatility. Despite improvements, the study mentions that foreign investors still face some procedural obstacles in the Chinese market. This detailed examination of net export volatility emphasizes the impact of external factors and policy changes on China's overall macroeconomic stability.

The research employs an autoregressive (AR) model to analyze the output growth process. The results indicate that neither the AR(1) coefficient nor the growth rate displays a clear trend over time. However, a notable decrease in the standard deviation of the regression residual is observed, falling from approximately 4.5 percent in the early 1990s to less than 1 percent in the 2000s. This mirrors the pattern observed in the standard deviation of output growth, suggesting that the reduction in output volatility is primarily due to a decrease in the variance of the error term—representing smaller external shocks—rather than a change in the persistence of those shocks. This conclusion is consistent with findings from similar studies by Blanchard and Simon (2001) and Rafferty (2003). The analysis strengthens the argument that smaller external shocks rather than changes in internal dynamics are the primary driver of the reduced volatility in China.

This section compares China's experience with the Great Moderation to that of other countries, particularly developed economies. The study notes that while China experienced a significant reduction in GDP volatility, similar to the global trend, the timing differed. The decline in macroeconomic volatility in the U.S. and other G7 nations occurred earlier, in the early to mid-1980s, while China's significant reduction in volatility started later. This comparative analysis highlights the unique aspects of China's economic development and the factors contributing to its later, but equally substantial, reduction in macroeconomic instability. The study mentions that Gregorio (2008) observed a similar decline in both inflation and output growth volatility since the mid-1990s in developing economies, linking it to lagged monetary policy reforms. This contrast underscores the importance of considering the unique developmental paths and policy contexts when analyzing macroeconomic phenomena across different nations.

The decreased volatility in China's GDP growth rate, alongside its sustained high growth, has significant implications. The study suggests that this reduced volatility translates to fewer and shorter recessions, aligning with findings from studies on the U.S. economy. To maintain this stability, the study recommends continued prudent monetary policy, focusing on inflation control. Additionally, it emphasizes the importance of sustaining the stability of consumption, investment, and net exports. The Chinese government is urged to improve financial market regulations to enhance legal stability, maintain stable international trade policies, and find a more sustainable pace of development to prevent overheating in sectors such as real estate. These recommendations highlight the importance of maintaining policy consistency and addressing potential vulnerabilities within the Chinese economy to ensure the long-term stability of its economic growth.

The study acknowledges limitations, such as focusing primarily on proximate causes of the decline in output volatility in China, prompting suggestions for future research. Future studies are encouraged to explore additional factors like changes in financial markets and their interaction with monetary policy in influencing output volatility. The Japanese experience of increased volatility in the 1990s, despite facing similar banking issues, is presented as a case study warranting deeper examination. Methodological improvements are also suggested; extending autoregressive (AR) models to higher orders to better capture output growth dynamics and addressing the ongoing debate in the literature about the nature of the Great Moderation—whether it was a sharp break or a gradual trend. Finally, the study notes the need for further research to explore the implications of lower output volatility on risk premiums. This final section underscores that the research represents a significant step toward understanding China's Great Moderation but also necessitates further investigation into several unanswered questions and potential contributing factors.