Int Adv Econ Res (2018) 24:311–324

https://doi.org/10.1007/s11294-018-9713-9

Chinese and European Financial Systems: Instability

Drivers and Contagion Channels

Paolo Canofari 1 & Alessandro del Ponte 2

Published online: 18 October 2018

# International Atlantic Economic Society 2018

Abstract This paper identifies systemic risk levels in the Eurozone and China. We first
analyze the political and macro-financial factors underlying potential financial insta-
bility in both currency areas. Then, we examine the impact of a possible breakup of the
Eurozone on the Chinese financial system and the risk of redenomination of Chinese
assets expressed in Euros. Finally, considering the increasing credit gap in the Chinese
economy and the enduring political instability in several Eurozone countries, we warn
against a possible opening of contagion channels between China and Europe.

Keywords Sovereign risk . Financial Stability . Eurozone . China . Contagion

JEL F30 . G15 . G20

Introduction

How financially stable are China and the Eurozone, and what are the sources and
channels of potential risk contagion between the two? Chinese investments in the
Eurozone have risen dramatically since 2009 (Meunier et al. 2014), yet at the same
time the Eurozone has been plagued by financial instability due to the sovereign debt
crisis of 2010 and its prolonged aftermath (Pisani-Ferry 2014). As the two areas deepen
their financial ties, systemic risk levels in both the Eurozone and China call for
identifying instability drivers in each and devoting scrutiny to potential contagion
channels.

The authors gratefully acknowledge the financial support from the Institute of European Studies of Macau via
the AECSRP - IEEM Academic Research Grant 2015-16

* Paolo Canofari
pcanofari@unite.it

1
Luiss School of European Political Economy, Rome, Italy
2
Stony Brook University, Stony Brook, NY, USA
312 Canofari P., del Ponte A.

Despite the slowdown of the 2010s, China’s economic growth has reached propor-
tions that could be troublesome in the case of a bursting of the ongoing credit bubble
(Kang 2018; McMahon 2018). After her entrance in the World Trade Organization
(WTO) at the end of 2001, the Chinese capital account has benefited from large capital
inflows until 2014, when the country suffered a capital flight that was exacerbated by
the Renminbi (RMB) depreciation of August 2015 (Allen et al. 2017; Chan 2017).
Both large-scale capital inflows and capital flights can drive financial instability. On
the one hand, massive foreign capital inflows may increase the risk of the so-called twin
crises, which imply a concurrent balance-of-payments and banking or stock market
crisis (Kaminsky and Reinhart 1999; Allen et al. 2012). Specifically, evidence collected
over 25 years for 20 countries indicates that difficulties in the banking sector predict
currency crises. Currency crises do not predict banking crises, but they exacerbate the
risk of a financial meltdown if the banking sector is already under stress. A relevant topic
regards contagion risk in China. Since the Chinese interbank market has grown rapidly,1
it may represent a contagion channel if a banking crisis affects a region in China, due to
the increase in the interlinkages in the interbank market (Allen et al. 2012). On the other
hand, significant capital outflows (such as the one of the mid-2010s) exacerbate the risk
of a bursting bubble in the Chinese economy (Caballero and Krishnamurthy 2006).
In comparison to the wider fluctuations in the Chinese economy, the Eurozone may
appear remarkably stable. In the absence of major turbulences, until the sovereign debt
crisis of 2010, the Eurozone enjoyed the age of Great Moderation, which comprised
steady growth rates, low interest rates, and low inflation (Goodhart 2008). Macroeco-
nomic convergence was supposed to be achieved via structural reforms to transform the
status quo of a macro-financially heterogeneous currency union into an optimal
currency area. Yet, the 2007 financial crisis and the subsequent sovereign debt crisis
have upset the apparent tranquility that had characterized the Eurozone since its
inception and put the stabilization mechanisms devised by the creators of the Euro
under severe stress. In addition, the political uncertainty regarding the future of the
Eurozone poses a long-term threat to the Eurozone’s financial stability and particularly
to its banks (Eichler and Sobański 2016). However, despite persisting structural
imbalances between member states, post-crisis steps, including the approval of Outright
Market Transactions in 2012 and the Bank Recovery and Resolution Directive of 2014,
have improved the Eurozone resilience in the face of future shocks.
In the aftermath of the financial and sovereign debt crises, ties between China and the
Eurozone have deepened. Chinese sovereign wealth funds have invested mainly through
foreign direct investments (FDIs) in key industrial sectors of the European Union (EU)
(Kamiński 2017; Meunier et al. 2014). Chinese investors have acquired European
strategic assets or companies in financial trouble at an increasing rate (Meunier 2014).2
Within less than a decade, Chinese-outward FDIs have soared eightyfold, peaking at
almost 36 billion EUR in 2016 according to the Chinese Ministry of Commerce.
The financial interlinkages between the Eurozone and China have received scholarly
attention (Langhammer and Schweickert 2006; Plummer 2006; Pomfret 2014). Yet the

1
According to Allen et al. (2012), the volume of overnight short-term contracts, for example, has increased
from RMB 103 billion to 24 trillion between 2001 and 2010.
2
Prominent examples include Swedish carmaker Volvo (acquired by Geely in 2010), the Greek port of
Piraeus, and the Belgian port of Zeebrugge (both acquired by Cosco in 2009 and in 2018, respectively).
Chinese and European Financial Systems: Instability Drivers and... 313

possible contagion channels between China and other countries remain understudied,
with a few exceptions. Using an international sample of returns from 2003 to 2009,
Luchtenberg and Vu (2015) found that the United States, Germany, and Japan were the
biggest sources of contagion during the 2008 financial crisis followed by China, Hong
Kong and the United Kingdom (UK). They showed that China represents an important
factor of contagion, especially for Japan, during global financial crises. Canofari et al.
(2017) develop a simulation model that tests the destabilization potential of internal and
external shocks on financial institutions in the Eurozone. Specifically, they focus on
external shocks from China. Simulation results suggest that financial institutions in core
Eurozone countries would suffer more than peripheral ones from a shock coming from
China due to their higher relative exposure.
This paper contributes to the literature characterizing the instability drivers and
financial interdependencies between China and the Eurozone in terms of systemic risk
both for governments and the banking system. We investigated the level of systemic
Chinese economic risk, as well as the policies implemented or designed to offset this
risk. We also considered whether the risk was only internal, or if contagion channels
toward European countries can be identified. We assessed possible channels of finan-
cial contagion from China to the Eurozone and vice versa. Furthermore, we examined
the levels of nationalization and regulation of China’s banking system, as they are
useful indicators of the potential resilience of her financial system to financial shocks.
Finally, we identified the main mechanisms that make the EMU and China macro-
financially relevant to each other.

China’s Macro-Financial System and Exposure to Systemic Shocks

China’s financial system is shaped by large state-owned banks. China’s stock exchange
is not comparable to its banking sector in terms of scale and importance, despite the fact
that it underwent significant development during recent years3 (Allen et al. 2012). The
development of firms belonging to the so-called “hybrid sector” played an important
role in fueling the most productive and less traditional part of the Chinese economy.
However, they were not financed through the banking system and financial markets,
but via alternative financial channels, such as internal financing and the governance
mechanism (Allen et al. 2005).
To construe the Chinese systemic risk level, a relevant question concerns its banking
system’s degree of nationalization, since expected bailouts of troubled banks positively
depend on the level of involvement of the Chinese government in bank ownership.
Historically, the Chinese government has played a major role in the country’s banking
sector, with state-owned banks holding significant shares of the bank’s total assets. The
relevance of state-owned banks in China dates back to major episodes of banking crises
in the 1980s and 1990s, when the government heavily intervened to absorb the losses
of the private sector (International Monetary Fund 2016a).
But state-owned banks would hold a substantial share of total assets in the Chinese
banking systems for decades to come, as Table 1 demonstrates. Notwithstanding its

3
For instance, bank credit to the private sector in 2016 amounted to around 156% of China’s GDP, while the
corresponding figure for the U.S. banking system was only 71% (World Bank 2018).
314 Canofari P., del Ponte A.

Table 1 Assets held by China’s state-owned banks and other banks (%)

Year State-owned banks

2003 58.03%
2004 56.91%
2005 56.10%
2006 55.15%
2007 53.66%
2008 51.58%
2009 51.31%
2010 49.20%
2011 47.34%
2012 44.93%
2013 43.34%
2014 42.21%
2015 39.21%
2016 37.29%
Average 49.02%

Source: Authors’ computation on Chinese Banking Regulatory Commission (2016), p. 204

RCCs rural credit cooperatives, UCCs urban credit cooperatives

gradual modernization, China’s banking system has been controlled by five large state-
owned banks until 2009. Moreover, despite the fact that large state-owned banks have
not held the majority of the assets in the Chinese banking system since 2010 (with
declining shares since), they have still held more than a third of the total assets during
the 2010s. These banks have been publicly listed and traded since the mid- to late-
2000s, but the government retains a controlling stake (Allen et al. 2012). These five
banks include the Bank of Communications and the so-called “Big Four” banks
(Industrial and Commercial Bank of China – ICBC; Bank of China – BOC; China
Construction Bank - CCB; and Agricultural Bank of China - ABC). These institutions
have controlled, on average, about 49% of the total assets owned by the national
banking system from 2003 to 2016. This pattern of state ownership in the Chinese
banking sector suggests that a government intervention in the event of a banking crisis
would be quite likely.
The government’s influence in the banking sector is reflected not only in the degree
of bank ownership, but also in regulatory matters. Chinese banks are primarily regu-
lated by the China Banking Regulatory Commission, which is authorized by the State
Council, and the People’s Bank of China, which remains a department of the State
Council. The Ministry of Finance exerts additional regulatory pressure through its
direct stake in the five biggest commercial banks or, indirectly, through the Central
Huijin Company (Elliot and Kay 2013).
The level of corporate debt in China can be considered large both from a historical
and an international perspective. The corporate debt-to-GDP ratio in China hovered
around 170% in 2018 and the credit-to-GDP gap significantly exceeds the average
Chinese and European Financial Systems: Instability Drivers and... 315

value that, in many cases, preceded relevant episodes of banking crises in several
countries between 1990 and 2008. This evidence seems to suggest a high probability of
a banking crisis in the following years (IMF 2016b).
Figure 1 offers a longitudinal perspective on the excessive Chinese leveraging
problem. China’s gross domestic product (GDP) experienced a tenfold increase
in less than two decades, jumping from $1.083 billion in 1999 to 10.867 billion
in 2016. The ratio of the government debt-to-GDP (in nominal value) remained
fairly stable over this period and thus it was not a source of instability for the
Chinese system. Figure 1, however, shows the surge of debt in the private non-
financial sector, which constitutes a large part of the balance sheets of Chinese
banks. Banks’ credit‐to‐GDP ratio, with credits evaluated at the market value,
rose by 60% in less than 15 years.4

Recent Financial Trends between China and Eurozone Countries

Financial integration between China and the Eurozone has sharply risen since 2009.
Figure 2 shows the evolution of the stock of Chinese assets5 held by the main Eurozone
countries. France ($43 billion in 2016) and Germany ($26 billion in 2016) represent the
countries with the highest levels of Chinese assets, followed by Spain ($5 billion in
2016) and Italy ($3 billion in 2016). The data show that France, Germany, and Spain
increased their levels of Chinese assets until 2014, when investors in the largest
Eurozone countries started gradually reducing the amount of Chinese assets in their
portfolios.
Table 2 shows the Bank for International Settlements Banking Consolidated
Statistics data about the foreign banks that hold the largest share of Chinese
assets. Data are disaggregated by counterparty sector, including banks, the
official sector, and the non-bank private sector. Claims are expressed on an
ultimate risk basis and thus consider the possible risk transfer. The table indi-
cates that the main Chinese creditors are the United Kingdom, the United States,
Japan, Chinese Taipei, and France. Remarkably, even though each Eurozone
country accounts for less than 10% of foreign investments, Eurozone countries
as a whole invest approximately as much as the United States, which is the
second largest foreign investor in Chinese assets. Thus, the Eurozone is a critical
investor in the Chinese economy. Yet in the absence of greater structural
convergence, the Eurozone is an investor affected by rising political instability,
a slow post-sovereign debt crisis recovery, and lingering financial fragility
(Holinski et al. 2012), hence the importance of focusing on the interdepen-
dencies between China and the Eurozone specifically.

4
Another critical issue regards the link between public debt and banking system stability. China reacted to the
global financial crisis of 2007 with a significant fiscal stimulus financed in large part by local governments.
The result has been an increase in financial exposure by RMB 1.7 trillion in 2009 at the city level, while
central government debt increased by RMB 700 billion (Huang et al. 2016).
5
Claims and other potential exposures to the country where the controlling parent is located, i.e. positions on
residents of the banks’ home country. Available only for countries that are reporting countries for consolidated
banking statistics Consolidated Statistics (Bank for International Settlements 2016).
316 Canofari P., del Ponte A.

Credit to non-financial sector

150

(% of GDP)
100

50

2008
1999
2000
2001
2002
2003
2004
2005
2006
2007

2009
2010
2011
2012
2013
2014
2015
2016
Year

China - Private Non-Financial Sector - From Banks

China - General Government- From All Sectors
Fig. 1 Credit to the non-financial sector in China as a percentage of GDP, 1999–2016. Source: Authors’
elaboration of Bank for International Settlements (2016) data

The Eurozone: Assessing Systemic Risks and the Impact of Recent Shocks

Examining the structural fragilities of the Eurozone in light of the financial- and
sovereign-debt crisis, we can identify a main source of concern: the dwindling credit
to non-financial sector companies and the large outstanding credit to the government
sector.
Unlike in pre-crisis times, where credit toward the private sector was abundant,
companies encountered increasing hurdles in refinancing or gaining access to capital to
make continued investments and stay competitive. Figure 3 shows the impressive credit
growth that benefited the Eurozone private sector until the crisis hit Europe in 2009.
The credit crunch is noticeable especially after 2010. This figure shows Europe’s
problem child: the government sector. In the aftermath of the first financial shock of
2009, while the private sector deleveraged, Eurozone governments burdened their
balance sheets with junk assets, which increased debt-to-GDP ratios across the board
in the single currency area and paved the way for the sovereign debt crisis. Due to
extremely high outstanding debt accumulated over time, even countries mostly unaf-
fected by bail-outs (such as Italy) experienced soaring interest rates on their govern-
ment bonds.
Figure 4 offers a nuanced perspective of the differential risks harbored by Eurozone
member states, as reflected by the long-term interest rates on government bonds

60,000
Milions of US $

50,000
40,000
30,000
20,000
10,000
0
3/1/2005
11/1/2005
7/1/2006
3/1/2007
11/1/2007
7/1/2008
3/1/2009
11/1/2009
7/1/2010
3/1/2011
11/1/2011
7/1/2012
3/1/2013
11/1/2013
7/1/2014
3/1/2015
11/1/2015
7/1/2016

Italy Germany Spain France

Fig. 2 Chinese assets held by the main Eurozone countries. Source: Authors’ elaboration of Bank for
International Settlements (2016) data
Chinese and European Financial Systems: Instability Drivers and... 317

Table 2 Main bank holders of Chinese assets by country: Data breakdown by counterparty sector (September
2016)

Country Total Banks Official sector Non-bank private sector

United Kingdom 22.93% 17.81% 37.82% 22.68%

United States 12.58% 9.89% 19.02% 12.87%
Eurozone 11.12% 10.20% 15.55% 7.62%
Japan 10.37% 8.97% 12.22% 11.01%
Chinese Taipei 8.02% 11.55% 2.40% 6.95%
France 6.56% 5.58% 8.75% 6.74%
Germany 4.01% 3.60% 6.53% 0.32%
Italy 0.45% 0.68% 0.14% 0.37%

Source: Authors’ elaboration of Bank for International Settlements (2016) data

between 2009 and 2017. While the apex of the turbulence is finally over due to massive
ECB interventions, stark differences have remained between risk premia, with Greek
bond yields in 2017 being 16 times as high as German bond yields. Interest rates on
peripheral countries’ debts stand out. Specifically, they move in tandem with core
countries, but in the opposite direction. In particular, the correlation has been negative
in the midst of the sovereign debt crisis, which coincided with the first and second
Greek bailout, and in correspondence with the negotiations on the third Greek bailout in
the spring of 2015. Reaching a deal in the summer of 2015 dampened the pressure on
Greek debt and restored the positive correlation relationship, even if the spread remains
high. This pattern poses significant challenges for the ECB’s monetary policy, which
has to reconcile divergent needs across member states.
In the aftermath of the sovereign debt crisis of 2010, political shocks have become
increasingly frequent in the EU. Politically destabilizing events, such as the Brexit vote
and the rise to power of Eurosceptic parties in major countries including Italy and
Greece, create the potential for extended financial instability. To shield itself from
financial speculation on government bonds and to discourage investors from engaging
in moral hazard in their decisions, the Eurozone has equipped itself with novel tools.
Two key assets in the toolkit of the ECB are the following:
Credit to non-financial

110
(% of GDP)

90
sector

70

50
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016

Year
Eurozone General Government- From All Sectors
Eurozone - Private Non-Financial Sector - From Banks
Fig. 3 Credit to the non-financial sector in the Eurozone (% of GDP, 1999–2016). Source: Authors’
elaboration of Bank for International Settlements (2016) data
318 Canofari P., del Ponte A.

35

30
Long Term Interest Rates (%)

25

20

15

10

0
2010 2011 2012 2013 2014 2015 2016 2017
-5 Year
France Germany Greece Ireland
Italy Portugal Spain
Fig. 4 Long-term interest rates of core Eurozone countries and PIIGS, 2009–2017. Source: Authors’
elaboration of European Central Bank (2018) data

First, the June 2012 ruling by the German Court of Karlsruhe that the Outright
Market Transactions (OMT) program of the European Central Bank is compliant with
the German Constitution. This ruling gives the ECB governor the legitimization to
enact his promise to do ‘whatever it takes’ to salvage the integrity of the Euro,
including purchases of sovereign bonds of troubled member states of the Eurozone,
as it happened in large amounts with Greece, Italy, Portugal and Spain in the aftermath
of the sovereign debt crisis of 2010–2012 (e.g. Dahn et al. 2015).
Second is the Bank Recovery and Resolution Directive (BRRD) of 2014, which
introduces a bail-in policy for bankruptcies in the financial sector of the EU member
states. A bail-in policy increases the responsibility of private investors, alleviates the
burden on the public finance of member states, and fosters the autonomy of the
European Central Bank (e.g. Del Ponte 2016; Masciandaro and Passarelli 2015).
In particular, the bail-in provision of 2014 represented a key step forward to improve
the financial stability of the Eurozone, since it helped reduce the contagion of bank risk
to sovereign risk. In a model of voting on Central Bank Independence, Masciandaro
and Passarelli (2015) demonstrated that bail-in policies offer an improvement over bail-
out ones in three ways. First, the government selects an optimum amount of money to
inject in the bank that is lower than under bailout, because it does not have to deal with
stakeholders. Second, moral hazard is lower, because under bail-in, investors know that
the consequences of risky financial behavior will fall entirely upon them. Third, the
voting outcome is independent from the amount of bank shares in voters’ portfolios,
because in case of default, all voters would lose everything, regardless of the policy
chosen. The degree of political distortion will be unambiguously smaller than under
bailout if the number of shareholders is a large majority or a small minority of the
voters. This happens because the proportion of shareholders determines the degree of
Chinese and European Financial Systems: Instability Drivers and... 319

political distortion with bailout. Since under bail-in the shareholders are uninterested
and uninfluential, the political distortion could be absent altogether.
The cases of default of four Italian banks in the mid-2010s (Banca Etruria, Banca
Marche, CariChieti, and CariFerrara) showed that even if shareholders were indeed a
small minority (140,000 citizens) compared to the general population (60 million
citizens), public demonstrations and political pressures on the government to provide
some form of relief to affected stakeholders are on the rise. Other theoretical work by
Alesina and Passarelli (2017) suggested that as time passes, voters will increasingly
perceive the new bail-in regulations contained in the BRRD as the new status quo.
Hence, as the notion that the burden of financial awareness and responsibility falls
entirely on the investors and large depositors will become the new social norm in the
Eurozone, it is plausible that political pressures on governments to intervene will
become rarer in years to come.

Euro Breakup Risks and Possible Spillovers to the Chinese Financial

System

Many studies have considered the stability of the Eurozone and in particular to the
possibility of its breakup (i.e., Eichengreen 2010, Alvarez and Dixit 2014, Hefeker and
Neugart 2015). From China’s standpoint, this is relevant for understanding the impact
of this risk on Chinese assets on Eurozone member states. If a country chooses to leave
the Eurozone, we can identify two main scenarios: The country will repay its debt in
euros or it will choose to redenominate its liabilities in the new national currency.
In both cases an exchange rate devaluation is expected to be characterized by current
account deficits, lack of international competitiveness, or expected relaxed monetary
policies. The first possibility is the most probable, at least for the management of
foreign debt. The explanation is based on the fact that internal debt is subject to national
law and thus, if a country abandons the monetary union, would be paid in the new
national currency. On the other hand, external debt, which also concerns Chinese
creditors, is normally subject to foreign law and thus has to be repaid in Euros. In this
case, due to the likely strong currency devaluation following the country’s exit from the
monetary union, it will experience serious difficulties in repaying a debt expressed in a
foreign currency. Under these conditions, partial or total default will likely occur. The
second scenario is less probable, especially for international claims.6 The scenario
changes if we consider countries like Germany, which are characterized by persistent
current account surpluses due to stronger external competitiveness or having a high
inflation aversion.7 These countries, if facing a Euro breakup, would experience a
strong revaluation of their new currency in order to rebalance their persistent trade
surpluses. In the event of redenomination, the value of credit expressed in the new
currency would increase. Similarly, given the revaluation of the new currency, the
country would easily repay (or refinance) its debts if the credit remains denominated in
6
In this case, Chinese creditors would be exposed to the so-called redenomination risk. In other words, the
nominal value of their credits is subject to the new currency’s strong devaluation due to the exit. Thus, the
chance that a country leaving the Eurozone will repay external debt could be low.
7
Examples in the literature on the destabilizing effects of German current account surplus include Kim and
Roubini (2008), International Monetary Fund (2016b) and European Commission (2016).
320 Canofari P., del Ponte A.

Euros. In fact, the low interest rates on the German Bund, which become negative even
for lower maturities, can be explained by the possible earnings in terms of exchange
rate revaluation in case of Eurozone breakup and redenomination of the German debts
into a new strong currency. Lower interest rates in Germany can be also explained by
the increasing solvency of German debtors should their liabilities remain dominated in
Euros.
As shown by Canofari et al. (2015), especially during the sovereign debt crisis, the
fears of the Euro reversibility and contagion from Greece have been the main drivers of
spreads in the yields of government bonds issued by peripheral countries with respect
to the German Bund. According to them, the risk premia on the government bonds of
peripheral countries are correlated to the risk of a Euro breakup and the probability of
devaluation (or default) and revaluation (or increased solvency) for European countries
after the Euro breakup. Thus, the possibility of a breakup of the common currency
strongly affects the risk associated with Chinese credits toward the European countries.
An assessment of this possibility is, therefore, particularly relevant for Chinese inter-
national investors and creditors.
Instead of considering the impact of asymmetric real demand shocks, Canofari et al.
(2017) assume that the breakup probability is related to the level of fiscal sustainability
of government finances in Eurozone countries. In the model, the European Central
Bank (ECB) internalizes this government debt sustainability as a target in implementing
monetary policies in order to minimize the breakup probability.8 Thus, public debt
stability represents a key element for the survival of the Euro. In this regard, Canofari
et al. (2018) show that the traditional approach for monitoring fiscal sustainability can
be misleading, since the most commonly used indicators based on debt-to-GDP ratios
compare a stock-variable–debt to a flow‐variable gross domestic product. Using an
endogenous growth model with dynamic-optimizing agents, the authors derive an
indicator of fiscal sustainability that includes the role played by private net wealth.
Using this measure, for instance, Italy’s fiscal position is found to be comparable to that
of Germany in terms of public debt sustainability. In other words, the Italian govern-
ment debt is quite sustainable compared to the other member countries. Countries
considered less reliable from a public finance standpoint seem to show more resilience
to shocks on their public finances and thus their exit from the Eurozone is less likely.
Overall, despite the lack of data regarding Chinese investments in European sover-
eign bonds, the considerations presented above suggest that the consequences of a Euro
breakup for China would be serious in terms of this risk on its credit to the Eurozone. In
particular, the risk of political contagion in Europe represents a looming threat to the
Eurozone stability, which coincides with EU member state political business cycles.
Nevertheless, the breakup is unlikely if we consider models based on possible real
asymmetric shocks affecting peripheral countries or we include indicators of fiscal
sustainability including the role played by private net wealth.9

8
In other words, the ECB internalizes the breakup risk in its objective function, which is equivalent to
internalizing the so-called “whatever it takes” measures announced by ECB governor, Mario Draghi, in
July 2012.
9
These indicators are consistent with the standard transversality conditions imposed in endogenous growth
models. These conditions are expressed in terms of pure stock variables.
Chinese and European Financial Systems: Instability Drivers and... 321

Conclusions: Contagion to the Eurozone from China?

The available evidence suggests that China has been financing the Eurozone not via
purchases of government bonds, but mainly through FDI in major industrial sectors and
critical infrastructure across the continent, which alone account for approximately 20%
of their European investments. During the sovereign debt crisis, European authorities
asked China to invest in government bonds to help bail out countries facing speculative
attacks, but data on Chinese FDIs in Europe demonstrate that the Chinese contribution
came mainly in the form of investment projects and assets in European infrastructure
(Kamiński 2017).
Thus, here we suggest that the Chinese and European financial systems are asym-
metrically integrated. Instead of making large purchases of bonds issued by financial
institutions and governments in Europe, Chinese banks and sovereign wealth funds
have chosen FDIs in the key European industrial sectors. On the other hand, European
countries have invested mostly in bonds issued by the Chinese government, by Chinese
banks, and other financial companies.
Considering this asymmetry, we argue that close attention should be devoted to
possible financial shocks from China to the Eurozone, since they are likely to have a
more substantial impact than shocks in the opposite direction. This is not trivial due to
the increasing risks characterizing the excess of credit in China. Remarkably, a relevant
part of the related discussion in Europe is devoted to the possible effects of China’s
necessary credit contraction and the subsequent bursting of the housing bubble looming
over the Chinese economy.
In this context, the credit-to-GDP gap plays an important role. It is defined as the
difference between the short run value of the credit-to-GDP ratio and its long-run trend.
Scholars have identified it as an excellent early warning indicator of financial crises
(e.g. Drehmann et al. 2011), especially if proper time-series management techniques are
used, which include adjusting for structural breaks and relying at least on approximate-
ly 10 years of available data.
Figure 5 shows the credit-to-GDP gap in China and the Eurozone since the onset of
the financial crisis in Europe in 2009. With the exception of 2010 and the first semester
of 2015, the trends are sharply diverging. China is experiencing a soaring credit gap,
while the Eurozone is in increasingly negative territory since 2010. This figure
summarizes the stark differences between the two economies that we have outlined
in the sections above. While in the Eurozone the private non-financial sector is severely
underleveraged mainly due to the lack of private and public investments, China’s
private non-financial sector is highly overleveraged. These are both alarming trends.
For Europe, it indicates the risk of a lost decade, similar to the economic stagnation that
Japan experienced between 1991 and 2010. For China, it warns of a financial collapse.
Looking at several major crises10 over the past 20 years, the Basel Committee on Bank
Supervision (BCBS) found that in many instances, the credit-to-GDP gap was greater
than 8 before the inception of a severe financial crisis (Basel Committee 2010). In
2018, China’s credit gap was around 30.

10
Norway (1990), Sweden (1991), Finland (1991), Japan (1992), Mexico (1994), UK (2007), US (2007),
Ireland (2008), and the Netherlands (2008).
322 Canofari P., del Ponte A.

40
30

Credit Gap
20
10
0
-10
-20

01.03.2009
01.08.2009
01.01.2010
01.06.2010
01.11.2010
01.04.2011
01.09.2011
01.02.2012
01.07.2012
01.12.2012
01.05.2013
01.10.2013
01.03.2014
01.08.2014
01.01.2015
01.06.2015
01.11.2015
Date

Credit-to-GDP gaps (actual-trend) - Euro area - Credit from

All sectors to Private non-financial sector
Credit-to-GDP gaps (actual-trend) - China - Credit from All
sectors to Private non-financial sector
Fig. 5 Credit-to-GDP Gap in China and the Eurozone, 2009–2016. Source: Authors’ elaboration from
Bank of International Settlement (2016) data

However, a word of caution is warranted when assessing the instability of the

Chinese system due to the fact that financial data are often available with considerable
delay, if publicly accessible at all. In this paper, we partially overcame this issue by
analyzing newer data at least for some of the data presented. Even so, we can draw
some overall conclusions.
Despite the Eurozone’s unresolved structural imbalances, we argue that the Chinese
economy should be carefully monitored for the worrisome dimensions of its financial
leverage. Yet, Chinese investors in Europe should pick their investments carefully, as
the mounting political uncertainty in both core and peripheral countries of the Eurozone
may represent a drag on the speed of the post-sovereign debt crisis recovery and
dampen sustained growth for years to come.

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