Foreign Banks, Financial Frictions and China’s Macroeconomic Stability

Abstract We develop a two-country DSGE model to investigate how financial frictions faced by foreign banks influence China’s macroeconomic stability and social welfare. Foreign banks benefit from liquidity support provided by their parent banks, yet their expansion in China is constrained by credit friction and deposit friction that limit lending and deposit-taking activities. A reduction in frictions is achievable if foreign banks increase their local engagement or China broadens its policy openness to foreign banks. Our counterfactual analysis examines a transition from China’s current high friction state, where foreign banks account for only about 1.5 % of total lending, to a low friction state similar to that observed in Eastern Europe, where their lending share reaches 30 %. The high-friction state currently prevailing means that foreign banks contribute almost insignificantly to macroeconomic fluctuations in China. Reducing financial frictions allows foreign banks to mitigate short-run domestic financial recessions with the help of liquidity transfer from parent banks but slowing long-run recovery and amplifying the impact of foreign financial shocks. Our model also reveals that the relationship between credit friction and deposit friction in determining welfare is non-monotonic. When credit friction is high, reducing deposit friction lowers welfare. Conversely, under low credit friction, welfare first rises and then falls as deposit friction decreases.