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Conceptualization of Developing SD Financial Model
---A Subsystem of Chinese Macro Economy Model
QifanWang2; Nongli. JiongYou;
(1. Tongji Development Institute, Tongji University; 2. Economics and Management School of Tongji University;
3.Management School of Fudan University; 4. Consulting Center of Intemet Economy in Shanghai; 5. Derivatives
Structuring, Asia Pacific, Citigroup Intemational )
Address: Professor Qifan Wang, School of Management, Fudan University, Shanghai, 200433, CHINA
Email: gfwang@fudan.educn
Abstract
As Chinese enlarges its opening level, Chinese economy will be widely influenced by
world economy. From the systems thinking perceptive, this article closely tested the
varying of constant change of the intemational finance. We built up a research direction
aiming at Chinese macroeconomic System Dynamics model. Under the frame of
finished and simplified macroeconomic model we began to explore an important
subsystem in macroeconomic dynamic model of financial system. At present stage, we
have completed a simply dynamic model of macroeconomy, on whose base finance
sub-model is a relatively independent dynamic model. In ourwhole model assumptions,
this is one of important submodels. This research will disclose the impact of the
intemdiional financial ciisis on national macro economy of a devdoping country.
Key words: Macro Economy; Financial Crisis; System Dynamics
1. Introduction
Tn 2002, China GDP reached RMB 10 tillion; annual growth rate was 8%. On the
other side, there are still some problems in Chinese macro economy, such as market's
inefficient demand for many years, RMB 309.8 billion budget deficit in 2002.
Compared with 259.8 billion RMB in 2001, increased 19.24%, and exceeds 3% GDP.
Tt has reached the bottom line of macro economy. The employment pressure is keep
increasing in this country. In 2002, the reported unemployment rate reached 4%,
compared to year 2001, and increased 0.4%. According to the estimation of relevant
departments, there are 22 million employments to be arranged yearly, and the yearly
new created job positions are around 8 million, at the same time, there are still 0.15
billion spared manpower needs to be transferred in country. The Labor and Social
Protection Department wishes that the unemployment rate could be controlled within
4.5% in 2003", Now the only countermeasure govemment taken is using financial
policy to stimulate the domestic market demand, using currency policy to stimulate the
consumer market. China economy has continuously increased in the past 20 years, to
keep this trend, a large amount of capital investment is necessary, while the low real
investirent retum rate weakened people’s investment passion. Once the market more
opens, the stability of financial market will be the core problem of the whole national
economy. This is the key issue we will address in this paper, and also the purpose to
devedop macro economy financial subsystem modd.
2. Background
In. 1994, financial crisis in Mexico, England Balin Bank bankrupted, financial industry
credit crisis and bankrupt successively took place in Taiwan, Japan and Russia, and
bank merger in America. On May 9" 1997 Moody’s Investors Services released
investigation report on 61 national banks that 58 banks had a high proportion of credit
ctisis. On July 2° Thailand central bank changed its foreign exchange policy from
USD-pegged currency to free floating rate because of market pressure and shortage of
foreign exchange reserve, so in short term the exchange rate dropped by 16.4 percent
against US dollar. By the end of December 1997 Thai Baht (B) was devalued by 65.92
percent, which eventually caused Asia Hnancial Crisis.
Retrospecting to the history, during the period of 60’s to 70’s last century, Japan was the
country with the fastest economy development, which had annual increase rate of 9% to
10%. Until 80's, its increase rate was still 4%, while from 90's, because of the economy
bubble broke, the economy growth rate was once negative. During the centuy
altemation, Japan economy growth was almost stopped; annual growth rate has been
almost zero for years. But, the Japanese Yenis the only major cunency which value of
currency has been successively appreciated. Generally speaking, Japanese Yeris
appreciation could be classified into four phrases. The first phase the yen appreciated
from USD/JPY 506 in 1971 up to USD/JPY 305 in 1976. Just during 6 years Japanese
Yen appreciated 40%. The second phrase took place between 1985 and 1990, from
USD/JPY 261 up to USD/JJPY 146. The third phrase began in 1994, from USD/JPY 192
to USD/JPY 99 in 1995, among which it even reached USD/JPY 79.7. The fourth phase
‘was about on April 1995, Japanese Yen reached its highest level.
Although JPY devalued recently, but compared to 1971, JPY versus USD has doubled
because of the increase of JPY exchange rate. (Japan 2002 GDP=3.5 tillion USD,
USA. GDP =8 tillion USD)
On the other hand, along with the capital output of Japan, and Asia four dragons, the
economy of SouthEast Asia is developing rapidly Since the end of 1970, China
economy wes in a high growth rate, but this healthy trend was intemupted by the
Financial Crisis. The first place in the trouble was Latin America, the Tequila Effect in
1994 stopped the rapid economy growth of Latin America, and caused a series of credit
ciisis. In 1997, the same thing happened to Asia. At the end of Dec 1997, the Thai
currency dropped 40 percent in value; the Indonesian rupiah (Rp) dropped 80 percent;
the Malaysian ringgit by 30 percent; the Singapore dollar by 15 percent; the Philippine
peso by 50 percent. Stock markets contracted by similar percentages.
Financial crisis has the severe impact on the developing country economy. What began
as an East Asian financial crisis in 1997 spilled over into Brazil in the following year
and soon enveloped the whole Latin American continent. The social consequences of
the resulting crisis were particularly severe especially in terms of unemployment and
growth of poverty. It is because of the fearful impact of such crises on developing
countries that any discussion of the New Intemational Financial Order must begin in
this part of the wold.
The Tequila Effect in 1994, Dragon Effect in 1997, and Tango Effect in 2002 all
predicted the fierceness of the financial crisis. One of its characters is out busting. This
out busting will be widely spread and expanded in the market together with the Domino
Effect. Then, whether China economy market will also be influenced by such financial
isis?
Refer to the recent Chinese economy development, it is expected that Chinese economy
compound develop rate will reach 7.5% in the future 10 years, and the most part of
increase is stimulated by domestic investment In the later 10years it is required a large
amount of capital investment in China to keep up the economic growth. It is estimated.
that the investment amount would reach ¥ 50 trillion While as increase of Chinese
opening level, during the process of Chinese economy incorporating into word
economy, the main question we must consider is the relationship between development
and safety in financial market, while the key to answer this question is an early waming
model of the macroeconony. Through model simulation experiment we can explore
the dynamic relation between development trend in fubure few years or even decades
and financial market in short tem. From the previous financial events, it is illustrated
that “The agitation oncoming force of financial crisis is unusually tuxbulent’, whose the
most noticeable characteristic is its “suddenness”. But this is just the conclusion from
watching on the result. In fact, occurrence of a crisis is not “the trembling with fear of
one day”.
According to the statistics in “China - The Growing Up Manufacturing Great Power”
by BNP PARIBAS PEREGRINE in Oct. 2002, in coming 5 years, China’s real utilized
foreign investment will increase to USD 100 billion; annual growth rade will be 16%.
The validity of the capitalization from China domestic stock market is widely doubted.
Till 2002, the total market value of Shanghai Stock Exchange was 2536.37 hillion,
liquid value was only RMB746.73 billion. Total liquid value of Shanghai and Shenzhen
was RMB1382.49 billion, compared to the stock market, which shrank 10% in 2001,
was different from the development trend of macro-econonyy. In 2002, total residential
savings were RMB9.81 trillion, increased 20% compared to the same time the year
before. Obviously, the main reason is that the stock market does not totally reflect the
development trend and operation system of macro economy. It’s easy to see that only
one-quarter stock can be circulated in the market, and its total market value is less then
30% of the total market value. The market leverage is very limited. After China joined
the WTO, in the coming years, the intemal operation system and organization banier
will be eliminated gradually with China financial market opening. Whether the
economy growth is positive based on the wishes of goverment (the compound growth
rate has to be at least 7.7%, if it doubles every 10 years) or negative based on the market
trend is not the key issue, the most important is stock market will eventually be the key
channd of capitalization and play a key role in adjusting market)
The govemment control on macro economy will be weakened with the market opens.
Being the largest developing country in the world, seems it still to take time for the
economy to achieve rapid development. So how to protect the macro-economy from the
harm of financial crisis, how to avoid the happening of financial crisis, and how to react
when the opening of the enclosed market? Whether the stability of the financial market
will be impacted, and how deep the impact is, when the market gradually opens and
extemal capital impacts the market more heavily? Whether the future development of
China financial market will be the same as of Japan, which was slowered with the
hugeness of market scope, or be the same as of South-East Asia and some Latin
America countries, which burst crisis because of the fragility of their market It’s
difficult to get the answer, but it’s inevitable. From this meaning, our modeling is a finn
step towards this problem, no matter it addresses the problem deeply or not, the
direction is comect.
3. Concept and Methodology of Modeling
With the opening and globalization of China economy after joining WTO, China
economy will be greatly impacted by the world economy. In this case, the authors will
build asubmodet -financial model in a macro background. And the academic results of
modem financial theories will be applied to build sucha financial submodd.
The main simulating objective of this model will be macro-economy variables. The
variables we need to concem are as follows: which are related to financial policies such
as Govemment bond; related to currency policies such as interest rate (name and real),
related to financial market such as “composite stock average index”; related to
macro-economy prosperity index such as supply-demand balancing index; related to
foreign exchange market such as exchange rate; and related to labor market such as
employment rate, and so on.
From the systems thinking perceptive, this paper closely tests the varying of constant
change of the intemational finance. The task of our research aims at building up
Chinese macroeconomic System Dynamics model. Under the frame of finished and
simplified macroeconomic model the authors began to explore an important
subsystem -financial system. Although Chinese economy wes not greatly influenced
by Asia Financial crisis, the latter still had direct influence on the economy
development mode of China. Under WTO as Chinese enlarges its opening level, while
its trade develops and incorporates the world economy, Chinese economy will also
widely influenced by the world. So, in the background of interaction of intemational
financial system a macro economy subsystem of finance is under building. The macro
economy of China, the interaction inside financial system and the interactions between.
the parts and the whole are considered as the core of research. The authors take Systems
Thinking as the main principle of modeling, synthetically integrate other relative
theories such as econometrics, statistic etc., and make use of the latest research results
of modem financial theory to set up the financial subsystem.
‘Weassume the predetenmined target of modd as the following aspects:
1. Financial subsystem model is one part of the whole macroeconomy model, it has
telative independence, and at the same time it plays the leading role in operation of
the whole maco econony.
2. As a relatively independent system, construction of financial subsystem stresses
operating characteristic of macro economy as the research emphasis, and specially
considers financial risk, economic fluctuation and other problexs.
3. Taking macroeconomy amount as the main variables of the system and capturing
the dyramic and devdoping trend of maceconony.
4 The model can be expandable, which lays a solid foundation for its further
devdopment
According to the target we assumed, the model itself should possess the following
functions:
1. Setting out from macroscopic, it is an experiment tool to make a basic research on
rdative financia poblers.
2. It can comparatively accurately and dynamically simulate macroscopic trend of
financial system, and describe the main variable of macro economy.
3. It can provide functions for macro economy policy tests. Under certain
circumstance, and carry out quantitative analysis for macro variables and the
development trend of macro economy.
At present stage, we have completed a simplified SD model of macro economy, on
whose base financial submodel is a relatively independent part. In the model
assumptions, this is one of the most important submodd..
; The finished SD Model of Macro Foonany ;
Finance Industry Trade Other
submodel submodel submodel submodds
Figure 1 The framework of the whole moda.
The Figure 1 above is to macroscopically depict the constructive model. The financial
subsystem is the most important part The whole model will possess simulating
function for the macro economy, have certain early waming ability of the risk in the
macro financial market, and lay a solid foundation for completing a larger macro
economy moda.
Generally, the model is built for the macro economy simulation. Its framework is
shown in Figure 1. This article will only be outspread from financial sub system. Fran
systems thinking, it’s a practical shortcut to build the model by dividing the whole
country’s macro economy into several subsystems. In order to plot out the behavior of
complicated sociakeco system, once the relative stable boundary is confirmed, SD
methodology provides us a convenient analyzing tool - simulation experiment. But to
get this purpose, firstly, we have to build the financial SD sub-mode, which is based on
the framework of macro economy model. Currently we have built this macro economy
model”!, and have simulated some of the variables in the model. Based on this,
financial submodel will be based on the financial market, dynamically simulate the
relationship between the economy variables of financial market and macro economy.
4. The framework of the Model
Figure 2 is the framework based on financial subsystem; it reflects the co-relationship
and interactions among the subsystems. Analyzed the logical relations of the main
influenced factors, the model is divided into three layers. The upper layer is financial
market, a relative macro concept. It is the main layer that influencing the entire finance
subsystem, and the first layer to react on the macro economy prosperity status. The
second layer is the capital market; this is a relatively de tailed capital flowing layer. It
directly reflects the economic functions, which are caused by the impacts of capital
flowing on the macro economy. The third layer is the capital market in the real world,
such as stock market, foreign exchange market, insurance market, and bank business
etc. They are the practical units in the finance subsystem, the results caused by the
series of economy operations. Partially speaking, it is the final result of the whole
finance subsystem after a dynamic development cycle. Certainly, during the dynamic
simulating process, the third layer's financial result will feedback to its upper financial
market. The model will utilize the advantage of SD approach, systemically unite the
whole finance and other subsystems. So as to simulate the complex causal relationship,
it will dynamically plot out the basic characters of financial subsystem in
macro-economy, and provide relative scenarios and for policy tests.
Extemal Impacts
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Figure 2. Thecausal feedback loops of financial subsystem
The objective of macro economy study is the fluctuation of economy cycle, but finance
system has its own characteristics. The core of the study on finance system is the
formation of the event of turbulence crisis. Figure 3 is the description and assumption
of this problem. Analyzed on a relative independent country’s macro econonry system,
it plots out the macro strucue and the possible reasons that caused the system
unbalance, fluctuate, and financial crisis. It also judges the polarity of the
co-relationship. Actually, by analyzing the main causal loop, Figure 3 has given out all
the important factors that cause financial crisis. The key of this problem is how to
transfer these factors into quantitative math model. The main object of the model is the
macro economy variables. Currently those variables we need to consider are: variables
related to financial policy such as govemment bond; variables related to currency
policy such as exchange rate (nominal and real); variables related to finance market
such as composite stock average index; and variables related to labor market such as
employment rate and so on. In the initial stage of the simulation, the value of these
variables are definitely quite different from the real ones, but we have to note that the
objective of modeling is not simulating the real world, but predict the related policies
and economy fluctuation. So the key of the modeling will be the consistency of the
system itself and the fact, at least keep the reality of the quantitative relationship. This is
the basic requirement and standard of the model we are going to build.
Financial Crisis Causal Loop Diagram
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Credit Expanding Oa
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Figure 3 the important factors that cause financial ciisis
5. Existing Studies and Problems
For the modeling development, currently a simple macro economy model has been
developed. And the study on the finance subsystem has been carried out for almost one
year, some fundamental studies have been done, the framework has been finished. The
variables in the current macro economy model are: levels 15-20, equations around 300.
Finance subsystem has been simulated and analyzed based on macro economy policies,
and has been connected with macro economy main model. At the same time, we still
need to consider keeping a room for industry subsystem,
There are some constraints during the modeling process. The main difficulty is to find
the experience functions to simplify the relationship among variables during the
dynamic simulating process. This is exploiting job, because in different system the
experience functions is different. For example, it’s difficult to describe the quantitative
telation between people's saving, govemment bond, and financing capital. In the real
world, these 3 factors are definitely co-related, so we have to build this relationship into
the model. In order to describe this in a middle sized model, we have to use conelation
functions, whichis difficult. This is the weakest point in SD methodology.
Although currently we are clear about the objective we are going to study, the fact we
are going to simulate, and the boundary of all the variables, the modeling process is still
being explored. To achieve what we want, there are still lot of hard works to be done.
6. Conclusion
The concept of the model is primary, our objective is to describe the relation between.
fluctuation and crisis from macro growth trend, so as to achieve the simulation and
experiment analysis on long-term macro economy policies, to basically analyze the
quality of macro economy operation. From our current study results, this work still has
great difficulties, but it’s worth if we see from the tragedy brought by the financial crisis.
Tt is a pity that the study hasn't been recognized enough. Although we have tiedour
best, the process is not satisfied ©! Hopefully in the near future, the authors can show
youn integrated moda.
References
[1]. Whether the unemployment rate will keep rising? People’s Daily, Feb. 8, 2008.
[2]. Li, Nong, Qifan Wang, SD Model and Simulation of China Macro-economy,
System Engineering Theory and Practices. 2001@9@ 1-6.
[3]. Wang, Qifan. System Dynamics [Ml]. Beijing, Tsinghua University Press. 1994
(Revised)
[4]. Wang, Qifaned. Theory and Application of SystemDynamics [M]. Beijing, New
Times Press. 1987
[5]. Wang, Qifan. On the Economic Long Wave and Chinese Economy [J]. World
Eoonomic Forum. 1999, 3" Issue.
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