Study on Green Credit Incentive Policies Based on the DSGE Model, a paper co-authored by our school’s Associate Professor Peng Yuchao, Wang Yao from the International Institute of Green Finance of CUFE, Pan Dongyang from the UCL Institute for Sustainable Resources, and Liang Xi from the University of Edinburgh Business School, was published as the first article in the 2019 11th Issue of Journal of Financial Research.
Traditional views hold that monetary policy “controls total volumes” while fiscal policy “manages structures”. However, against the backdrop of structural transformation of the Chinese economy and vigorous promotion of the development of ecological civilization, monetary policy that can “manage structures” is gaining popularity among regulators. Should monetary policy manage structural issues of the economy and proactively promote the green transformation thereof while “controlling total volumes”? What are the potential effects and costs of monetary policy on “green finance policies” aimed to promote the green transformation of the economic structure? And how can we build theoretical models on which to analyze these issues? This paper answers the above questions to a certain degree.
This paper employs a methodology called the “dynamic stochastic general equilibrium (DSGE)” model, and pioneers in proposing the introduction of “green finance” factors into the model so that it can be used to analyze “green finance policies” and predict the effect thereof. The specific methods with which the DSGE model brings in “green finance” factors include: First, bring in heterogeneous production sectors, i.e. green and other production sectors. Second, introduce the credit demand of production sectors by setting their “working capital”; the credit granted to green production sectors is “green credit while that extended to other production sectors is traditional credit. Third, introduce banks as financial intermediaries to grant green and traditional credit. Fourth, introduce the central bank and finance authorities to implement targeted RRR cuts, relending, and interest subsidies, among other policies.
The study finds that interest subsidies, targeted RRR cuts and relending (with adjustment to relending rates and pledge rates) are all effective and desirable incentive policies. Policies with certain intensity can not only increase the volume of green credit, optimize economic structures in an environment-friendly way, but also generate no substantial negative impact on total output and employment, creating win-win results for both the “economy” and the “environment”. Specifically speaking:
First, the three types of incentive policies for green credit (i.e. targeted RRR cuts, relending and interest subsidies) can all directly boost the volume of green credit, regardless of whether they are introduced in the form of temporary preferential policy or incorporated into the economic system based on specific endogenous rules. Judging by the short-term policy effect on which the DSGE model focuses, they can be sequenced in the following descending order: relending (with synchronous adjustment to banks’ green credit relending rates and pledge rates), interest subsidies (with adjustment to the rate of interest subsidy), targeted RRR cuts (with adjustment to the elasticity of RRR relative to the ratio of green credit vs. total credit).
Second, if introduced in the form of temporary preferential policy, the three types of policies will increase the output and employment of green production sectors, but reduce those of other production sectors, with certain negative impact on total output and total employment. Under China’s current credit and industrial structures, positive impact is evident, and negative impact is not. All three types of policies can cut total pollution.
Third, if the three policies are incorporated into the economic system based on certain endogenous rules, their intensity must reach a specific level so as to bring about the transformation to green economy after productivity shocks. This means that the effect of too weak endogenous green credit incentive policies in the economic system is not apparent; but in terms of the share of green and other production sectors, all three can optimize the economic structure.
The working mechanism of policies in the economic system is as follows: Introduce green credit incentive policies → The interest rate (namely price) of green credit is lower → Green credit is more profitable for banks and incurs lower costs for enterprises → The green credit granted by banks and received by enterprises increases compared with other credit → Production factors (including labor or employment) obtained by green (other) projects increase (decrease) → The output value of green (other) projects rises (drops) → Environmental pollution decreases. In the meantime, incentive policies will cause a general rise in salaries, whose income effect outweighs substitution effect on household decision-making, resulting in a relative decrease in total labor input (namely, total employment) provided by households, and hence in total output.
Based on the above conclusion, this paper offers the following policy advice on how to further encourage the development of green credit. First, the central bank can study ways to launch a specialized business of “relending to support green development” to encourage banks to carry out green credit business. Second, with risks under control, the central bank and banking & insurance regulatory authorities can loosen the conditions for obtaining policy support, such as the rating requirements for green bonds used as a pledge for relending. Third, banking & insurance regulatory authorities can work with the Basel Committee to launch a country-specific pilot on capital regulatory requirements for green credit. Fourth, the central bank can implement a “green asset purchase program” or “green QE” in times of a market liquidity crunch. Fifth, financial regulators can collaborate fully with finance authorities and local governments to expand sources of funding required such as interest subsidies for green credit and risk compensation, and formulate accurate and effective policy implementation rules. Sixth, corresponding to the subsidy policy, relevant authorities can also study how to extend the exemption of VAT on the interest income of financial institutions to green credit.
