Analysis of the non-linear relationship between Interest Rate Distortions in China’s Shadow Banking System and short-term Capital Flows

Using semiparametric generalized additive models, we studied how the market-based interest rates in China’s shadow banking system and interest rate distortion affect the country’s short-term capital flows. We used big data of shadow banking products to calculate the shadow banking interest rate and the interest rate distortion index. We improved the indirect measurement method for capital flows and used the bounds testing cointegration approach to measure China’s monthly short-term capital flows. With the calculated data, we estimated the nonlinear impact of shadow banking interest rate spreads and interest rate distortion on short-term capital flows. Results indicate that a higher shadow banking interest rate spread creates greater short-term capital inflows and the degree of interest rate distortion has a non-linear inverted U-shaped effect on short-term capital flows. Thus, the Chinese government should proceed with interest rate liberalization to eliminate the current “dual-track interest rate system” and strengthen the monitoring of cross-border capital flows so as to reduce the risks of abnormal short-term capital flows.