The impact of Chinese macro risk shocks on global financial markets

Prepared by David Lodge, Ana-Simona Manu and Ine Van Robays

Published as part of the Financial Stability Review, May 2022.

Since the middle of last year, global investors have stepped up their scrutiny of risks emanating from China as it experiences rising defaults and a slowing economy.[1] In the past, spillovers from China to other financial markets were typically judged to be small,[2] Reflecting China’s less developed financial markets, a largely closed capital account regime, a managed exchange rate and a relatively small share of foreign investors in the domestic market. Yet China’s footprint in the global economy has grown rapidly over recent years, while domestic financial markets have deepened and integrated more with global capital markets.[3] This box looks at how Chinese macro risk shocks identified from movements in Chinese and US asset prices can affect global and European financial markets.

This box takes a two-step approach to quantify the importance of China-specific shocks for global financial markets. The first step involves applying a structural Bayesian vector autoregression (BVAR) model using daily financial market data from 2017 to 2021 to disentangle the drivers of movements in US and Chinese financial markets.[4] The five structural shocks – Chinese macro risk and monetary policy shocks, US macro risk and monetary policy shocks, and global risk shocks – are identified using sign restrictions.[5] and relative magnitude restrictions in the spirit of the recent literature.[6] The second step entails assessing the effects of shocks originating in China on global financial markets using panel local projections[7] in a sample of advanced and emerging economies.

Chart A

Shocks originating in China have a modest impact on core financial markets, but a larger impact on commodity markets

Sources: Haver Analytics, Bloomberg Finance LP, Refinitiv and ECB calculations.
Notes: Panels a) and b) show the (same-day) impact of structural shocks on financial market prices in a sample of 30 advanced and emerging economies. Panels c) and d) show the impact on commodity price indices. To make it easier to compare results, the impulse response function to Chinese shocks is scaled to represent the effect of a shock that would lead to a decline of 1% of China’s stock market capitalization. Similarly, the responses to US and global risk shocks are scaled to represent the effect of a shock that would lead to a decline of 1% of the S&P500 equity price index. For all countries in our sample, equity prices refer to the spot domestic stock market indices, while long-term interest rates refer to long-term yields on government bonds with five- or ten-year maturity, depending on data availability. Energy prices and metals prices refer to the S&P GSCI Energy Index and Industrial Metals Index. The S&P GSCI Spot Index is calculated using the most recent prices for liquid commodity futures contracts and world production weights.

The empirical evidence suggests that shocks emanating from China have a noticeable effect on global financial markets, although the impact is smaller than in the case of shocks originating in the United States or global risk shocks. Global equity prices respond significantly to Chinese macro risk shocks. However, the impact is roughly half of the effect of shocks stemming from the United States and a third as large as after global risks shocks (Chart A). At the same time, shocks in China are associated with a much more modest impact on global bond markets.

By contrast, shocks originating in China have larger spillover effects on commodity markets, which in some cases are even larger than those of shocks originating in the United States. This is consistent with the major role played by China in the demand for global energy and non-energy commodities. For example, China consumes a similar amount of energy goods to the United States and yet a significantly higher share of global non-energy commodities (such as metals).[8] This suggests that a shift in the outlook for the Chinese economy could expose firms in commodity-related industries to increasing financing costs, making it harder for them to secure or roll over debt.

Shocks from China also affect European bank valuations, with a greater impact when general market conditions are more volatile. While, on average, the effects on European banks from Chinese macro risk shocks appear modest (Chart B, panel a and panel b), the impact is more pronounced during periods of high market stress. Moreover, there is some evidence to suggest that banks with higher exposure to China are likely to see their equity prices react more heavily to negative Chinese macro risk shocks (Chart Bpanel c).

Chart B

Shocks from China also affect European bank valuations, with larger effects during periods of heightened market volatility

Sources: Bloomberg Finance LP, Refinitiv and ECB calculations.
Notes: Panels a) and b) show the (same-day) impact response of equity prices and five-year CDS spreads of EU banks to structural shocks from local projections. The responses are scaled to represent the impact of Chinese (US and global shocks) shocks that would knock 1% off Chinese (US) equity prices. The gray bars indicate the 95% confidence intervals based on corrected Driscoll-Kraay standard errors. Panel c) shows the individual response of a bank’s equity price to a positive Chinese macro (risk) shock that would knock 1% off Chinese stock market capitalization relative to the bank’s exposure to China as a share of total assets.

All in all, the analysis suggests that macro risk shocks originating in China can have a material impact on global financial markets in specific asset classes such as equities and commodities.. This is particularly true when such shocks hit in a time of heightened global volatility. China’s policy paradigm has shifted from a tightly controlled system towards a more market-based mechanism with ongoing efforts to allow market forces to play a greater role in the functioning of credit and forex markets. Consequently, its impact on global financial markets will continue to catch up with its role in the global economy[9], increasing the country’s importance for euro area financial stability. This calls for close monitoring of developments in China from the perspective of both financial market liberalization and economic growth.

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