The Impact of Chinese Macroeconomic 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 the risks emanating from China as it experiences an increase in defaults and a slowing economy.[1] In the past, spillovers from China to other financial markets were generally considered weak,[2] reflecting China’s less developed financial markets, a largely closed capital account regime, a managed exchange rate, and a relatively low share of foreign investors in the domestic market. Yet China’s footprint in the global economy has grown rapidly in recent years, as domestic financial markets have deepened and become more integrated with global financial markets.[3] This box examines how Chinese macroeconomic risk shocks identified from Chinese and US asset price movements can affect global and European financial markets.

This box takes a two-step approach to quantifying the significance of China-specific shocks for global financial markets. The first step is to apply 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 macroeconomic risk and monetary policy shocks, US macroeconomic risk and monetary policy shocks, and global risk shocks – are identified using sign restrictions[5] and relative magnitude restrictions in the spirit of recent literature.[6] The second step is to assess the effects of shocks originating in China on global financial markets using local panel projections[7] in a sample of advanced and emerging economies.

Table A

Shocks from China have a modest impact on major 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 facilitate comparison of results, the Chinese shock impulse response function is scaled to represent the effect of a shock that would lead to a 1% decline in Chinese market capitalization. Similarly, responses to US and global risk shocks are scaled to represent the effect of a shock that would cause the S&P500 stock index to decline by 1%. For all countries in our sample, equity prices refer to national spot stock market indices, while long-term interest rates refer to long-term government bond yields with five- or ten-year maturities. , depending on data availability. Energy prices and metals prices refer to the S&P GSCI Energy Index and the Industrial Metals Index. The S&P GSCI Spot Index is calculated using the most recent liquid commodity futures prices and world production weights.

Empirical evidence suggests that shocks emanating from China have a noticeable effect on global financial markets, although the impact is less than in the case of shocks emanating from the United States or global risk shocks. Global stock prices react significantly to Chinese macroeconomic risk shocks. However, the impact is about half the effect of shocks originating in the United States and a third of that after shocks from global risks (Table A). At the same time, shocks in China are associated with a much more modest impact on global bond markets.

In contrast, shocks from China have larger spillover effects on commodity markets, which in some cases are even larger than those from shocks from the United States. This is consistent with China’s major role in global demand for energy and non-energy commodities. For example, China consumes a similar amount of energy goods as the United States and yet a significantly higher share of global non-energy commodities (like metals).[8] This suggests that a change in the outlook for China’s economy could expose companies in commodity-related industries to increased financing costs, making it harder for them to obtain or refinance debt.

Shocks from China also affect the valuations of European banks, with a greater impact when general market conditions are more volatile. If, on average, the effects on European banks of Chinese macroeconomic risk shocks seem modest (Table B, panel a and panel b), the impact is more pronounced during periods of high market stress. In addition, there is some evidence to suggest that banks with higher exposure to China are likely to see their stock prices react more strongly to negative macroeconomic risk shocks in China (Table Bpanel c).

Table B

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

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

Overall, the analysis suggests that macroeconomic risk shocks originating in China can have a significant impact on global financial markets in specific asset classes such as equities and commodities.. This is especially true when such shocks come at a time of heightened global volatility. China’s policy paradigm has shifted from a tightly controlled system to a more market-based mechanism, with continued efforts to allow market forces to play a greater role in the functioning of credit and foreign exchange markets. Therefore, its impact on global financial markets will continue to catch up with its role in the global economy.[9], increasing the importance of the country for the financial stability of the euro zone. This requires close monitoring of developments in China from the perspective of both financial market liberalization and economic growth.