A hidden dragon: China’s spillovers on the financial markets of emerging economies

Global financial markets are becoming increasingly intertwined. This column analyses the potential spillovers of shocks originating in China on the financial markets of emerging economies, distinguishing between disturbances stemming from monetary policy and those related to China’s macroeconomic developments. The findings reveal that macroeconomic disturbances in China have significant lasting effects on financial variables of emerging economies, suggesting that such shocks could influence economic cycles and financial stability in those markets. The findings also offer insights into the transmission of stimulus measures announced by the Chinese authorities to the rest of the world.

In an increasingly interconnected world, global financial market movements often reflect broader economic conditions rather than isolated events in individual countries – a phenomenon often referred to as the ‘global financial cycle’ (Miranda-Agrippino and Rey 2021). The increasing globalisation of the financial cycle reflects, in part, deeper real economic integration through international trade, and, in part, heightened financial integration, evidenced by the expansion of cross-border banking claims (Claessens et al. 2014) and the inclusion of assets from emerging economies into the major benchmark indices used by institutional investors.

Thus far, scholarly attention has predominantly focused on the US, finding that shocks originating there are one of the main drivers of the global business and financial cycles (Miranda-Agripino and Rey 2015, Miranda-Agrippino et al. 2020, Boehm and Kroner 2023).  Recently, the literature has shifted its focus to China as a driver of the global financial cycle, as this country has undergone significant structural changes that have increased its relevance for the global economy. These papers argue that shocks originating in China have distinct transmission channels, often through trade and commodities (Miranda-Agrippino et al. 2020, Barcelona et al. 2022, Lodge et al. 2023, Watt et al. 2019), global value added chains (Copestake et al. 2023), or through global inflation (Dieppe et al. 2024). Emerging economies are especially vulnerable to global turbulence due to their less developed, incomplete and less liquid markets. A growing body of literature has studied these spillovers  (Canova 2005, Eichengreen and Gupta 2015, Engler et al. 2023, Faia et al. 2024).

In our recent paper (Campos et al. 2024) we assess the reaction of financial markets in East Asia, Eastern Europe, and Latin America to Chinese shocks. Using daily financial data from China and the US, and a Bayesian vector autoregression (VAR) with a combination of narrative, sign and magnitude restrictions, we identify five structural (orthogonal) shocks: two monetary policy shocks (one emanating from China and the other from the US, two macroeconomic shocks (one for China and one for the US), and a global risk shock, following the methodology of Lodge et al. (2023). We then measure the dynamic response of financial markets in individual emerging countries to the structural shocks related to China using a local projections framework.

This strategy offers an additional advantage over previous approaches. The fact that the influence of China on the rest of the world is found to be exerted primarily through its effect on global GDP and mediated by trade relationships raises the question of whether spillovers from China should affect other countries with a delay rather than immediately, as trade flows take some time to materialise. Consequently, relying solely on actual trade flows for identification might overlook the anticipatory aspects of these developments, which should instead be captured by financial market reactions.

Our findings indicate that Chinese macroeconomic shocks have immediate and lasting effects to emerging economies’ equity markets, as shown in Figure 1. However, the impact of monetary policy shocks originating in China is negligible.

Figure 1 Responses of emerging economies equity index to shocks in China

Source: Campos et al. (2024).
Note: The figure shows the average for all emerging economies in the sample (Brazil, Chile, Colombia, Mexico, Peru, Korea, Malaysia, Indonesia, Czech Republic, Bulgaria, Hungary, Poland, and Romania) of impulse response function of individual equity index to a positive macroeconomic or monetary policy shock in China that raises the equity price in China by 1%. Impulse responses are estimated with Local Projections for each country and then averaged. Blue areas show the average of 95%-confidence bands with standard errors adjusted for serial correlation using the Newey-West adjustment. These areas are not proper confidence intervals but give a rough indication of the uncertainty around the point estimates.

Moreover, spillovers from China are strongest for Latin America (Figure 2): a macroeconomic shock in China leads to an increase of about 0.26% in Latin American stock markets on the same day, compared to only 0.15% in East Asia and Eastern Europe.

Figure 2 Responses of the equity index in emerging economies to macroeconomic shocks in China

Source: Campos et al. (2024).
Note: The figures show averages for each region of impulse response function of equity prices to a positive macroeconomic shock in China that raise the equity price in China by 1%. Impulse responses are estimated with Local Projections for each country and averaged by region. LA is the average for Brazil, Chile, Colombia, Mexico, and Peru. EA is the average for Korea, Malaysia, Indonesia, and Thailand. EE is the average for the Czech Republic, Bulgaria, Hungary, Poland, and Romania. Blue areas show averages by region of 95%-confidence bands with standard errors adjusted for serial correlation using the Newey-West adjustment. These areas are not proper confidence intervals, but give a rough indication of the uncertainty around the point estimates.

At first glance, the stronger spillovers for Latin America may be surprising, given the higher integration of the industrial sectors of East Asia with China. However, as the Chinese economy is an important driver of commodity prices, economies that are more linked to the global commodity cycle should react more strongly than those which are less dependent on raw materials. As shown in Figure 3, Latin American companies whose core business is related to commodities have a stronger reaction to Chinese macroeconomic shocks than those whose business is more dependent on the domestic cycle.

Figure 3 Responses of Latin America equity index to macroeconomic shocks in China

Source: Campos et al. (2024).
Note: Black dots represent the impact of the estimated response of a variable to a positive macroeconomic shock in China that increases Chinese equities by 1% (i.e., the first element of the impulse response function). The impulse response functions are estimated using Local Projections. Grey areas show 95%-confidence bands with standard errors adjusted for serial correlation using the Newey-West adjustment. Commodity related firms are defined as mining and industrial metals companies. Domestic cycle firms belong to sectors comprising real estate, automobile, consumer staples, chemicals, telecommunications, health care, retailers, and banks.

In addition to equity markets, we also quantify the impact that shocks originating in China have on key financial variables of other emerging economies. Results are very similar: the impact of macroeconomic shocks on the cost of sovereign external debt of these economies, as well as on their exchange rates versus the US dollar, is significant (Figure 4). ¹

Figure 4 Responses of financial variables of emerging markets to shocks in China

Source: Campos et al. (2024).
Note: The figure shows the average for all emerging economies in the sample (Brazil, Chile, Colombia, Mexico, Peru, Korea, Malaysia, Indonesia, Czech Republic, Bulgaria, Hungary, Poland, and Romania) of impulse response function of individual sovereign and corporate spreads, and the exchange rate versus the USD, to a positive macroeconomic shock in China that raises the equity price in China by 1%. Exchange rate response is scaled by 10 for presentation reasons. A fall in the response indicates an appreciation of the currency. Impulse responses are estimated with Local Projections for each country and then averaged. Blue areas show the average of 95%-confidence bands with standard errors adjusted for serial correlation using the Newey-West adjustment. These areas are not proper confidence intervals, but give a rough indication of the uncertainty around the point estimates.

Overall, our analysis reveals that macroeconomic shocks from China significantly influence emerging markets: a positive macroeconomic shock in China leads to an increase in stock prices, a compression of sovereign and (except in Eastern Europe countries) corporate external debt spreads, and an appreciation of local currencies, although financial spillovers from a monetary policy shock in China are found to be weak. Moreover, the macroeconomic shocks from China have a more substantial effect on Latin America, and this greater impact appears to be driven by fluctuations in commodity prices.

Our results prompt two key consideration: (1) central banks’ multi country models often overlook significant and persistent financial spillovers from China to other emerging economies, while our results suggest that this is unrealistic; and (2) financial markets may channel the effects of commodity prices on real activity, beyond traditional trade linkages, as suggested by our results of relatively strong financial spillovers to Latin America.

Source : VOXeu