The influence of Chinese and US financial markets on Asia-Pacific 3

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1 The influence of Chinese and US financial markes on Asia-Pacific 3 Chang Shu, Dong He, Honglin Wang and Jinyue Dong Absrac This paper presens some early resuls from ongoing research assessing he impac of China s financial markes on hose in oher Asian-Pacific economies, and comparing i wih ha of he Unied Saes (Shu, He and Wang, forhcoming). Our analysis suggess ha China s influence on he regional sock and FX markes has grown over ime, bu is bond marke is sill isolaed from hose of he Unied Saes and Asia. US financial markes remain a srong driver, paricularly during imes of sress. Keywords: China s impac, spillovers o Asian financial markes, US, srucural VAR, sign resricions JEL classificaion: F 3 The views expressed in his paper are hose of he auhors and do no necessarily represen hose of he Bank for Inernaional Selemens, Inernaional Moneary Fund or he Hong Kong Moneary Auhoriy. Jimmy Shek provided excellen research suppor. We would like o hank Richard Levich, Aaron Mehrora, Ilan Noy, Chrisopher Orok and Frank Packer for deailed commens. We also appreciae oher useful suggesions received a he 12h Hong Kong Insiue for Moneary Research Summer Workshop, he Chinese Economiss Sociey 14 Annual China Conference and he RBNZ-BIS Conference on Cross-Border Financial Linkages. Corresponding auhor: Chang Shu, Bank for Inernaional Selemens, chang.shu@bis.org. BIS Papers No

2 Inroducion China has rapidly become an imporan driver ouside he Unied Saes for Asian financial markes. Marke developmens in he Unied Saes, wheher driven by moneary policy, financial marke or poliical evens, have long been a dominan force in he global markes. The financial crisis in 8 9 and, much more recenly, he mid-13 aper anrum, are prime examples of spillovers emanaing from he US markes. Meanwhile, hough, here have been an increasing number of cases where marke moves in China sen shock waves hrough Asia and beyond. In November 8, Chinese equiies rose by 7.3% afer a RMB 4. rillion simulus package was announced. On he same day, Asian shares jumped by 3.4%. China s influence has become such ha, apar from policy and macro news, even comparaively small credi evens in China can move regional markes. For example, he near defaul of a Chinese rus produc in January 14 weighed down emerging markes for a number of days unil a resoluion was reached. China s increasing regional influence arises, firs and foremos, from is srong rade linkages and, o a lesser exen, from is financial linkages wih Asia. As he larges rading naion in he world, China rades exensively wih oher Asian-Pacific economies. This reflecs China s significan role in he Asian producion chain as well as is expanding capaciy in generaing final demand for Asian expors. By comparison, China s direc financial linkages wih Asian-Pacific economies have been much more modes in scale. This is refleced in China s small inernaional invesmen posiion compared o hose of he Unied Saes and many oher economies (Table 1). China s liabiliy in foreign direc invesmen as a percenage of GDP shows a smaller gap vis-à-vis he Unied Saes, as foreign direc invesmen was he earlies caegory of invesmen o be liberalised under he capial accoun. By conras, China has limied foreign direc invesmen asses, and limied asses and liabiliies in porfolio invesmen under more conrols in hese capial accoun caegories. As he Unied Saes and China have differen degrees of inegraion wih Asia, heir respecive influence on financial markes also differs. Wih is exensive financial linkages wih he Asia-Pacific region, he Unied Saes can exer is influence hrough funding coss, porfolio rebalancing and risk appeie channels. China s srong rade ies ye limied financial linkages wih oher Asian economies sugges ha China s influence is mainly a reflecion of is impac on he real side. Is spillovers o regional financial markes may be hrough expecaions and risk appeie channels. In addiion, Asian asses are also known o be used as proxy rade for renminbi asses, and hus hey are affeced by developmens in China s financial markes. The relaive influence of he US and Chinese financial markes on Asia-Pacific may be differen in sress and ranquil periods. The negaive spillovers from he Unied Saes can be paricularly acue in periods of sress marked by high funding coss and a sharp rise in risk aversion. These condiions are accenuaed by he asymmeric inernaional invesmen posiions of Asian economies. On he asse side, he governmen or governmen-relaed securiies of advanced economies are held by he official secor, which ends o be a long-erm invesor. Ye he liabiliy side ends o be dominaed by foreign direc invesmen and porfolio invesmen held by privae invesors in advanced economies. This srucure is suscepible o risk-on, risk off flows, which are ofen driven by developmens in advanced economies, especially when global markes experience sress (McCauley (12)). 172 BIS Papers No 82

3 Inernaional invesmen posiion End-13 1, as a percenage of GDP Table 1 PI asse 2 PI liabiliy 2 PI oal 2 FDI asse 3 FDI liabiliy 3 FDI oal 3 China IFCs Hong Kong SAR , Singapore Seleced Asian economies Indonesia Korea Malaysia Philippines Thailand Advanced economies Unied Saes Unied Kingdom Germany End-12 figures for Indonesia, he Philippines and Thailand. 2 PI refers o porfolio invesmen. 3 FDI refers o foreign direc invesmen. Sources: IMF; CEIC; auhors calculaions. This paper is par of an ongoing projec sudying he ransmission of financial marke shocks from he US and Chinese financial markes (including he sock, bond and currency markes) o hose in oher Asia-Pacific economies (Shu, He and Wang, forhcoming). The US influence on global financial markes has been well documened. Ye, here are few sudies abou China s impac on regional financial markes. A number of sudies assess he renminbi s influence on regional currencies, eg Shu, Chow and Chan (7), Henning (12), Subramanian and Kessler (12), Frazscher and Mehl (14), and Shu, He and Cheng (14). He, Zhang and Wang (9) examine he impac of US and Chinese financial markes on Hong Kong SAR, covering he sock, bond and FX markes. There is no similar sudy for he region as a whole. The res of paper is srucured as follows. The second seciondescribes he empirical framework and daa for sudying he influence of US and Chinese financial markes on he Asia-Pacific region. Secion 3 repors some iniial resuls. The final secion summarises he major findings and considers he implicaions. Empirical framework and daa We use a srucural vecor auoregression (SVAR) o model he complex ineracions among he US, Chinese and Asian financial markes. The sudy is in he spiri of Ehrmann, Frazscher and Rigobon (11), who use SVAR models o sudy financial ransmission wihin and beween he Unied Saes and euro area, and cover he money, bond, equiy and FX markes. Our sudy focuses on inernaional ransmission beween financial markes. Our model conains hree counry/region BIS Papers No

4 blocks, ie he Unied Saes, China and Asia, and covers he sock, bond and FX markes. Specifically, he reduced and srucural form vecor auoregressions (VARs) are given, respecively, as: (1) B(L) y = ε, and (2) A(L) y = e.. In equaions (1) and (2), y US _ bond US _ sock China _ bond China _ sock =, RMB / USD Asian _ bond Asian _ sock Asian _ currency and A and B are parameer marices in he model. Also, ε is he innovaions of he reduced form in equaion (1), and e is he normalised and orhogonalised disurbances of he srucural form. Based on he Bayesian Informaion Crieria, he lag lengh is seleced o be 2 for he esimaion. Idenificaion by sign resricions This sudy idenifies he SVAR hrough sign resricions. The idenificaion procedure esablishes he link beween parameers in he reduced form and srucural VARs, which allows he analysis of VAR dynamics in erms of srucural shocks. Unlike he radiional Cholesky mehod, which requires an arbirary ordering of he endogenous variables in he VAR, he sign resricion approach allows subsanial flexibiliy in modelling, and permis pairwise ineracion among all variables. Idenificaion is achieved by imposing sign resricions beween some pairs of variables and using informaion from he variance-covariance marix in he VAR. 4 The following assumpions are imposed in our sudy for idenifying he SVARs. Cross-counry, wihin-marke spillovers: 4 This mehod for SVAR idenificaion is relaively new. Afer i was inroduced by Faus (1998), i has been furher developed by Canova and De Nicolo (2), Uhlig (5), Hau and Rey (4). Fry and Pagan (11) provide a criical review of his approach. 174 BIS Papers No 82

5 US impac on China and Asia: US socks have a posiive impac on Chinese and Asian socks. US bond yields have a posiive impac on Asian bonds, reflecing he funding cos and search-for-yield effecs (He and McCauley (13)). The same effecs migh no be direcly exered on Chinese bonds, in view of China s capial conrols. China s impac on Asia: Chinese socks have a posiive impac on Asian socks. In he meanime, he renminbi moves Asian currencies in he same direcion, in line wih earlier evidence abou he renminbi s regional impac by Shu, Chow and Chan (7), Henning (12) and Subramanian and Kessler (12), Frazscher and Mehl (14), and Shu, He and Cheng (14). No assumpion is made for he impac of Chinese bonds on Asian bonds. Cross-counry, cross-marke spillovers Spillovers from equiies o currencies: Hau and Rey (2 and 4) show ha a rise in he share of wealh held in foreign asses due o higher foreign equiy reurns can rigger a relocaion of equiy funds away from he foreign counry o he home counry and a home currency appreciaion. This reflecs he need o reduce foreign currency exposure due o imperfec hedging of currency risks. Thus, a rise in US equiy prices migh induce a porfolio rebalancing by US-based invesors o foreign asses, leading o a srenghening of Asian currencies; and a rise in Asian equiy prices leads o a weakening of Asian currencies. The same channel does no apply in China s case wih a closed capial accoun. US bond shocks on Asian currencies: US bond yields have a posiive impac on Asian currencies. Higher US bond yields will arac invesmen ino US bonds, and he resulan falling ineres raes in Asian asses leaves Asian currencies weaker. Wihin-counry, cross-marke spillovers Ineracion beween bond and sock markes: A rise in bond yields leads o a fall in sock reurns. A posiive bond yield shock indicaes a higher funding cos and a worsening of liquidiy condiions, which can drive sock prices lower. Bond yields and exchange rae: Asian bond yields have a negaive impac on he exchange rae. Tha is, bond yields in Asia will arac foreign invesmen, leading o domesic currency appreciaion. Daa The eigh-variable SVAR is esimaed using daily daa from 1 January 2 o 3 Sepember 13. The daa are obained from he CEIC daily daabase. The daa for he Asian block are aken as he simple average of Ausralia, Hong Kong SAR, India, Indonesia, Japan, Korea, Malaysia, New Zealand, he Philippines, Singapore and Thailand. One issue o address in he modelling is he differen ime zones of he US, Chinese and oher Asian financial markes. As Asian rading is ahead of he Unied Saes, shocks from Asian markes are always incorporaed ino US asse prices, while shocks o US markes can only affec Asian rading on he nex rading day. Following he pracice in he lieraure (eg Forbes and Rigobon (2) and Ehrmann, Frazscher and Rigobon (11)), we use wo-day rolling average reurns in he analysis. BIS Papers No

6 Some resuls This secion repors some iniial resuls of he ongoing research comparing he impac of China and he Unied Saes on Asia-Pacific financial markes. Impulse response The impulse response resuls show ha, in he case of Asian equiies, he iniial responses o innovaions from he US and Chinese equiies are comparable (Graph 1). One uni shock o US equiy price (around.86%) will lead o a.12% rise in Asian equiy prices upon impac, which rapidly dies down. Upon one uni shock of Chinese equiies (.96%), he rise in Asian equiies lass longer, and is he sronges on he second day, a.15%. The impac dissipaes afer hree days. Shocks o he RMB/USD rae and US bonds can move Asian currencies (Graph 2). Upon a one-uni shock in US bonds (1.89 basis poins), Asian currencies will weaken by over.4% each day for wo days. The response o a one-uni shock in he RMB/USD rae (.21%) is around.3%, bu becomes weaker on he second day. The finding of he renminbi s impac on Asian currency movemens corroboraes ha of earlier research menioned above. By comparison, Asian bonds only respond o shocks o US bonds. Chinese bonds and oher financial markes have no influence on Asian bonds. Impulse response of Asian sock In percenage poins Graph 1 US sock Chinese Sock Response o one uni of shock. Source: Auhors esimaes. 176 BIS Papers No 82

7 Impulse response of Asian currency In percenage poin Graph 2 US bond RMB Response o one uni of shock. Source: Auhors esimaes. Variance decomposiion Variance decomposiion is used o examine he relaive imporance of differen shocks in driving Asian sock, bond and currency marke movemens. We focus on comparing he relaive impac of he US and Chinese markes, and how his has evolved over ime and in differen marke condiions. Graph 3 shows how he volailiy of Asian sock markes is driven by shocks o he eigh endogenous variables, namely he US bond yield, US equiy price, Chinese bond yield, Chinese equiy price, he RMB/USD rae, Asian bond yield, he Asian exchange rae and he Asian equiy price iself over he whole sample. The variance decomposiion for he firs period is referred o as he shor erm, and ha for he fifh period he long erm. Impulse responses repored in he earlier secion sugges ha he impac of shocks ends o dissipae wihin one o hree days. For he overall sample period, he volailiy of Asian sock prices is found o be mainly driven by spillovers from US equiies (5.1%), closely followed by Chinese equiies (46.%) in he shor erm. In he long erm, he US and Chinese equiies remain he wo mos imporan drivers, bu US bond yields also have some impac. BIS Papers No

8 Asian sock marke: variance decomposiion Graph 3 Shor erm Long erm % % US sock China sock RMB/USD US bond Shor erm Asian sock Asian currency Asian bond China bond US sock China sock US bond RMB/USD Long erm Asian bond Asian sock Asian currency China bond Source: Auhors esimaes. Shocks o US bonds and he RMB/USD rae are he dominan drivers of regional exchange raes, paricularly in he shor run (Graph 4). The renminbi s impac moderaes in he long run, bu ha of US bonds rises slighly. A wider range of shocks also come ino play over he long run, including hose o US and Chinese equiies. On he Asian bond marke, US bond marke movemens have a clearly dominan effec. This effec becomes even sronger in he long run. In complee conras, all he Chinese financial markes, including equiies, bonds and he exchange rae, have barely any influence on Asian bond movemens. Asian currency: variance decomposiion Graph 4 Shor erm Long erm % % US bond RMB/USD US sock China sock Shor erm China bond Asian sock Asian bond Asian currency US bond RMB/USD US sock China sock Long erm China bond Asian sock Asian currency Asian bond Source: Auhors esimaes. 178 BIS Papers No 82

9 Esimaion from subsamples shows ha he US impac rises during periods of marke sress, bu he Chinese influence becomes more comparable wih ha of he Unied Saes in non-crisis periods. For example, during he global financial crisis and European sovereign deb crisis, he spillovers from he US equiies accouned for wo hirds of he variance of Asian equiies in he shor run, dropping o half over he long run. These compare wih around one hird in he non-crisis period. By comparison, he conribuion of Chinese equiies rises from around % o around 4% in he non-crisis period in boh he shor and long run. China s influence on he regional sock markes and currency movemens has been rising. In he period afer he European deb crisis, China s sock marke explains close o half of he shor-run variaion in Asian equiy prices, compared o around a hird before he global financial crisis. Similarly, he renminbi s impac has risen during he same period. China s move o a managed floa exchange rae regime in July 5 played an imporan role in he case of spillovers in currency movemens. Barely having any influence on regional currencies in he early s, he renminbi s impac began o be fel afer he move. Concluding remarks The paper repors some early resuls from ongoing research ha, for he firs ime, sysemaically examines China s impac on Asian-Pacific financial markes. The analysis poins o he significan influence of China on he regional equiy and FX markes. In normal or non-sress imes, China s influence on Asian sock markes rises o a level comparable wih ha of he Unied Saes, alhough spillovers from he Unied Saes o Asian financial markes end o be sronger han China s influence in periods of sress. The renminbi has also become capable of moving regional currencies afer China shifed o a managed floa regime in 5. Noneheless, China s bond marke remains isolaed from hose of boh oher Asian counries and he Unied Saes. China s rising influence and is ineracion wih ha exered by he Unied Saes have significan implicaions for financial markes and capial flows o Asia- Pacific. The influence of he Unied Saes on he world markes remains dominan, driving global liquidiy condiions and risk appeie paricularly during imes of sress. Conceivably, he Chinese influence, as an imporan regional force, may o some exen provide a couneracing facor o capial movemens should he US and Chinese markes move in opposie direcions, hus moderaing volailiy in capial movemens. Looking forward, poenial increases in he cross-holdings of financial asses wihin Asia may dampen he relaive imporance of influence from he Unied Saes while raising ha of regional facors, which migh help reduce volailiy in capial flows. Wih rising income and financial developmen, cross-border holdings of financial asses and overseas invesmen by privae secor eniies are likely o grow (Lane and Milesi-Ferrei (8a)). Conceivably, hese, under he influence of graviy facors, will have a regional focus (Lane and Schmukler (7); Lane and Milesi- Ferrei (8b); Park (13); Park and Mercado (13)). Inra-regional financial flows may be furher promoed by he inernaionalisaion of major regional currencies, especially ha of he renminbi. Regional economic and financial facors could sar exering a greaer influence on Asian invesors, paricularly insiuions, who migh sar developing views differen from hose of advanced economy invesors on BIS Papers No

10 global and regional rends. This could, in urn, sar o ac o counerac or moderae he risk-on, risk-off flows driven predominaely by he hinking of invesors currenly locaed mainly in advanced economies. References Canova, F and G De Nicolo (2): Moneary disurbances maer for business flucuaions in he G-7, Journal of Moneary Economics, vol 49(6), pp Ehrmann, M, M Frazscher and R Rigobon (11): Socks, bonds, money markes and exchange raes: measuring inernaional financial ransmission, Journal of Applied Economerics, vol 26(6), pp Faus, J (1998), The robusness of idenified VAR conclusions abou money, Carnegie-Rocheser Conference Series on Public Policy, vol 49, pp Forbes, K and R Rigobon (2): No conagion, only inerdependence: measuring sock marke comovemens, Journal of Finance, vol 57(5), pp Frazscher, M and A Mehl (14): China s dominance hypohesis and he emergence of a ri-polar global currency sysem, Economic Journal, vol 124(581), pp Fry, R and A Pagan (11): Sign resricions in srucural vecor auoregressions: a criical review, Journal of Economic Lieraure, vol 49(4), pp Hau, H and H Rey (2): Exchange rae, equiy prices and capial flows, NBER Working Paper, no (4): Can porfolio rebalancing explain he dynamics of equiy reurns, equiy flows, and exchange raes? American Economic Review, vol 94(2), pp He, D, Z Zhang, and H Wang (9): Hong Kong s financial marke ineracions wih he US and Mainland China in crisis and ranquil imes, HKMA Working Papers, no 1/9. McCauley, R (12): Risk-on, risk-off flows, BIS Working Paper, no 382. Lane, P and S Schmukler (7): The evolving role of China and India in he inernaional financial sysem, Open Economies Review, vol 18(4), pp Lane, P and G Milesi-Ferrei (8): The drivers of financial globalizaion, American Economic Review, vol 98(2), pp Park, C-Y (13): Asian capial marke inegraion: heory and evidence, Asian Developmen Bank Economics Working Paper, no 351. Park, C-Y and R Mercado (13): Deerminans of financial sress in emerging marke economies, Asian Developmen Bank Economics Working Paper, no 356. Shu, C, D He and X Cheng (15): One currency, wo markes: The renminbi s growing influence in Asia-Pacific, China Economic Review, 33, Shu, C, D He, H Wang and J Dong (forhcoming): Regional pull vs global push facors: China and US influence on Asia-Pacific financial markes. Shu, C, N Chow, and J-Y Chan (7): Impac of he renminbi exchange rae on Asian currencies, China Economic Issues, vol 3(7). 18 BIS Papers No 82

11 Subramanian, A and M Kessler (12): The renminbi bloc is here: Asia down, res of he world o go?, Peerson Insiue for Inernaional Economics. Uhlig, H (5): Wha are he effecs of moneary policy on oupu? Resuls from an agnosic idenificaion procedure, Journal of Moneary Economics, vol 52(2), pp BIS Papers No