spillovers from china - quarterly bulletin - bank of england

Quarterly Bulletin2018 Q2

© Bank of England 2018ISSN 2399-4568

Topical articleFrom the Middle Kingdom to the United Kingdom: spillovers from China

Topical articles Spillovers from China 1

From the Middle Kingdom to the United Kingdom: spillovers from ChinaBy Robert Gilhooly, Jen Han, Simon Lloyd, Niamh Reynolds and David Young of the Bank’s International Directorate.(1)

• China’screditboomisoneofthelargestandlongestrunningeverrecorded.Similarcreditboomshavetypicallyprecededcrisesinothercountries.

• ThisarticleprovidesanupdatedassessmentofhowashocktotheChineseeconomycouldaffecttheUKeconomyviastandardtransmissionchannels—suchastradeandfinanciallinkages.Itthenconsidershowamplificationmechanisms,whichcouldplausiblyoperateintheeventofaparticularlylargeshock,couldfurtherincreasetheimpactontheUKfromaneconomiccrisiswithinChina.

• WefindthattheeffectsviastandardchannelsfromamodestfallinChineseGDParelargerthanourpreviousestimates,primarilyduetoChina’sincreasingroleinglobaltrade.Amoreextremeshockwhichtriggersamplificationmechanisms—suchasalargerfinancialmarketreaction—couldpotentiallydoubletheeffectsfromthestandardchannelsalone.

Overview

TheeffectsfromaChinesehardlandingontheUKeconomywilldependonhowtheshocktransmitsthroughtheglobaleconomyandfinancialmarkets.

DirectlinksbetweentheUKandChinaviatradeareverysmall(only4%ofUKexportsgotoChina),butChinaisakeyplayeringlobalsupplychainsmeaningthatindirecttradeeffects,forexampleviatheeuroarea,aremuchmoresignificant.WhileChinaremainsrelativelyunintegratedwiththeglobalfinancialsystem,theUKisunusualinhavingastrongerlinkviaHongKong.Incontrast,sharpfallsincommoditypricesfollowingahardlandinginChinacouldacttooffsetsomeofthenegativeeffectsontheUK;petrol

pricesshouldfallsupportinghouseholdspending,forexample.

Ontopofthestandardchannels,ahardlandinginChinamaytriggeramplificationmechanismswhichcouldcompoundtheimpactontheUKeconomy.ThefinancialmarketreactiontoaChinacrashisasyetuntested;hence,amoreextremeshocktoexchangeratesandassetpricescouldoccur,resultingingreaterdeclinesindemandforUKexportsandwealthandinvestorconfidence.AndaChinashockcouldpotentiallyinteractwithexistingUKvulnerabilities:commercialrealestatehasbeensupportedbyforeigninvestors,inparticularfromAsia.

(1) Theauthorswouldliketothank:theQuarterly Bulletineditors,KatharineNeissandJamesTalbotforusefulcomments;andShaheenBhikhu,ScottSimmonsandSameetaThakrarforprovidingexcellentresearchassistance.

AmplifiersStandard channels

Trade

Financial links

Commodities

China hardlanding

10% off levelof Chinese GDP

Up to two timeslargerAsset prices

Exchange rates Effects on theUnited Kingdom

1.3% to 1.4% off levelof UK GDP

Spillovers to theUnited Kingdom

Quarterly Bulletin 2018 Q2 2

Introduction

China’seconomicgrowthandintegrationintotheglobaleconomyhasbeenparticularlyrapid.Chinaaccountedforjust2%ofglobalGDPin1990,butnowmakesup15%ofglobalGDP(in2017USdollarterms).FollowingaccessiontotheWorldTradeOrganisation(WTO)in2001,Chinahasbecometheworld’slargestexporterofgoods.AndChinaisamajorproducerandconsumerofcommodities.

Suchrapideconomicgrowthhas,inpart,beenmaintainedbyanexceptionaldegreeofcreditgrowthielendingtoindividualsandbusinesses.China’screditboomisnowoneofthelargestandlongestrunningeverrecorded.Indeed,rapidcreditexpansions,suchasChina’s,havetypicallyprecededfinancialcrises(Chart 1).

Creditgrowthhascontributedtothebuild-upofthreeinterconnected‘pillarsofvulnerability’withinChina:(2)

(1) acomplexandopaquefinancialsystem;(2) aheavyrelianceontherealestatesector;and(3) risksofcapitalflightattimesofstress.

Asaresult,thereremainsariskthatChinesegrowthcouldslowmoresharplythanexpectedoraneconomiccrisis,commonlytermeda‘hardlanding’,couldoccur.AhardlandinginChinawouldhavelargeramificationsfortheworldeconomyand,inturn,theUKeconomicoutlook.

ThisarticleprovidesanupdatedassessmentofhowashocktotheChineseeconomycouldaffecttheUKeconomy.(3)ThefirstsectionconsidersthestandardtransmissionchannelsthatarelikelytooperateregardlessofthesizeoftheChinashock—suchastradeandfinanciallinkages.China’sroleinglobaltradehasrisensinceBankstafflastinvestigatedtheselinks(4)andweintroducenewestimatesfromourexpandedmodelsuite.Althoughinformative,particularlyformodestmovesin

Chinesegrowth,theseestimatesmayunderstatetheimpactofahardlandinginChina.ThefinancialmarketreactiontoaChinacrisisisasyetuntested,forexample.Thesecondsectionthereforeconsidershowamplificationmechanisms,whichcouldplausiblyoperateintheeventofalargeshocktotheChineseeconomy,mightincreasetheimpactontheUKfromaneconomiccrisiswithinChina.Finally,weconsiderhowChina’sintegrationintotheglobalfinancialsystemcouldmagnifythespillovereffectsinthefuture.

Standard transmission channels from a China shock to the rest of the world

DevelopmentsintheChineseeconomyspillovertotheUKandrestoftheworldthroughanumberofdifferentchannels,inparticularvia:trade,commoditiesandfinanciallinkages.Thesechannelsarelikelytooperateregardlessofthesize,orthenature,oftheshocktotheChineseeconomy.InordertothinkabouttheoverallimpactfromChinatotheUK,itishelpfultothinkabouthowthesechannelshavedevelopedandhowlargethesechannelscouldbe,consideringboththeUK’sdirectlinkstoChinaanditsindirectlinksviaothercountriesandregions.Sothissectionprovidesanoverviewofthesechannelsbeforepresentingupdatedestimatesoftheircombinedeffects.

Trade channelsThemainchannelthroughwhichashocktotheChineseeconomywouldaffecttheUKeconomyisinternationaltrade.Simplyput,afallinChina’srateofgrowthreducesdemandforthegoodsandservicesproducedbyUKfirms.

TheUKhaslittledirecttradeexposuretoChina—only4%ofUKexportsgotoChina.Butthereareconsiderableindirecttradelinks,inparticularviatheeuroarea(Chart 2).(5)China’simportanceintheglobaltradenetworkroserapidlyfollowingitsaccessiontotheWTOin2001,andithascontinuedtorisemorerecently,evenifthepaceofintegrationhasslowednotablysince2010.ChinaisdeeplyembeddedinglobalsupplychainswhichcouldriskpaintingamisleadingpictureofChina’simportanceasadriveroffinaldemand.Almost20%ofChina’simportsarestillusedascomponentswithinexportstoothercountries,butthisisdownfrom35%since2005,reflectingthemigrationofsomelowvalue-addedmanufacturingtootherpartsofAsia,forexampletextileproductiontoVietnam.Thismeansthat,whilethepaceoftradeintegrationhasslowed,therestoftheworldcontinuestobecomeincreasinglyexposedtoChinaasasourceoffinaldemand.(6)

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Japan asset price bubble

Danish financial crisis

China credit boom

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Thailand(Asian crisis)

Chart 1 China’s credit boom in a historical context(a)

Sources:BIStotalcreditstatisticsandBankcalculations.

(a) Lendingtotheprivatenon-financialsectoratmarketvalueasapercentageofGDP,adjustedforbreaks.

(2) FormoredetailsonChina’simbalances,seeChapter2ofDieppeet al(2018b).(3) AllreferencestoChina’seconomyrefertomainlandChina.MainlandChinaand

HongKongarereferredtoas‘GreaterChina’inthisarticle.(4) SeeCesa-BianchiandStratford(2016).(5) GermanyistheUK’ssecondbiggestexportmarket(11%ofourgoodsexports),

slightlybehindtheUS(13%).Germanyexportsover50%ofthetotalvalueofeuro-areagoodsexportstoChina.

(6) Indeed,Chart 2nowlookssimilarineithernominalvalues(shown)orvalue-addedspace(availableonrequest).


Commodity marketsChinaunderpinsmanymajorcommoditymarkets;hence,afallinChinesedemandcouldleadtodramaticfallsinsomecommodityprices.

Chinaaccountsforaround40%–50%ofcoal,steel,copperandaluminiumconsumptionandproduction,anditisnowthesecondlargestconsumerofcrudeoil(Chart 3).Itisalsotheworld’slargestimporterofmanyagriculturalcommodities,suchassoybeans.EstimatesbyBankstaffandtheEuropeanCentralBank(ECB)suggestthata1%declineinChineseeconomicactivitycouldreduceoilpricesbyaround5%,whilemetalspricescouldfallbybetween5%to15%.(7)

FallingcommoditypricesshouldboosttheUKeconomy,giventhattheUKisanetimporterofthesegoods.Householdsand

firmsbenefitwhencommoditypricesfall;lowerpetrolpricesfreeupmoneytospendonothergoods,forexample,boostingconsumption.Thiswouldbepartlyoffsetbyafallininvestmentspendingbythecommodityextractionsector,forexampleintheNorthSeaoilfields.Butreflectingtheirrelativesharesintheeconomy,theconsumptioneffecttypicallydominatestheinvestmenteffectintheUK.

AdditionaleffectsviatheUK’stradingpartnerswillalsodependontheirbalancebetweenconsumptionandproduction.TheemergenceofNorthAmericanshaleoilproductionhasshiftedthebalanceintheUSandCanadamoretowardsproduction.ConsumersintheUSandCanadawouldstillbenefitfromfallingpetrolprices,buttheboosttotheireconomies—andinturntheirdemandforUKexports—wouldbepartlyoffsetasfallinginvestmentinshaleoilfieldswoulddragontheireconomies.ThisimpliesaslightlylessfavourableboosttoUKtrade,ascombinedtheUSandCanadaaccountforalmostafifthofUKexports.

Financial channelsFinancialchannelsplayanimportantroleinthetransmissionofinternationalshocks.ApreviousQuarterly BulletinarticlefoundthatfinanciallinkagesarelikelytohaveaccountedforthemajorityoftheimpactofworldshocksontheUnitedKingdomsince2007.(8)GivenChina’ssizeintheglobaleconomywemightexpectsuchspilloverstobesignificant.

Butdespitethesizeofitseconomyanddomesticfinancialsystem,Chinaisnotveryintegratedintheglobalfinancialsystem.China’sshareofglobalholdingsofoverseasassetsandliabilitiesremainslowat5%and3%,respectively.Incomparison,theUSshareofglobalexternalassetsandliabilitiesismuchhigher,ataround18%and23%,respectively.Anetworkchartofbankinglinks(Chart 4)showsaparticularlystarkdifferencetoChart 2’stradelinks.Unliketradelinks,mostcountrieshaveverylimitedbankinglinkswithChina,evenindirectly.Overall,lowexposure,combinedwithimprovedbankcapitalisationpost-crisis,suggeststhataChinashockisunlikelytogeneratelargedirectfinanciallossesformanycountries.

However,unlikemostcountries,theUKisuniqueinhavingbothsizabledirectexposurestomainlandChina,andindirectlyviaUKbanks’exposurestoHongKong(Chart 5).Together,UKbanks’exposurestomainlandChinaandHongKongexceedexposurestotheUS,euroarea,JapanandKoreacombined,despitetheUKeconomybeingafifteenthofthesizeoftheseeconomiescombined.(9)

Rest of Europe United Kingdom

ChinaUnitedStates

Rest ofAsia

Australia andNew Zealand

Hong Kong

Japan

Canada

Mexico

South America

Euroarea

Chart 2 China’s role in the global trade network(a)

Source:IMFDirectionofTradeStatistics.

(a) Linethicknessisproportionaltototalgoodstradebetweenregions.Circlesizeisproportionaltoregions’totalgoodstradewiththeotherregionsshowninthechart.PinklinedenotestheUK’sdirecttradelinkswithChina,andtheblueandredlinesillustratetheUK’sindirectlinkstoChinaviatheeuroarea.Databasedonnominal2017USdollars.

(7) TheECB’sstudyconsidersironore,copperandaluminiumprices(Dieppeet al(2018b)).

(8) SeeChowla,QuagliettiandRachel(2014).(9) TheUK’sfinancialexposurestoChinaandHongKonghaveincreasedsubstantially

relativeto2007,while,incontrast,UKexposurestotheUSandeuroareahavemorethanhalved.

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Chart 3 China’s share of global consumption and production of selected commodities

Sources:Bloomberg,CEIC,ThomsonReutersDatastreamandBankcalculations.


Bringing together the channels to model spillovers from China to the UKToquantifyhowashocktoChinamightaffecttheUnitedKingdomitisimportanttotryandcapturetheimpactfromallofthetransmissionchannels,includingtheirindirecteffectsviaothercountries.

Wehaverecentlyupdatedandexpandedourmodelsuiteaspartofourcontinuedmonitoringoftheglobaleconomyandinternationalrisks.TocapturethetransmissionchannelsoutlinedaboveweuseourupdatedGlobalVectorAutoregressive(GVAR)modelandthenewECB-Global(ECB-G)model.TheGVARwasusedinapreviousQuarterly BulletinarticleassessingspilloversfromChina,(10)andECB-GhasbeendevelopedbytheECBforstudyinginternationalspillovers.(11)Anintuitiveoverviewofthemodels

isprovidedintheannex.BothmodelsarewellsuitedtoestimatespilloversfromChinatotheUnitedKingdom.Bothallowshockstopropagateacrosstheworldeconomythroughmanychannelsofinterdependence,suchastradeandfinance,includingindirectlyviaothercountries.Andbothmodelscanbeusedtostudycountries’changingimportanceintheglobaleconomyovertime.

OurupdatedandexpandedmodelsuitenowsuggeststhatspilloversfromChinatotheUnitedKingdomarelikelytobeabout50%largerthanpreviouslyshownintheQuarterly Bulletin.StrongereffectsintheupdatedGVARreflecttwochanges.First,wehaveaddedadditionaleconomiestothemodel,includingHongKongandTaiwan,whichareimportanttradehubswithinAsia.Thisshouldcapturemoreofthesecond-roundeffects,astheimpactonChina’sclosetradingpartnersamplifiestheinitialshock.Second,China’simportanceintheglobaleconomyhascontinuedtoincreaseoverthepastfewyears.

ToquantifythetotaleffectfromthestandardchannelswefirstdefineamodestshocktoChinaasonethatreducesthelevelofitsGDPby3%afterthreeyears,comparedtotheInternationalMonetaryFund’s(IMF’s)currentforecast.Weassumetheshockisfront-loaded,suchthatChineseGDPgrowthisaround2percentagepointslowerinthefirstyearandalmost1percentagepointlowerthantheIMFforecastinthesecondyear.TheupdatedGVARandnewECB-GmodelsbothsuggestthatUKGDPcouldbereducedbyaround0.2%–0.3%inthefirstyearfollowingtheshock,andbythesecondyearUKGDPwouldbe0.4%–0.5%lower(Chart 6).(12)ThelargerpeakeffectsfromtheECB-GcouldbebecauseitallowsawiderrangeoffinancialspilloversthantheGVAR,aswellasnegativedemandeffectsthroughcommodityproducers.

Amplification mechanisms could increase the effects of a China hard landing on the UK

Althoughinformative,theseestimatesriskunderstatingtheimpactontheUKifamoresevereshockweretooccur.Additionalamplificationmechanisms—suchaslargeforeignexchangeorassetpricemoves—couldkickinifChinawastosufferahardlanding.AlthoughChina’srapidintegrationintotheglobaleconomymeansthattheseamplificationmechanismsarelargelyuntested,aswediscussbelow,financialmarketsdoappeartobemoresensitivetoChinanewsintimesofstress.

UnitedStates

Rest of EuropeHong Kong

China

Rest of AsiaJapanEuro

areaMexico

CanadaUnited Kingdom

Australia andNew Zealand South America

Chart 4 China’s role in the global banking system(a)

Sources:BISinternationalbankingstatisticsandBankcalculations.

(a) Linethicknessisproportionaltoanaverageoflocationalandconsolidatedbankingclaimsbetweenregions(subjecttodataavailability).Aregion’scirclesizeisproportionaltothatregion’stotalclaimsontheotherregionsshowninthechartplustheirtotalclaimsonthatregion.PinklinedenotestheUK’sdirectbankinglinkswithChina,andtheblueandredlinesillustratetheUK’sindirectlinkstoChinaviaHongKong.Databasedon2017nominalUSdollars.

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United Kingdom United States Japan Euro area(a) Korea

US$ billions

Hong Kong

China

Chart 5 Country banking links to China and Hong Kong, 2017 snapshot

Sources:BISconsolidatedbankingstatisticsandBankcalculations.

(a) EuroareaconsistsofAustria,Belgium,Germany,Greece,Ireland,Italy,Netherlands,PortugalandSpain.

(10) SeeCesa-BianchiandStratford(2016).(11) Dieppeet al(2018a)providesadetailedexpositionofECB-G.(12) Forcomparison,thesameshockwouldreduceUKGDPby0.20%inyearoneand

0.25%inyeartwointhepreviousGVARusedinCesa-BianchiandStratford(2016).WithintheupdatedGVARandECB-G,similarshockstoUSandeuro-areaGDPwouldreducethelevelofUKGDPbyaroundtwoandahalftimesmoreatpeak.TheseeffectsaregreaterbecauseoftheUK’slargertradeandfinanciallinkageswiththeUSandeuroarea.


An illustrative hard-landing scenarioChart 7showstheIMFforecastforChineseGDPgrowth,whichslowstoaround6%perannumoverthenextthreeyears.WeshowwhatmighthappenifasevereshockweretohittheeconomyresultinginChineseGDPgrowthfallingverysharplyinthenearterm.Thisillustrativescenarioisextreme:four-quarterGDPgrowthdropsfromaround7%tonear-1%.Althoughgrowthrecoversfairlyquickly,thelevelofChineseGDPis10%belowthebaselineforecastafterthreeyears.

Consideringbothmodels,thisillustrativescenarioforaChinesehardlandingcouldreducethelevelofUKGDPby0.9%–1.0%afteroneyearand1.3%–1.4%atthepeak.SincetheGVARandECB-GarelinearmodelsthetotaleffectsareroughlythreetimesthatshowninChart 6(aswemovefroma-3%shocktoa-10%shock).(13)

WecanhoweverusetheECB-Gmodeltoexplorehowlargepotentialamplificationandmitigationmechanismscouldbeintheeventofalargeshock.Inthissectionwenextbuildupaspectrumofadditionaleffects(Chart 8).

Amplification from foreign exchange marketsOurmodelsmaynotcapturethedepreciationoftheChinesecurrency(therenminbi)thatcouldoccurinaChinahardlanding.WithinECB-G,theChineseexchangerateisnotfullyflexible.Andmoregenerallyourmodelsappeartostruggletocapturepotentialdepreciationeffects,inpartbecausetherenminbiwasheavilymanagedbefore2014.ItisalsoplausiblethatotherAsiancurrenciescouldalsofall,giventheirlargeexposurestoChina,magnifyingtheeffects.(14)Safe-havencapitalflowscouldalsocontributetotherelativeappreciationofadvanced-economy(AE)currenciesvis-à-visAsiaoremergingmarketeconomies(EMEs)moregenerally.

Largerforeignexchange(FX)movesinAsia(relativetoAEs),couldpotentiallyreduceUKGDPinthefirstyearbyanadditional0.4percentagepoints(Chart 8).TheFXestimateshownhereisofcoursequiteuncertainandsterlinghasinthepasthadatendencytodepreciateagainstsafe-havencurrencies—suchastheUSdollar—duringperiodsofacuteglobalstress.FortheUK,arelativedepreciationofsterlingvis-à-visotherAEcurrenciescouldthereforedampenthenegativeeffectasUKexportsbecomemorecompetitivecomparedtosafe-havencurrencies,eveniftheylosecompetitivenessagainstAsiancurrencies.

Amplification from equity markets Globalfinancialmarketsexhibitsubstantialtime-variationintheirresponsivenesstoChineseeconomicdevelopments.Formanycountries,responsivenesstoChinawillreflecttosomeextenttheirexposuretoChinaviatradeandcommoditymarkets.(15)ButdownsideChinesenewsnowappearsto

(13) Tradechannels,bothdirectandindirect,likelyaccountforoverhalfthehittoUKGDP,whilemonetarypolicyandcommoditiescushiontheeffectontheUKsomewhat.

(14) Afterthesurprisedevaluationoftherenminbion10August2015,otherAsiancurrenciestypicallydepreciatedbyasimilarorlargerdegreeagainstthedollar.WeassumethatHongKong’scurrencyboardarrangement(LinkedExchangeRateSystem)totheUSdollarremainsinplace.

(15) Mwaseet al(2016).

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Chart 6 Impact of a negative 3% shock to Chinese GDP on UK GDP after one year and at peak

Source:Bankcalculations.

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Chart 7 An illustrative hard-landing scenario(a)

Sources:IMFWorld Economic Outlook (WEO)April2018 andNationalBureauofStatisticsofChina.

(a) ThereddashedlinedisplaysanillustrativescenarioinwhichthelevelofChineseGDPisassumedtofall10%belowtheIMFforecastafterthreeyears.

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Chart 8 Potential amplification and mitigation effects from a China hard landing to the UK, one-year horizon

Source:Bankcalculations.


mattermorethanitdidpreviously.Forexample,on24August2015(knownasChina’s‘BlackMonday’)Chineseequitiesfellbyover8%,erasinggainsfortheyear.Thestockmarketcollapsespilledovertoequitymarketselsewheretoo,withAEandEMEindicesfallingby4%–5%ontheday(Chart 9)—thisisconsiderablymorethantheaveragereactiontolargestockmarketmovesinChina,shownbytheredbars.Andonthesameday,theVIX—ameasureoffinancialmarketuncertainty—surgedsomuchthatquotationsweresuspendedintheearlytradingsession.Ifweaddinalargerequityshocktoourmodels—inasimilarveintoChina’s‘BlackMonday’—thiscouldknockafurther0.4percentagepointsoffUKGDP.Hence,thecombinedeffectfrommoreadversefinancialmarketmovescouldnearlydoubletheeffectofaChinahardlandingontheUK(Chart 8).

Mitigation from a more robust UK banking sector Post-crisisregulatoryreformmaymitigatesomeofthenegativeeffectsontheUKeconomy.Simplyput,morerobustbanksintheUKshouldabsorbsomeofthenegativeeffectsbeforetheyreachhouseholdsandfirms.

WeillustratethisinECB-GbyassumingthataddedUKbankresiliencecouldlimittheextenttowhichhigherriskpremiainfinancialmarketsarepassedontointerestratesfacingborrowers.(16)Thiscouldmitigatearound0.5percentagepointsoftheshocktotheUKeconomy.Andtotheextentthatbanksgloballyarealsosignificantlymorerobustthanthepre-crisisperiod,thiswouldalsofurtherdampentheshocktotheUKbyreducingthenegativeeffectscomingfromtheUK’smaintradingpartners.

Risks from Chinese investment in UK real estate Finally,whilemostoftheeffectsfromaChinahardlandingcomeindirectlyviabroadmacrofinancialeffects,thereisonedirectchannelthatposesariskwhichwedonotmodel:investmentfromChinainUKproperty.

EstimatesofChineseinvestmentinUKpropertyaresomewhatuncertain,butitappearsthatinvestmentfromAsiahasrisennotablysince2010andaccountedforover40%ofLondoncommercialrealestatepurchasesin2017,upfromonly6%in2010.(17)AndasflaggedintheFinancial Stability Report,Londoncommercialrealestatevaluationslookstretched.

Overall,itisnotclearwhattheimplicationsofaChinahardlandingwouldbe:investmentscouldbeliquidated,butcapitalflightfromChinatotheUKmayalsoactasasupport,furtherbuoyingmarkets.

China’s integration into the global financial system will raise spillover effects in the future

Asdiscussedearlier,China’sfinancialintegrationhaslaggedwellbehindChina’sintegrationintotheglobaleconomy(Chart 10).OnereasonforthisisthatChina’scapitalaccount—whichreflectscross-borderflowsofinvestment—hasbeenveryrestricted.Forinstance,althoughforeigndirectinvestmentinflowshavebeengraduallyliberalisedsincethelate1970s,tightrestrictionsonportfolioandbankingflowshavepersisteduntilveryrecently.Andalthoughithasbecomemoreopenovertime,restrictionsonChina’scapitalaccountremainhighrelativetootherG20countries.

Impact of liberalisation — an illustrative scenarioOverthepastfewyearstheChineseauthoritieshavegraduallytakenanumberofmeasurestofurtheropenupthecapitalaccount.Althoughprogressslowedin2016inresponsetocapitaloutflowpressures,Chineseauthoritiesmaintaintheircommitmenttofurthercapitalaccountliberalisationinthefuture.

ApreviousQuarterly BulletinexploredthepotentialimpactoffullfinancialliberalisationinChinaontheglobalfinancialsystem,(18)whichwilldependonthespeedandscaleofcapitalaccountopening,andonthefuturesizeandcompositionofChina’sexternalbalancesheet.(19)Underaplausiblescenario

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Chart 9 Equity market and VIX moves around large Chinese stock market events(a)

Sources:Bloomberg,ThomsonReutersDatastreamandBankcalculations.

(a) AlargeChinesestockmarketeventisdefinedasadateonwhichtheShanghaiCompositefellbymorethan5%andwasassociatedwithChinesenews(foralistofdates,seeArslanalpet al(2016)).AEequityindexisanaverageofFTSE100,S&P500andEuroStoxx50.EMEequityindexisMSCI.

(16) Wemodelthisbystoppingrisingprivatesectorriskpremiafrombeingpassedontoborrowers—areasonablystrict,buttractable,modellingassumption.ThiscouldalsobeachievedbytheBankofEnglandusingaTermFundingScheme,whichprovidesfundingtobanksandbuildingsocietiesatratesclosetoBankRate—itisdesignedtoencouragethemtoreflectcutsinBankRateintheinterestratesfacedbyhouseholdsandbusinesses.

(17) Wong(2017),usingavarietyofsources,showsthatmorethan10%ofChineseforeignresidentialrealestateinvestmenttypicallyendsupintheUK—worthabout£7billionin2015.

(18) SeeHooley(2013).(19) ThecompositionofChina’sexternalbalancesheetismuchmoreheavilyweightedto

foreigndirectinvestmentontheliabilitiessideandofficialforeignexchangereservesontheassetsidecomparedtoothermajoreconomies.


inwhichChina’sexternalpositionconvergestowardstheexperienceofadvancedAsianeconomiessuchasSouthKorea,China’sshareofglobalcross-borderassetholdingscoulddoubleby2025.(20)

Evenunderthisrelativelyconservativescenario,thiswouldimplylargeshiftsinportfolioinvestment.Likewise,cross-borderbanklendingto,andborrowingfrom,China,wouldalsoincreasemarkedly.Hence,astheChinesefinancialsystemintegratesfurtherintotheglobalfinancialsystem,theinfluenceandrisksfromChinatotherestoftheworldwillcontinuetorise.IncreasingfinanciallinkagescorrespondinglywithinECB-GsuggeststhatfurtherintegrationofChina’sfinancialsystemcouldincreasespilloversfromahardlandingbyathird.(21)

Conclusion

Thisarticleanswersthreequestions:first,throughwhatchannelscouldashocktotheChineseeconomyaffecttheUKeconomy?Second,howlargearethespillovereffectsfromChinatotheUKlikelytobe?Andthird,howmightaChinahardlandingamplifythespilloverstotheUK?

WeanswerthesequestionsbyupdatingtheBank’sGlobalVARmodel,andapplyingthenewECB-Globalmodel.TheupdatedGlobalVARaccountsforaricherarrayoftradelinksthantheversionusedinapreviousQuarterly Bulletin.Inparticular,theupdatedGlobalVARcapturesimportantindirecttradelinksthroughHongKongandTaiwan.ThenewECB-Globalmodelexplicitlycapturesadditionaltransmissionchannels,includingfinanciallinksandtheeffectsonoilproducers.Consideredtogether,ourupdatedandexpandedmodelsuitenowsuggeststhatspilloversfromChinatotheUnitedKingdomarelikelytobeabout50%largerthanpreviouslyshownintheQuarterly Bulletin.

Wefindthatamodest3%shocktoChineseGDPcouldreducethelevelofUKGDPby0.4%–0.5%.Alargefractionofthisreflectsindirecttradelinks.Alarger,illustrative‘hardlanding’inChinathatreducesthelevelofChineseGDPby10%couldreducethelevelofUKGDPby1.3%–1.4%.Butifamplificationmechanisms—fromexchangerateandassetpricemoves—areallowedtooperate,thehittoUKGDPcouldpotentiallybetwicethesize.

Post-crisisregulatoryreformhassubstantiallyimprovedthecapitalisationofbanks,makingthemmoreresilienttoeconomicstress.Inthatsense,morerobustbanksmayhavecreatedamitigationmechanismtoreducethenegativeeffectsontheUKeconomy.TheBankofEngland’s2017annualcyclicalscenariostresstestsincorporatedaChinahardlandingofamagnitudesimilartothatshownintheillustrativescenariohere,butalsoincludedmoresevererecessionsintheUSandeuroareathanareplausiblefromaChina-centricshockalone.Bankswerejudgedtoberesilienttothislargerglobalshock.(22)

Lookingahead,China’scontinuedintegrationintotheglobaleconomyislikelytohaveimportantimplicationsfortheUKeconomyandtherestoftheworld.TheUK’sindirecttradelinkswithChinawillprobablyremainthemaintransmissionchannelfromChinatotheUK,butChina’scontinuedintegrationintotheglobalfinancialsystemwillmaketheglobaleconomyincreasinglysensitivetodevelopmentsinChinainthefuture.

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Chart 10 China’s international integration, 1980–2017

Sources:IMFInternational Financial Statistics,IMFWEOApril2018,LaneandMilesi-Ferretti(2007)andBankcalculations.

(20)Weestimatethatholdingscouldincreasefrom3%to7%.Theincreaseinthesizeoftheexternalbalancesheetisassumedtobeaccompaniedbyamarkeddiversificationtowardsprivatesectorflows.And,forcomparison,theUSinternationalinvestmentpositioncurrentlyaccountsforaround15%oftheworldtotal,suggestingthatfinancialintegrationwouldcontinuetorisebeyond2025.

(21) AssumingtheshareofChineseassetsininternationalportfoliosweretodouble(withanequaloffsetinholdingsofassetsfromtherestoftheworld),theadditionalimpactontopofthe‘standardchannels’oftheChinahardlandingonUKGDPwouldincreaseby0.3percentagepointsto1.2%.

(22) The2017stresstestshowstheUKbankingsystemisresilienttodeepsimultaneousrecessionsintheUKandglobaleconomies,largefallsinassetpricesandaseparatestressofmisconductcosts.Theeconomicscenariointhetestismoreseverethantheglobalfinancialcrisis.Formoredetailspleasesee:StresstestingtheUKbankingsystem:2017results;www.bankofengland.co.uk/stress-testing.

www.bankofengland.co.uk/stress-testing


AnnexA quick overview of the models

The Global VAR(GVAR)isanempiricalmodelestimatedwithhistoricaldata.Itshouldcapturetheaveragespilloversfromshocksthathavebeenseeninthepast.Themodelallowsshockstopropagateacrosstheworldthroughmanychannels,includingdirectandindirectspilloversthroughtradeaswellassomeassetandcommoditypricelinks.

ApreviousQuarterly BulletinarticledescribedGVARestimatesofthespilloversfromChinatotheUKeconomy.ThatarticlealsoincludesamoredetaileddiscussionoftheadvantagesanddisadvantagesoftheGVARmodellingapproach.Themodelisestimatedintwosteps.First,individualmodelsarebuiltforalargenumberofeconomies.Inthesemodels,anumberofkeydomesticvariables—realGDP,inflation,equityprices,interestratesandtheexchangerate—areallaffectedbyeachother,aswellasbyinternationalvariablesliketheoilprice,worldGDPandworldinflation.Second,individualcountrymodelsarelinkedwithinternationalvariablestocreateaglobalmodelfortheworldeconomy.

The ECB-Global(ECB-G)modelisarichmulti-countrymodelfortheeuroarea,theUS,theUK,Japan,China,oil-producingeconomies,andtherestoftheworld.LiketheGVAR,shocks

canpropagateacrosstheworldthroughdirectandindirecttradechannelsinECB-G.Inaddition,ECB-Gincludesmoredetailedcross-countryfinanciallinksthantheGVAR.

WithinECB-G,coredomesticmacroeconomicvariables,likeinflationandGDP,aredeterminedbywell-knownstructuralrelationshipsthatunderpinaggregatedemandandaggregatesupplyineacheconomy.Tradeflowsarealsoaccountedforusingdataoncountries’bilateraltradeflows.Asaconsequence,areductioninoneregion’sGDP(egChina)canspillovertotheUKthroughboththedirecttradinglinksbetweenChinaandtheUK,andindirecttradinglinksthroughthirdcountries(egtradebetweenChinaandtheeuroareaand,inturn,tradebetweentheeuroareaandUK).

Themodelcoreisenrichedbyequationswhichcapture,amongotherthings,therelationshipsbetweenfinancialriskpremiaandthestateoftheeconomy.Theriskpremiaaremodelledtoreplicaterealisticrelationshipsbetweenassetpricesandthestateoftheeconomy.Forinstance,financialriskpremiaareassumedtoincreasewheneconomicactivitywithinacountryfalls.Reflectinginternationalfinanciallinks,changesinfinancialriskpremiainoneregion(egChina)canspillovertotheUKwithinthemodel.Aswiththetradelinks,financialspilloverscanbedirectorindirectandaredeterminedbyregions’internationalfinancialexposures.


References

Arslanalp, S, Liao, W, Piao, S and Seneviratne, D (2016),‘China’sgrowinginfluenceonAsianfinancialmarkets’,IMF Working Paper WP/16/173,August.

Cesa-Bianchi, A and Stratford, K (2016),‘HowcouldashocktogrowthinChinaaffectgrowthintheUnitedKingdom?’,Bank of England Quarterly Bulletin,2016Q1;www.bankofengland.co.uk/quarterly-bulletin/2016/q1/how-could-a-shock-to-growth-in-china-affect-growth-in-the-united-kingdom.

Chowla, S, Quaglietti, L and Rachel, Ł (2014),‘HowhaveworldshocksaffectedtheUKeconomy?’,Bank of England Quarterly Bulletin,2014Q2;www.bankofengland.co.uk/quarterly-bulletin/2014/q2/how-have-world-shocks-affected-the-uk-economy.

Dieppe, A, Georgiadis, G, Ricci, M, Van Robays, I and Van Roye, B (2018a),‘ECB-Global:IntroducingtheECB’sglobalmacroeconomicmodelforspilloveranalysis’,Economic Modelling,inpress.

Dieppe, A, Gilhooly, R, Han, J, Korhonen, I and Lodge, D (2018b),‘ThetransitionofChinatosustainablegrowth—implicationsfortheglobaleconomyandtheeuroarea’,European Central Bank Occasional PaperNo. 206,January;www.ecb.europa.eu/pub/pdf/scpops/ecb.op206.en.pdf.

Hooley, J (2013),‘BringingdowntheGreatWall?GlobalimplicationsofcapitalaccountliberalisationinChina’,Bank of England Quarterly Bulletin,2013Q4;www.bankofengland.co.uk/quarterly-bulletin/2013/q4/bringing-down-the-great-wall-global-implications-of-capital-account-liberalisation-in-china.

Lane, P and Milesi-Ferretti, G (2007),‘TheexternalwealthofnationsmarkII:revisedandextendedestimatesofforeignassetsandliabilities,1970–2004’,Journal of International Economics, Vol.73,November,pages223–50.

Mwase, N, N’Diaye, P, Oura, H, Ricka, F, Svirydzenka, K and Zhang, Y (2016),‘SpilloversfromChina:financialchannels’,Spillover Notes No. 5,InternationalMonetaryFund.

Wong, A (2017),‘China’scurrentaccount:externalrebalancingorcapitalflight?’,International Finance Discussion Papers No. 1208,BoardofGovernorsoftheFederalReserveSystem,June.

spillovers from china - quarterly bulletin - bank of england

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