Spillovers of the US subprime financial turmoil to mainland China and Hong Kong SAR: Evidence from stock markets

Xiaojing Zhang, Tao Sun, 12 September 2009



The financial turmoil that originated in the US subprime market quickly went global. The linkages between emerging market economies and advanced economies have thus become a major topic of debate. Some argue that emerging economies have thus far been relatively unscathed by the mature markets’ turbulence, in part because they were not as heavily involved in structured financial products. Others claim that increasing global financial integration has potentially raised emerging markets’ vulnerability to abrupt reversals in market confidence related to those subprime external shocks and spillover effects (Walti 2009 and Eichengreen 2008). US events can have sharp impacts on EM economies.

But has the such financial turmoil actually affect daily movements of the stock prices in mainland China and Hong Kong SAR. China and Hong Kong experienced a long run-up in asset prices, including equities, despite the partial reversal since late 2008; their resilience will to be tested if financial uncertainty remains protracted and the global economy slows.

The impact on China and Hong Kong

China and Hong Kong’s financial systems have coped relatively well with shocks due to their minimal exposure to securitised products, but they are not immune. Stock market declines (71% and 56% for China and Hong Kong, respectively, October 2007 to October 2008) were linked declines in major economies’ stocks.
But exactly how could the Wall-Street hurricane have been transmitted? Possible spillover channels from the US to China and Hong Kong include:

  • Loss exposures. Financial institutions in China and Hong Kong had some direct exposures; the Chinese financial system reportedly held about $10 billion of US structured credit products. The direct exposure to subprime-related assets accounted for 3.7% of total banking assets (CBRC, 2008). Lehman’s collapse also impacted China and Hong Kong’s financial institutions via loans, credit derivatives, and bond exposures. Reportedly, 7 Chinese listed banks announced total bond holdings of $721 million in the bankrupt US investment bank Lehman Brothers as of 22 September 2008. Hong Kong banks’ total exposure to US subprime securities and structured assets remained well below 0.5% of banking system assets (IMF, 2008a).
  • Loss of confidence. For example, as the subprime crisis became in August 2007, China and Hong Kong’s stock markets were still moving up. However, with the increasing number of news releases about the losses at China’s financial institutions and the pessimistic projections for the US economy, market sentiment shifted and both stock markets dropped reflecting the echo of Lehman’s bankruptcy , Merrill’s sale and AIG’s rescue .
  • Uncertain direction of capital flows. The advanced economies’ credit crunch certainly drew foreign capital out of China and Hong Kong to meet investors’ liquidity needs. However, some foreign investors saw China and Hong Kong as attractive, resilient markets. For example, in the first two quarters of 2008, China experienced a hot money inflow of about $130 billion, even larger than that for the whole of 2007 ($124.9 billion), while in the third and fourth quarter it experienced a hot money outflow of about $7.2 billion and $90 billion. The US Resident’s Net Foreign Transactions in Foreign Corporate Stocks, a proxy of capital flows to China and Hong Kong, has also showed more volatility in capital flows to Hong Kong since the beginning of the subprime crisis. These capital flows clearly could increase stock price volatility in China and Hong Kong.
  • Slower export growth. Slowing export demand could hit hurting stock markets via a dampening of sentiments.

Moreover, three characteristics of China and Hong Kong’s stock markets are worth noting:

  • The development of China’s stock market has been greatly supported by the tremendous structural changes in the past 4 years. Before 2005, the two-tier share structure, under which about two-thirds of the shares of China’s listed companies were nontradable, had a negative effect on the development of the stock market. The uncertainties related to this split structure prevented the market from recovering from the previous decline and affected the overall credibility of Chinese stock market. To cope with this problem, the Chinese authorities initiated the so-called “reform of nontradable shares” in the capital market in 2005. With the gradual floating of nontradable shares in the stock market, the real market value of the shares began to be realised and contributed to the rising stock prices since 2005. The institutional reform has been a key factor in China’s stock market development.
  • China and Hong Kong’s financial markets are not homogeneous in their openness. China is still in the process of opening up its capital account and there are various sorts of restrictions on inward and outward capital flows, while Hong Kong is open to all foreign investors and issuers and does not impose any restrictions on its residents investing or obtaining funding in foreign financial markets. Hong Kong’s financial sector is open to Chinese issuers and institutions, while institutions in Hong Kong have limited access to China.
  • Policy choices and financial market development in China have important implications for Hong Kong to maintain its status as an international financial centre with the increasing financial integration between the two sides. On the one hand, Hong Kong has been playing an important role in the opening up of China’s capital account and the development of China’s financial markets. On the other hand, China’s rapid economic growth and financial market development provided tremendous scope for Hong Kong to fortify its competitiveness as a leading international and regional financial centre. This bilateral promotion has laid a foundation for the increasing comovements of stock prices on both sides.

Empirical evidence

In Sun and Zhang (2009), we present new evidence on these channels of transmission, examining the impact of US subprime financial turmoil on the daily returns and conditional volatility of stock prices in China and Hong Kong. To capture the possible spillover effects, we employ a two-stage procedure. In the first stage we estimate a group of univariate GARCH models, and in the second stage we set up a group of multivariate GARCH models to further identify the sources and magnitudes of the spillovers.
Using both univariate and multivariate GARCH models, we find that

  1. China’s stock market has not been immune to the financial crisis and there is no decoupling story, as clearly evidenced by the price and volatility spillovers from the US to China.
  2. Hong Kong’s equity returns exhibit more significant price and volatility spillovers from the US, and past volatility shocks in the US have a more persistent effect on future volatility in Hong Kong than in China, indicating that Hong Kong has been more affected due to its role as an international financial centre.
  3. The lower cross-volatility between Hong Kong and China than between the US and China shows that the impact of the US on China is greater than that of Hong Kong in the context of volatility persistence, due mainly to the US as the origin of the subprime crisis
  4. As expected, the conditional correlation between China and Hong Kong outweighs their correlations with the US, echoing increasing financial integration between China and Hong Kong.

Policy implications

This empirical evidence implies important policy implications:

  • There is no “decoupling” story for China and Hong Kong. Even though the Chinese and Hong Kong economies may be diversifying their exports and becoming less dependent on the US, their financial markets are still very much influenced by US monetary and financial conditions. China and Hong Kong have become increasingly integrated into the global financial system, and the authorities should be alert to the drift toward negative spillover effects.
  • Greater attention should be paid to the risk of a virulent feedback loop between the financial markets and the economy. Beyond the financial impacts of subprime crisis on China and Hong Kong, great attention should also be paid to the spillover effects on the real economy. The deteriorating subprime crisis has increased the downside risks to the US and global economies, potentially taking their toll on the growth of China and Hong Kong.
  • International policy coordination has become more important. The tendency for the markets to transmit volatility rapidly leaves policymakers little time to intervene. Recent unprecedented circumstances have called for commensurate action to be taken by central banks, given the rising interdependence among economies. The fact that recent policy actions have been taken by both advanced and emerging market central banks (including China) underlines the need for coordination. Moreover, as evidenced by the increasing volatility spillover between China and Hong Kong’s stock markets, the interdependence has been increasing with the strengthening financial integration between the two markets, necessitating further cooperation between the mainland and Hong Kong authorities.
  • The Chinese authorities should be more cautious in their approach to capital account liberalisation. Given increasing trade openness and financial spillovers from the international market, the capital account is de facto becoming more open over time irrespective of government attempts to control it (Prasad and Rajan, 2008). In this natural opening-up process, it becomes more urgent for the authorities to strengthen financial markets and relevant infrastructure (governance, the exchange rate system, the supervisory system, etc.) alongside the de facto capital account liberalisation. It is argued that, in the Asian financial crisis, China suffered less than other Asian countries just because of its lower level of financial openness. And even now, some consider that China’s limited vulnerability to the subprime crisis is due mainly to its lower level of financial openness. However, in the era of financial globalisation, this limited financial openness, which has insulated China well in the past, may be much harder to maintain in the future. The key issue will be how to choose a pragmatic approach to capital account liberalisation.

Note: The views expressed herein are those of the authors and should not be attributed to the IMF or the Chinese Academy of Social Sciences (CASS).


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Topics: Global economy
Tags: foreign acquisitions, global crisis, national security, security threats

Economist in the Monetary and Capital Market Department at the International Monetary Fund

Professor in the Institute of Economics, Chinese Academy of Social Sciences