External risk shocks and China's macroeconomic Fluctuations: Which transmission channel matters?

This paper examines how external risk shocks transmit to China's macroeconomy and identifies the dominant transmission channel. We develop a two-country dynamic stochastic general equilibrium model with cross-border risk contagion, estimated via Bayesian methods using China–U.S. data. Simulations show that external risk shocks raise China's domestic market risk, increase corporate risk premia, reduce cross-border capital inflows, and weaken trade, investment, and output. We then estimate a structural vector autoregression model and find consistent evidence that risk contagion, credit, cross-border capital flows, and trade serve as key transmission channels. Variance decomposition indicates that risk contagion is the most important channel, accounting for about 17% of output fluctuations. Counterfactual analysis further shows that weakening this channel substantially reduces the macroeconomic effects of external shocks. These findings suggest that macroprudential tools and financial market reforms that insulate the domestic economy from external risk can effectively safeguard macroeconomic stability.