The Interaction of Real and Financial Markets in the Global Economy: What Role Does China Play?

This chapter examines the role that China plays in the global economy for the propagation of financial uncertainty and volatility. For this purpose, it seeks to measure the interdependence of real and financial markets for a key set of developed markets — the US, the UK, Germany, and Japan — in relation to China. We employ vector auto-regressions (VARs) and make use of generalized impulse responses and variance decompositions to explore the interconnections among these countries. Among other results, we find that the US, Japan, UK, and Germany are highly integrated and form a cluster in terms of financial market volatility and industrial production growth. Surprisingly, we find that financial market volatility in developed countries is strongly affected by volatility shocks emanating from the Hong Kong Stock Exchange, attesting to the growing importance of Asian financial markets and real activity in the global economy. By contrast, China has a different story. Chinese financial and production markets are decoupled, and Chinese industrial production growth is mainly determined by its own shocks to domestic conditions.