中文
 
HOME           RESEARCH           EVENTS           EXPERTS           PUBLICATIONS           ABOUT US          
 
 
 
 
· Fiscal Policy Should Provide Legitimate Channels for Local Gov. Financing
· Capital Market Reform in a Modern Financial System
· Strengthening Market Mechanisms to Build China's Modern Financial System
 
 ACDEMIC EXCHANGES
 
· Research: macroeconomics, international finance and world economy
· Research: Political Economy, Monetary Policy, Financial Reform, Foreign Exchang
· Research: Macroeconomics, Capital Market
 
 EVENTS
 
Nov
   
20
CF40 - Sun Yefang Book Club on Forty Years of Reform and Opening-up
 
 
 
Nov
   
17
2018 Beijing Global Fintech Summit Focuses on Innovation and Regulation
 
 
 
Oct
   
26
Exiting Unconventional Monetary Polices
 
 
 
 
Location > RESEARCH
 
 
 
What is the financial market impact of the China-US trade war?

        2018-10-30

What is the financial market impact of the China-US trade war?

Gao Shanwen

CF40 Academic Committee member; Chief Economist, Essence Securities

The biggest difficulty in carrying out quantitative analysis of the impact that China-US trade war has on the financial markets is that we cannot know what the financial markets would have been if there had been no trade war. We cannot make a counterfactual test, so we are not able to have a clear and precise understanding on the impact of the trade war. As a practitioner in the financial sector, I would say a number of events that occurred this year have left a great impact on financial markets, especially the one in China. The US-China trade war is undoubtedly one of them. More events have built up persistent pressure on the financial markets in addition to the trade war, such as the on-going deleveraging in the financial sector, the escalating bond defaults, implementation of new macroeconomic policies at the beginning of the year and the mid-year adjustments, slowdowns in economic activities in the emerging markets, and the Fed’s interest rate hikes. It’s difficult to remove the above-mentioned factors completely and accurately. Therefore, from the perspective of empirical research, namely quantitative estimation and analysis, it is particularly difficult to measure the impact of the trade war.

In this paper, I present the results in three aspects: First, based on market performances, other researchers and I have speculated about the trade war’s impact on the financial markets. No in-depth analysis was applied at this point. Second, we have produced a result based on quantitative analysis and through cautious estimations. We believe this result captures the main impact of the trade war. Third, we give an interpretation of the trade war’s impact.

 

Evaluate Impact of China-US Trade War from Capital Markets Performances

First, we studied the Shanghai Composite Index. According to our observation, in the early days of the trade war, that is, from March to the end of May this year, China’s financial market regarded the trade war as nothing more than a war of words. People didn’t believe that it would actually break out, so no one was prepared for this. At that time, people considered the mutual threats between the two countries as preparations for future comprehensive agreement that they thought would be very likely to reach. Therefore, the market was not hit badly then. Later, China and the United States issued a joint statement and reached a consensus on not engaging in any trade wars. Since the market did not pay much attention to this matter, the consequent rise was not strong. However, in mid-June, China and the United States formally claimed that they would impose tariffs in the following period. This prompted the market to quickly adjust its expectations and it immediately realized that the previous thoughts were too "Utopian". China-US trade war was actually a serious threat. Against this background, the market suffered several painful tumbles, especially at the time when the tariffs were implemented. Therefore, we come to a rough speculation that the China-US trade war is an important factor driving the market decline, but this does not rule out the possibility of other factors.

 

Then we turned to the US market. The US market has an advantage that the majority of investors there are US investors who are not directly affected by China’s deleveraging policy. That is to say, credit defaults in China won’t affect their cash flows. Thus to some extent, the changes in China's financial system have a much weaker impact on the structure and adjustment of US investors’ portfolios.

Fig. 1 Stock market trends since early 2018 and main events of China-US trade war

Sources: Wind; Essence Securities.

 

In terms of the US market, we have observed China Concepts Stock index and the Nasdaq Composite Index. The China Concepts Stock index refers to an index comprised of major Chinese companies listed on the New York Stock Exchange and Nasdaq. We back traced over three months of data before 1 November 2017, when the China-US trade war had not broken out. During this period, the Nasdaq Index, Dow Jones Index and S&P Index combined, and the Nasdaq Index itself were found to have similar explanatory power on the China Concepts Stock Index. For most of the time, the trend of China Concepts Stock Index has resembled that of Nasdaq, which could be used as an important reference of counterfactual testing.

 

It can be seen that China and US markets shared similar views on the trade war. From March to May when China and the United States were at a stage of threatening each other with tariffs, the China Concepts Stock Index remained unchanged and showed strong synchronization with US mainstream indices. This was because behind the China Concepts Stock index, there were US investors. However, when the China-US bilateral tariffs were officially implemented, the two indices showed a huge differentiation and reverse movements: while the Nasdaq Index kept hitting a record high, the China Concepts Stock Index suffered a sharp decline. A possible explanation might be as China and the United States started to impose bilateral tariffs, investors immediately adjusted their expectations when they recognized the serious problems between the US and China. We attributed the trade war as a key factor, but not the sole reason for the relative gap between the two indices. In addition, the relative gap between the two indices has increased dramatically: starting from November 1, 2017, it had remained 0 till mid-June, and now reaching 30%.

 

Fig. 2 China Concepts Stock Index and Nasdaq Index movements

Sources: Wind; Essence Securities.

 

Note: The Halter USX China Index is composed by Halter Financial Group, and constituent companies include Chinese firms listed on the New York Stock Exchange and Nasdaq.

 

In the last step, we observed the Hong Kong Stock Exchange Hang Seng China Enterprises Index (HSCEI). Similar to the China Concepts Stock Index, the HSCEI is also an index comprised of Chinese companies listed overseas, with international investors being dominant in number. So the HSCEI is more heavily affected by international financial environment changes such as US dollar interest rate hike and exchange rate movements than China’s deleveraging and the contraction of domestic financial condition. That is to say, to some extent, the HSCEI can rid itself from impacts of China’s changing financial system. Moreover, HSCEI is a better research object than the China Concepts Stock Index in terms of the number of listed companies.

We applied the same analysis method in studying the HSCEI and came to the following conclusions. Generally speaking, before the Sino-US trade war broke out, the HSCEI was more affected by the MSCI Emerging Markets Index than the S&P. International investment managers commonly place H shares as part of the emerging market portfolio and would only make general adjustments. Therefore, though the HSCEI is also affected by the S&P index, it is basically in line with the movement of the MSCI Emerging Markets index. During the period from November 1 2017 to June this year, the HSCEI was very close to the MSCI Emerging Markets index, but generally stronger than the latter. After the breakout of the China-US trade war, the HSCEI significantly went weaker than the MSCI Emerging Markets Index. One possible explanation is that the trade war has resulted in the gap between the two indices. Our second conclusion is that Chinese and international investors in the Hong Kong market showed similar reactions towards the trade war. At the time when China and the United States threatened each other with tariffs, people did not care much, nor did they believe that the trade war would truly happen. However, the market witnessed dramatic adjustments as soon as the two countries officially released their tariff policy papers. 

 

Fig. 3 HSCEI, S&P 500 Index and MSCI Emerging Markets Index

Sources: Wind; Essence Securities.

 

Quantitative analysis of the impact of the trade war on capital markets

 

First, we conducted a rough test to see the impact of the China-US trade war on some Made in China 2025 related products. We grouped all the industries related to Made in China 2025 into a constituent value, and then used the CSI 500 Index to explain this constituent value. The CSI 500 Index was found to have an extremely strong explanatory power about the constituent value, that is, despite the daily market fluctuations, the goodness of fit between the two exceeded 90%, reflecting strong synchronization of the markets. However, when we took out the time between the two rounds of slapping tariffs at each other, that’s when the market showed obvious worry and made adjustments, and then applied dummy variables, we got a very clear result: these dummy variables were very insignificant, and the sign of the coefficient seemed to be problematic. In other words, investors are not worried that Made in China 2025 would be suppressed, nor that the upgrading of China's manufacturing industry or the rise of advanced manufacturing curbed. Judging from market price changes, this assumption lacks solid support.

 

Second, we applied quantitative estimation to see the impact of the trade war on the markets. First, when the S&P 500 Index and the MSCI Emerging Markets Index were used to explain the daily fluctuations of the HSCEI, they were found to have a strong explanatory power about the latter, especially the MSCI Emerging Markets Index. Because of the difference between the US economy and global emerging economies, S&P usually has a reverse impact on the HSCEI. In the next, we took out the 13 trading days (about 3 weeks) in which the market fluctuated dramatically, and applied dummy variables that had the equidistant pattern taken into consideration. In statistics, we got an explicit result: the trade war has heavily impacted the markets. Compared with the counterfactual situation with no trade wars, the HSCEI’s decline was an average of 0.6% more per day during the 13 trading days.

 

Finally, we constructed a same model to study China Concepts Stock Index and found very similar results that HSCEI showed. Compared with a counter-factual situation with no trade wars, during the 13 trading days, the China Concepts Stock Index falls 0.8% more on average every day, with a cumulative decline slightly higher than 10%. In addition, we also found that the gap between the China Concepts Stock index and the Nasdaq index expanded by 30% during this period. We would not attribute the above declines completely to the trade war, but still we are confident to conclude that at least 10% of the decline is resulted from it.

 

Fig. 4 Regression result of the influence of the trade war


Note: Set Dummy 1 at 1 during the first (6/15-6/27) and second rounds (7/31-8/6) of the trade war and 0 at other times;

Set Dummy 2 at 1 during the second round of the trade war and 0 at other times;

2025 index refers to a capitalization-weighted index of electric equipment, mechanical equipment, and electronic equipment stocks;

All variables other than dummy variables are daily percentage changes.

 

Four conclusions

 

First, the Made in China 2025 initiative and the tariff measures that targeted at it didn’t arouse much reaction of the markets. The markets didn’t regard the initiative as the main target, nor did they believe such tariff measures would help achieve the purpose.

 

Second, capital markets made violent reactions when the China-US trade war broke out. Even based on relatively conservative estimates, we could see strong market sentiment. Let’s look at the most extreme case, assuming that during the period between the two rounds of tariff hikes, the US$50 billion extra tariffs imposed by the US were all manifested as the loss of profit of Chinese companies listed at home and abroad. These companies were not able to pass the losses on to the government, consumers and employees, nor did they mitigate the impact by adjusting export structures, such as increasing exports to Europe and emerging economies. We calculated profit loss of Chinese listed companies under this most extreme condition, and set it as the denominator. Then we calculated the loss of market value of Chinese listed companies using dummy variables, and set it as a numerator. In this way, we got the price-earnings ratio which was close to 80 times; however, if all the losses were undertaken by A-shares companies listed at home, which meant excluding those included in the China Concepts Stock index and HSCEI, the price-earnings ratio would be 40 to 50 times.

 

The data have enabled us to understand market sentiment very well. If the markets believe that the losses caused by the trade war is one-off, that is, the trade war will end in a short time, then the price-earnings ratio would not be as high as 10 times. If the markets believe that the losses are permanent, that is, the tariffs on the US$50 billion products will not cancel for a long time in the future, then the price-earnings ratio would generally be between 10 and 20 times, and would not exceed 20 times. According to our calculation, the ratio is between 50 and 80 times. The actual price-earnings ratio may be as high as 100 times or more. The extremely high actual price-earnings ratio indicates two points: First, the market believes that the deterioration of Sino-US economic and trade relations will last long; second, the market believes the damage on China caused by the trade war will further expand, and tariffs will increase on products of from US$50 billion to US$100 billion to US$200 billion. The markets believe that the confrontation will increase dramatically in the foreseeable future. Only under this assumption can we understand why a price-earnings ratio of over 100 times is needed to absorb losses. Perhaps the market has overly panicked, but this is the common reaction of Chinese and foreign investors in the markets of Chinese Concepts Stock and the HSCEI. Domestic investors might be labeled as being too emotional, but the US stock market and the Hong Kong stock market are dominated by institutional investors. Overall, the market has changed from not believing the trade war would happen from March to May, to believing the China-US confrontation will get increasingly serious. 

 

Third, the exchange rate is also a very important channel for a trade war to impact on financial markets. First, we look at the RMB exchange rate index measured by CFETS. The advantage is that CFETS is a package of indices that, at least to some extent, it has removed the influences of the US dollar index and the emerging market index. From August and September 2017 to mid-June this year, CFETS had appreciated sharply, with a cumulative appreciation of more than 5%. We need to explain the appreciation seriously, otherwise we cannot understand the impact of the trade war on the exchange rate market.

 

To explain the sharp appreciation of CFETS, we first need to observe the yield of non-securities investment trusts (non-standard assets yield). This is because non-standard assets yield is the most market-oriented one and has the closest connection with the real economy compared to loans on banks’ balance sheets. Moreover, the market of non-standard assets has a very large scale and flexible interest rate. Since the second half of last year, the non-standard assets have gradually fallen into a state of collapse. From October 2017 to the present, the non-standard assets yield has risen largely. In the same period, other parts of the financial market have maintained a generally stable interest rate; floor trading has seen declined interest rate affected by non-standard assets adjustments. However, in areas that have a closer connection with the real economy, such as the credit market, interest rates have remained stable or witnessed slight rises. Speaking of timing, CFETS also began to appreciate sharply from October last year, close to the time when non-standard assets yield rose.

 

Fig. 5 R007 and trust yield

 

 

Fig 6 RMB exchange rate index and China government bond CDS

 

 

As market participants, we believe the new regulations on asset management have led to the collapse of non-standard asset market. As a result, companies’ cash flows become tight, and under such pressure, overseas funds are transferred back home or companies start to finance in the overseas market. Consequently, even under the background of US dollar interest rate hike and currency strengthening, a large amount of funds flowed back to China, leading to dramatic CFETS appreciation. The correlation between this interpretation and the current situation is that as of the end of July, the non-standard assets market had remained under severe pressure, and might even worsen. On the contrary, in the bond market, the key reason for the decline in interest rates is the pressure on non-standard assets market. The non-standard assets market has been suffering rising pressure, and a large amount funds for non-standard investments have returned to business on the banks’ balance sheets, resulting in a decline in the bond market yield.

 

When looking at the non-standard assets market, we would not expect the CFETS to depreciate under the conditions that the pressure on the financial market did not ease significantly before the end of July and might deteriorate further. However, the reality is that the Chinese and American financial markets take the trade war seriously. While the China Concepts Stock, HSCEI and A shares tumbled sharply, CFETS also experienced a sharp depreciation in mid-June which lasted for more than a month. However, it’s difficult to explain the liquidity pressure in the financial market. To put it another way, I personally think that the magnitude and timing of the sharp adjustment of the CFETS market are close to that of the stock market, which occurred after the US and China started to slap tariffs on each other, indicating that the trade war also forced the participants in the exchange rate market to re-evaluate the prospects of China-US relations and China's foreign trade. The quick adjustment in a short term has also led to changes in investor behavior, as evidenced by the sharp fall in exchange rates in the CFETS market.

 

Fourth, sticking to exchange rate reform, making the RMB exchange rate formation mechanism more flexible, and more generally driving market-oriented economic development will be of great significance to risk management. In the early days of the outbreak of the trade war, the exchange rate and the stock market began to fall, and China’s overseas sovereign debt CDS (credit default swap) rose sharply. But with the dramatic decline of the external market and relative adjustments, the CDS rate became stabilized rapidly. For example, the five-year China government bond CDS rate is generally at the bottom level of recent years. In this regard, we believe that in the early stage of the trade war, the market drastically adjusted stock and foreign exchange pricing, but also had worries that China would confront more serious financial risks and turmoil. However, as both the exchange rate and the stock markets have relatively flexible and effective adjustments, the market's fear of uncontrollable collapse of the financial system and the risk of serious financial stability damage began to decline rapidly, and basically disappeared in late July. This can be evidenced by the fact that the CDS rate quickly returned to normal. It indicated that a flexible exchange rate formation mechanism and stock price changes greatly released pressure in this process, so that the financial system's general risk assessment quickly returned to normal. If in this process, we promise to intervene in exchange rate levels and the stock market, these CDS rates will continue to climb rapidly. In the end, due to market concerns that the financial system may disintegrate at any time, the rate level will be difficult to control.

 
 
copyright2008-2009 All rights reserved CHINA FINANCE 40 FORUM