Can “Concerted” Macroprudential Policies Mitigate Cross‐border Contagion of Financial Risks? Evidence from China and Its Financially Connected Economies

• Published date: 01 May 2021
• Author: Xiaoyu Liu,Xiaoli Chen
• Date: 01 May 2021
• DOI: http://doi.org/10.1111/cwe.12375

©2021 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 26–54, Vol. 29, No. 3, 2021

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*Xiaoyu Liu, PhD Candidate, College of Economics, Shandong University, China. Email: liuxiaoyuzb@126.com;

Xiaoli Chen (corresponding author), Professor, College of Economics, Shandong University, China. Email:

xiaolichen@sdu.edu.cn. The authors are grateful for support from the Humanities and Social Science

Fund Project of Ministry of Education of China (No. 20YJA790003), the Natural Science Foundation of

Shandong Province (No. ZR2020MG039), and the Future Plan for Young Scholars of Shandong University

(No. 2016WLJH05). The authors are grateful for the anonymous reviewers’ helpful suggestions.

Can “Concerted” Macroprudential Policies Mitigate

Cross-border Contagion of Financial Risks? Evidence

from China and Its Financially

Connected Economies

Xiaoyu Liu, Xiaoli Chen*

Abstract

We construct a connected network between China and the economies that are fi nancially

linked to it, based on the network topology of variance decompositions, and measure the

cross-border contagion of fi nancial risks among these economies. We then examine whether

the concerted use of macroprudential policies mitigates the cross-border contagion of

fi nancial risks. The empirical results show that the tightening of macroprudential policies,

especially counter-cyclical capital buffers and limits on credit growth, in economies with

net spillover risk (e.g. the US and China), can reduce the cross-border spillover of domestic

financial risks to other economies. The concerted use of macroprudential policies can

contribute to global fi nancial stability. However, the tightening of “capital” macroprudential

policy tools will increase domestic cross-border absorption of financial risks. Hence,

macroprudential regulation of cross-border capital fl ows must be strengthened.

Key words: concerted action, cross-border contagion, fi nancial risk, macroprudential policy

JEL codes: F42, G15, G28

I. Introduction

Financial globalization has led to the emergence of extensive financial links among

countries; however, this interconnectedness has also increased the possibility of cross-

border risk contagion. The 2007–2008 global fi nancial crisis (GFC) has demonstrated

that fi nancial stability is paramount for economic growth. It is therefore critical to reduce

©2021 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Macroprudential Policies and Cross-border Contagion of Financial Risks 27

cross-border risk contagion to maintain economic stability in the context of financial

openness. After the GFC, central banks or regulatory authorities of most countries have

focused on implementing macroprudential policies, primarily to reduce pro-cyclical

financial behaviors and systemic financial risks. Meanwhile, the Financial Stability

Board of the International Monetary Fund (IMF), and other global organizations have

discussed strategies for the international coordination of macroprudential policies.

Notwithstanding such calls from international organizations, there is no empirical

evidence that “concerted” macroprudential policies can mitigate cross-border risk

contagion and maintain global fi nancial stability. Thus, this study attempts to answer the

following questions from the Chinese perspective: first, can macroprudential policies

prevent the cross-border contagion of fi nancial risks? Specifi cally, what is the impact

of macroprudential policies on the cross-border spillover of domestic financial risks?

Second, can the concerted use of macroprudential policies among countries mitigate

cross-border contagion of fi nancial risks? Third, is it necessary for China to promote

international coordination of macroprudential policies?

Based on the network topology of variance decompositions, we first construct a

“directed and weighted” financial network between China1 and the economies with

which it is closely linked financially, and measure the cross-border financial risk

contagion among these economies using a rolling window method. Second, based on

the measurement results and the integrated Macroprudential Policy (iMaPP) database,

we empirically test the impact of macroprudential policies on cross-border financial

risk contagion. Finally, we investigate the impact of concerted macroprudential policies

involving China and other economies on cross-border fi nancial risk contagion.

This study contributes to the literature by demonstrating that tight macroprudential

policy measures reduce the risk spillover to other economies, and that “concerted”

macroprudential policies can contribute to global financial stability. This study also

considers some implications for regulating the macroprudential policy framework

and for decision making for China’s participation in the international coordination of

macroprudential policies.

The paper is structured as follows. The literature review is presented in Section II.

In Section III, the study measures the cross-border contagion of fi nancial risks. Section

IV examines how this contagion evolves when macroprudential policies are employed.

The important role of concerted macroprudential policies between China and other

countries in reducing the cross-border contagion of Chinese fi nancial risks is discussed

in Section V. The conclusion is presented in Section VI.

1In this paper, “China” refers to “Chinese mainland” unless specifi ed.