Economic policy uncertainty spillovers in small open economies: The case of Hong Kong

• Author: Michael Cheng,Paul Luk,Philip Ng,Ken Wong
• Date: 01 February 2020
• Published date: 01 February 2020
• DOI: http://doi.org/10.1111/1468-0106.12283

ORIGINAL MANUSCRIPT

Economic policy uncertainty spillovers in small open

economies: The case of Hong Kong

Paul Luk

1

| Michael Cheng

2

| Philip Ng

2

| Ken Wong

2

1

Hong Kong Baptist University, Kowloon,

Hong Kong

2

Hong Kong Monetary Authority, Central Hong

Kong, Hong Kong

Correspondence

Paul Luk, Department of Economics, Hong Kong

Baptist University, WLB 530, The Wing Lung

Bank Building for Business Studies, 34 Renfrew

Road, Kowloong Tong, Kowloon, Hong Kong.

Email: paulskluk@hkbu.edu.hk

Abstract

This paper studies the extent to which economic policy

uncertainty shocks in major economies affect real eco-

nomic activity in small open economies. We use Hong

Kong as a case study. Following Baker, Bloom and Davis

(2016), we construct a newspaper-based economic policy

uncertainty index for Hong Kong for the period 1998 to

2016. We estimate international spillovers of uncertainty

and find large spillovers of uncertainty from major econo-

mies to Hong Kong. Furthermore, using a structural vector

autoregressive approach, we show that a rise in domestic

economic policy uncertainty leads to tight financial condi-

tions, and lower investment and vacancy posting, dampen-

ing domestic output growth.

1|INTRODUCTION

Heightened uncertainty is believed to be a key reason contributing to the weakness in global eco-

nomic growth in recent years. In particular, a series of geopolitical and economic shocks, such as the

Euroepan sovereign debt crisis and the Brexit referendum, are perceived to have raised economic pol-

icy uncertainty, with repercussions on private domestic demand in many economies. One natural

question for international macroeconomists and policy-makers around the world is whether and to

what extent economic policy uncertainty shocks originating in one country affect economic policy

uncertainty and, ultimately, the business cycle in another country. In particular, the international

transmission of economic policy uncertainty shocks may have large impacts on small open econo-

mies with free capital mobility, sizable openness and a large financial sector. Having a large external

sector and free capital mobility means that the economy is strongly affected by the external environ-

ment. The size of the financial sector matters, with recent studies finding that uncertainty shocks can

affect financial conditions and, hence, the real economy (Caldara, Fuentes-Albero, Gilchrist, &

Zakrajšek, 2016; Gilchrist, Sim, & Zakrajšek, 2014).

We choose Hong Kong as a case study because its openness to trade and financial flows is among

the highest in the world. For instance, in the year 2011–2015, Hong Kong’s imports and exports

added up to approximately 440% of GDP, and its trading and logistics industries accounted for

Received: 14 August 2017 Revised: 7 July 2018 Accepted: 9 August 2018

DOI: 10.1111/1468-0106.12283

Pac Econ Rev. 2020;25:21–46. wileyonlinelibrary.com/journal/paer © 2018 John Wiley & Sons Australia, Ltd 21

around 20% of total employment. Hong Kong is also an international financial hub. During the same

period, the ratio of average gross foreign assets to GDP was approximately 1400%.

1

With such a high

degree of openness, the impact of uncertainty spillovers estimated using Hong Kong data can be

viewed as the upper bound of the impact of external uncertainty shocks on a small open economy.

Our empirical analysis comprises three steps. First, we compile an economic policy uncertainty

index for Hong Kong for the period 1998M4–2017M4 using the Baker, Bloom, and Davis (2016)

method to count the number of related news articles. This method has several advantages. It captures

a wide range of uncertainty in a timely manner. The measure is of high frequency and can go back

for decades. Our constructed measure can be compared with economic policy indices for other coun-

tries constructed by Baker et al. (2016) as well. The resulting index is intuitive and signals high

uncertainty during major past economic and political events. We compare our economic policy

uncertainty index with another proxy of uncertainty based on realized stock market volatility and find

that our index has stronger predictive power for real GDP growth.

In the second step, we examine to what degree uncertainty shocks in Hong Kong are “imported”

from the rest of the world. The Hong Kong economy is sensitive to economic developments in the

USA, and highly connected to other major economies such as the European Union, Mainland China

and Japan. Following Diebold and Yilmaz (2009, 2014), we adopt a non-structural network-

connectedness approach to study cross-country spillovers of economic policy uncertainty from these

major economies to Hong Kong. To account for the small-open-economy nature of Hong Kong, we

restrict uncertainty spillovers from Hong Kong to the rest of the world to zero. We find that over

40% of Hong Kong’s economic policy uncertainty stems from its major trading partners. This figure

is much larger than what is found in Klößner and Sekkel (2014), who study a network of G7 coun-

tries. Our finding suggests that uncertainty spillovers are more important for financially-integrated

small open economies.

The third step of the analysis investigates the impact of economic policy uncertainty on macro-

financial conditions. We estimate a structural vector autoregressive (SVAR) model using our con-

structed economic policy uncertainty index together with maroeconomic and financial variables of

Hong Kong. We employ a standard Cholesky approach to identify an unanticipated shock to eco-

nomic policy uncertainty. Our impulse response analysis shows that a one-standard-deviation

increase in the uncertainty index results in a 1% fall in real output growth in 2–3 quarters. The shock

works through financial, employment and investment channels.

The rest of the paper is organized as follows. Section 2 discusses the related literature. Section 3

describes the methodology we use to compile the economic policy uncertainty index for Hong Kong,

followed by an assessment of its perfomance in predicting real GDP growth. Section 4 conducts an

inward spillover analysis of uncertainty. Section 5 estimates a vector autoregressive (VAR) model to

assess the macro-financial impact of uncertainty on the Hong Kong economy. Section 6 reports the

results of our robustness checks. Section 7 concludes.

2|RELATED LITERATURE

Our paper is related to the newspaper text search literature. Following the influential paper by Gen-

tzkow and Shapiro (2010), which uses text search methods to study media slant, Baker et al. (2016)

and Alexopoulos and Cohen (2015) use similar methods to extract uncertainty measures from news-

papers. Lam (2017) is the first to apply text search methods to newspapers in Hong Kong, focusing

on political influences on newspaper advertisement behaviour. To the best of our knowledge, we are

the first to construct a newspaper-based measure for economic policy uncertainty in Hong Kong.

22 LUK, CHENG, NG AND WONG