Impact of US monetary policy rate shock and other external shocks on the Hong Kong economy: A factor‐augmented vector autoregression approach

• Author: Andrew Tsang,Hongyi Chen
• DOI: http://doi.org/10.1111/1468-0106.12262
• Date: 01 February 2020
• Published date: 01 February 2020

ORIGINAL MANUSCRIPT

Impact of US monetary policy rate shock and other

external shocks on the Hong Kong economy: A

factor-augmented vector autoregression approach

Hongyi Chen | Andrew Tsang

Hong Kong Institute for Monetary Research,

Hong Kong Monetary Authority, Central,

Hong Kong

Correspondence

Andrew Tsang, 55/F, Two International Finance

Centre, 8 Finance Street, Hong Kong Institute for

Monetary Research, Hong Kong Monetary

Authority, Central, Hong Kong.

Email: andrewtsang@alumni.cuhk.net

This paper uses the factor-augmented vector autoregres-

sion framework to study the impact on the Hong Kong

economy of the diverging monetary policies by the Fed,

the European Central Bank (ECB) and the Bank of Japan

as well as the slowdown of the Mainland economy. The

empirical results show that shocks in US monetary policy

rate mainly affect interest rate-sensitive sectors in Hong

Kong and that monetary easing from the European Cen-

tral Bank and the Bank of Japan somewhat offsets the

impact of tightening of the Fed. The transmission of

external shocks is through trade and capital markets. Real

variables such as real GDP growth and the unemploy-

ment rate are more sensitive to the economic slowdown

in Mainland China. It is estimated that the combined

effect of the four external shocks will on average lower

Hong Kong’s quarterly GDP growth by 0.6 percentage

points and quarterly inflation by 0.2 percentage points in

the first four quarters. However, Hong Kong’s financial

stability, particularly with regard to loan quality, banks’

capital and liquidity, is well maintained by macropruden-

tial policies, suggesting that Hong Kong’s financial sys-

tem is resilient to external shocks.

1|INTRODUCTION

Hong Kong as a small open economy is very sensitive to external shocks. With the linked exchange

rate system and free capital mobility, Hong Kong essentially adopts the Fed’s monetary policy.

Shocks in the Fed’s monetary policy rate will affect different sectors of the Hong Kong economy.

As an international financial centre with open capital markets, shocks in monetary policy rate of

other major central banks also impact Hong Kong. With the divergence of monetary policies among

Received: 30 May 2016 Revised: 24 August 2017 Accepted: 15 February 2018

DOI: 10.1111/1468-0106.12262

Pac Econ Rev. 2020;25:3–20. wileyonlinelibrary.com/journal/paer © 2018 John Wiley & Sons Australia, Ltd 3

the Fed, the European Central Bank (ECB) and the Bank of Japan (BoJ), the Hong Kong economy

is subjected to the impact of both the tightening of the Fed and the easing of the ECB and the BoJ.

In contrast, Hong Kong’s real sector is closely connected to Mainland China and the growth slow-

down of Mainland China will have a significant impact on Hong Kong.

The present paper studies how external shocks are transmitted to the different sectors of the

Hong Kong economy, focusing on the following questions. First, how are shocks in the Fed’s mone-

tary policy rate transmitted to different sectors of the Hong Kong economy, especially the financial

sector and the real estate sector? With several rounds of large-scale quantitative easing (QE) by the

Fed, how is Hong Kong’s financial stability affected? Second, how are diverging monetary policies

among major global central banks transmitted to the Hong Kong economy, particularly in relation to

the Hong Kong dollar exchange rate and financial stability? Third, how will the growth slowdown

of Mainland China affect the Hong Kong economy and how will it add to the combined effects of

diverging monetary policies?

The vector autoregression (VAR) approach is a standard method to study the dynamic impact of

monetary policy rate shocks on macroeconomic variables. However, because of the degree of free-

dom problem, only a small number of macroeconomic variables can be included in a VAR. There-

fore standard VAR can only evaluate the impact of monetary policy rate shocks on the included

variables. To analyze the large number of data series available, Bernanke, Boivin, and Eliasz (2005)

suggested a factor-augmented VAR (FAVAR) approach that can incorporate a large amount of

information in a comprehensive analysis.

As demonstrated in Bernanke et al. (2005), a key benefit of using a FAVAR model is the inclu-

sion of more information for analysing the dynamics of endogenous variables. This includes resolv-

ing of the degree of freedom problem as well as using as many variables as possible. In the original

paper, this method is used to analyse the effect of monetary policy innovations on the US economy.

The inclusion of additional variables serves two purposes: more accurate estimation of the monetary

policy reaction function, which is the systematic part of the VAR; and a more comprehensive pic-

ture of the impact of monetary policy innovation.

In our study, we use the FAVAR mainly to achieve the second purpose: more comprehensive

analysis of the transmission of external shocks to the Hong Kong economy, especially to different

sectors of the Hong Kong economy. The FAVAR approach involves extracting a few factors from a

large number of data series and estimating a VAR system using the extracted factors together with

shock variables. This way, the FAVAR incorporates a large data set without having to choose which

data series should be included in a VAR system, and the dynamic responses of all the data series

can be determined. The factors extracted could be used to represent abstract concepts, such real

activity and financial stability. Therefore, it is an ideal framework for a comprehensive analysis of

the impact of monetary policy rate shocks on different sectors of an economy. The reason for not

achieving the first purpose of the Bernanke paper is that these shocks can be considesolid line exog-

enous. Our purpose is reasonably achieved by including 116 variables. In the later part of our paper,

we show that the impact of external shocks can be analysed individually or in aggregate.

Given that Hong Kong is a small open economy with the Hong Kong dollar pegged to the US

dollar under a currency board system, the monetary policy rate shocks of the Fed could be conside-

solid line exogenous. The same is true for the monetary policy rate shocks of the ECB and the BoJ

and the economic slowdown in Mainland China. This provides a very good justification for using

the Cholesky decomposition as the identification scheme.

The main findings of this paper are as follows. The impact of the US monetary policy rate shock

on the Hong Kong economy is mainly on interest rate-sensitive sectors (e.g. affecting property

4CHEN AND TSANG