How China is reshaping market correlations in Asia

Two new studies show Asian equity and currency markets are swaying to the Chinese beat

How big is China's influence on Asian assets? Investors seeking an answer to the question have some new figures to mull over. China's increasing trade and financial heft has ramped up correlations in equity and currency markets in Asia in recent years, challenging diversification strategies for investors as new and increasingly complex feedback loops emerge.

Two recent studies reveal just how Chinese-driven other Asian markets have now become, a reminder of the region's vulnerability if market fears over China's economic footing re-emerge.

On Monday, a report from the Bank for International Settlements (BIS), which its authors say is the first attempt to systematically examine China's impact on Asian financial markets through regression models, concluded that the country's influence on regional equity markets has risen to a level close to that of the U S in non-stress periods. The study, written by Chang Shu, Dong He, Jinyue Dong and Honglin Wang, found that the yuan's exchange rate relative to the dollar also increasingly drives the outlook for regional currencies.

The results echo an IMF report last month, which showed that the co-movements of Asian and Chinese equity and currency markets have jumped since the global financial crisis (with the notable exception of bond markets, given their relatively-closed nature in the world's second-largest economy.) In short, China is the new Japan, the IMF report concludes, referring to the former's regional influence on currency and equity markets.

As capital markets become increasingly globalised, correlations have naturally risen in recent years, exacerbated by risk on/risk off strategies, carry trades, cross-asset arbitrage techniques, and the herding behaviour of foreign investors in emerging markets.

The two studies strike a different note, however, ascribing rising asset-class correlations in the region to changing real-economy dynamics in China. Shifts in the Chinese exchange rate and the stock market have a statistically significant impact on regional counterparts as "China's economic and financial developments affect investors' assessment of the region as a whole and fund flows to the region as a whole," the authors of the BIS report write.

While the conclusion sounds intuitive, the report seeks to put a firm figure on correlation trends across asset classes, using historic market data over a sweeping time frame, from January 2002 to end-September 2013.

The BIS report formally establishes how China is driving regional markets, including Hong Kong, Singapore, Indonesia, South Korea, Malaysia, Philippines, and Thailand, by deploying a popular statistical model known as structural vector autoregression, or VAR.