Identifying crucial financial markets in the flows of cross-border capital – evidence from China's financial risk network

With the increasing openness of China's financial markets, it is important to address cross-border capital risks. This paper first calculates the stress indicators of financial markets by 24 variables, and then utilizes the Diebold-Yilmaz connectedness approach to examine the spillover effects among the volatility of cross-border capital and the stress indicators of various financial markets. We show both the real estate and stock market are crucial for cross-border capital flow. Using the rolling window method, we find significant time-varying spillovers between cross-border capital and financial markets, which peak during the periods with significant events such as the global financial crisis, the COVID-19 epidemic, and the shift in currency regime. This paper further applies the Markov-switching autoregressive model to identify three different states for the synthetic financial stress. After re-analyzing the subsample data, we observe that stock and real estate markets play significant roles in the low-stress state, foreign exchange and real estate markets in the medium-stress state, and stock and money markets in the high-stress state.