China Trade Exposure Index: Using principal component analysis to compare countries’ exposure to the Chinese economy

Abstract

This paper studies countries’ economic dependence on China through trade. As China’s importance in the world economy has grown significantly in recent years, developments in China will increasingly be reflected in its trading partners’ economic performance. Therefore, measuring and identifying countries’ economic exposure to China has become increasingly relevant. Responding to the need by risk management practitioners in financial institutions, the paper builds a tool to measure and compare countries’ exposure to the Chinese economy through trade channels, using principal component analysis. The resultant China Trade Exposure Index ranks countries based on their economic dependence on trade with China. The utilisation possibilities of the index are broad, yet the most obvious application is in financial institutions’ stress testing exercises. Indeed, the index can be used in a China-specific stress testing scenario to transmit a shock to other countries according to their China dependence. To validate the relevance of the index, the paper further shows that the China Trade Exposure Index is significant in explaining countries’ cyclical economic growth co-movement with China, with a higher ranking implying a stronger real gross domestic product (GDP) growth correlation. Therefore, the China Trade Exposure Index helps global investors, risk professionals and policymakers in analysing potential China-related country risks.