No economy is an island: how foreign shocks affect UK macrofinancial stability

Overview

The UK’s interconnectedness with the rest of the world is high compared to other major economies. This openness brings many benefits, but also means that events abroad can significantly affect both the outlook for the UK economy and the resilience of the financial system, as recent global shocks such as the GFC have demonstrated – suggesting that openness could be a ‘double-edged sword’.

In this article, we summarise the channels through which foreign developments can be transmitted to the UK. These include a range of trade and financial channels. In some cases, these channels can interact and amplify each other.

We then analyse how global developments affect GDP and financial conditions in the UK in practice. Here we provide historical estimates from 1997 to 2019. We show that global financial shocks, like the GFC and the euro-area crisis, account for around half of the variation in UK GDP and almost all of the variation in financial conditions.

We also present a measure of macroeconomic tail risks, which reflects the severity of a GDP downturn that has a 1-in-20 chance of materialising in the medium term. We show that foreign developments affect this tail-risk measure significantly, and by even more than they affect average (or median) outcomes.

Finally, we discuss the actions taken following the GFC to address vulnerabilities in the global financial system. By co-ordinating these policies across countries, it was possible to promote the ‘safe openness’ of both the global system and the UK. The Covid crisis was a test of that system, and we discuss the policy lessons learnt so far, including the possibility of increasing the resilience of global supply chains and non-bank financial intermediation (NBFI). The role of NBFI in transmitting the economic shock across borders was larger than in previous downturns, reflecting its growing importance in the global financial system.

The UK’s role in global finance and trade

Throughout their history, the islands that now make up the UK have been connected through trade and commerce with neighbours close to home and further afield. As early as the 17^th century, London was establishing itself as a financial centre, with the first financial institutions emerging from merchant guilds that accumulated financial capital through their trading activity, and the coffee houses where merchants and ship owners came together to pool risk. The Bank of England itself can trace its history back to this time.

Today, the UK remains an open economy that is highly integrated in the global trade and financial systems. Total trade, the sum of imports and exports, is equivalent to over 60% of UK GDP, more than the average across major economies (Chart 1). And the UK is an important international financial centre too. Its total foreign assets, and liabilities, are over five times larger than UK GDP (Chart 2) – the highest among the same set of major countries in Chart 1 by a significant margin.

This openness brings many benefits to the UK. Trade openness can boost economic growth by fostering competition, exploiting economies of scale and encouraging innovation transfer across borders. Similarly, cross-border capital flows can facilitate risk-sharing and diversification, and help allocate resources efficiently. In doing so, openness can boost productivity, foster economic growth and leave the economy less vulnerable to economic shocks originating at home.

But openness also means that the UK economy is affected by foreign developments. For example, the GFC was a shock that originated abroad – in the US housing market – that spilled over to the UK (and elsewhere) through financial linkages. And the domestic economic effects of the Covid pandemic were compounded by trade and financial disruption abroad.

Chart 1: The UK economy relies heavily on trade

Footnotes

• Sources: Organisation for Economic Co-operation and Development and Bank calculations.
• Note: ‘Average’ refers to the mean trade-to-GDP ratio across countries in the chart, where trade is the sum of import and exports.

Chart 2: The UK economy has more foreign assets and liabilities than other major economies

Footnotes

• Source: Bank calculations using the data from Lane and Milesi-Ferretti (2017).

The Bank of England has long recognised the importance of overseas events for the UK economy – as a number of past Quarterly Bulletin articles discuss (Chowla et al (2014), Cesa-Bianchi and Stratford (2016), Gilhooly et al (2018)) – and has developed a suite of models to monitor the global economy and international risks.^{footnote [1]} Our estimates show that the UK is, on average, most affected by developments in the euro area and the US, as it has strong trade and financial linkages with the two (Chart 3). But, even when direct linkages are smaller (as in the case of China), spillovers can be material, as they spread through the world economy and can affect the UK indirectly as well.

Chart 3: Developments in the euro area and the US have the greatest impact on the UK economy

Spillovers from a 1% increase in euro area, US and China GDP to UK GDP

Footnotes

• Source: Bank calculations.
• Note: Bars represent the range of estimates from a suite of models.

In order to meet their policy objectives, the Bank of England’s policy committees – the Monetary Policy Committee (MPC), Financial Policy Committee (FPC), and Prudential Regulation Committee (PRC) – need to understand the influence of the rest of the world on the UK economy and the financial system. Foreign developments are a key determinant of the outlook for the UK economy and prospects for inflation. So as the MPC works to keep inflation at target, it must carefully consider these foreign developments. In addition, developments abroad are a key driver of tail risks that may affect the resilience of UK-based financial institutions and the UK financial system overall. So the FPC and PRC need to be alert to developments overseas and their spillovers to the UK.

The magnitude of global spillovers is heavily influenced by the structure of the international monetary, financial and trading systems. So the Bank of England looks to influence the structure of those systems, and the global rules and norms that govern them, through its engagement in relevant international fora. This helps to ensure greater economic and financial stability, both internationally and in the UK. In other words, to ensure that there is ‘safe openness’ in global trade and finance (Bailey (2021)). These international efforts have proven instrumental for the resilience of the global banking system during the Covid pandemic.

Against that background, this article presents evidence on the importance of global developments for the UK economy, focusing on three questions. First, how can shocks abroad transmit to the UK and affect its economy? Second, how important have global shocks and these spillover channels been historically? And, third, what is the role of global developments in affecting the probability of extreme GDP growth events, or tail risks, in the UK?

How can shocks abroad transmit to the UK?

In this section, we summarise the main channels through which events abroad can be transmitted to the UK (Figure 1). While somewhat distinct, these channels rarely operate in isolation.

Figure 1: Foreign shocks can affect the UK economy in four key ways

Trade channels

Trade channels are pivotal to the UK economy. UK exports are impacted by foreign demand for goods and services produced in the UK. A boom in one of the UK’s overseas trading partners – for example due to expansionary macroeconomic policies or loose financial conditions – would likely increase the demand for UK exports, boosting UK output. This could also generate inflationary pressure by pushing up UK prices as increased foreign demand puts upward pressure on domestic production. Inflationary pressure in the UK is also affected by the prices of the goods and services that the UK imports, which can change if the costs of inputs or level of global demand change.

Trade in goods is not limited to ‘final’ goods – goods that are directly consumed – either. As Chart 4 demonstrates, trade in ‘intermediate’ goods, used as inputs in production, has increased substantially since the early 1990s as sophisticated global supply chains – known as global value chains (GVCs) – have been established. While these links connect a number of countries, the US and China are central to the global network of supply chains and Germany plays a key role within Europe.

The interconnectedness of the global trading system means the UK may not only face spillovers from its closest trading partners. A shock in a country without sizable direct trade links to the UK can still influence the UK economy through indirect links. For example, a previous Quarterly Bulletin article emphasised the UK’s indirect trade links to China, via the euro area in particular. While only 4% of UK exports go to China, these indirect links open up the possibility for a downturn in China to reduce demand for euro-area exports and, in turn, influence euro-area demand for UK exports.

Chart 4: Global value chain trade grew rapidly in the 1990s, although growth slowed following the global financial crisis

Footnotes

• Source: World Bank, World Development Report (2020).

Financial channels

As an international financial centre, financial spillover channels are particularly important for the UK. Events abroad can impact financial market prices across the world, the value of UK-based banks’ cross-border assets and the ability of UK borrowers to access foreign funding.

Asset prices

Many UK assets – such as equities and bonds – are traded globally, and numerous UK investors hold foreign assets. UK asset prices correlate strongly with global asset prices: the correlation between UK equity returns and global equity returns is 80%, significantly higher than the correlation between UK GDP growth and that of other countries (45%).

As such, developments in global markets can have a significant impact on UK households and businesses. A global asset price boom – for example from a general improvement in risk sentiment – would increase the value of UK residents’ foreign asset holdings. It would also likely boost domestic asset values as it feeds through to UK financial markets. Together, this increase in wealth can stimulate UK consumption and business investment. These changes can also affect UK-based financial institutions’ willingness to lend to domestic firms.

UK-based banks’ credit exposures

The UK has sizable banking exposures to other countries (over 250% of GDP). In fact, the UK has the highest cross-border banking claims, which includes loans and other assets, of any global banking hub. UK-based banks’ foreign claims are around 60% larger than US banks and 20% larger than French banks, which have the second highest foreign claims.

These foreign-asset holdings leave UK banks directly exposed to financial and macroeconomic developments abroad. In the event of a downturn overseas, UK-based financial institutions, who have extended loans abroad, would likely face losses on their cross-border exposures. And they can also be exposed indirectly, via the effects of foreign spillovers on the UK economy. For example, a recession abroad could generate a domestic downturn through reduced demand for exports. In turn, UK households and businesses could default on their loans from domestic banks.

The magnitude of this spillover channel will depend on a range of factors. For example, UK-based banks with high capital ratios will be better placed to withstand losses from downturns abroad. And such banks may not need to cut domestic credit or reduce new lending in the face of losses on their foreign exposures.

The FPC’s July 2021 Financial Stability Report (FSR) emphasises the importance of cross-border exposures for major UK banks. In the interim results of the 2021 solvency stress test, around 40% of the credit losses of the UK banks are from their foreign portfolios.

Foreign funding

Around a third of total UK corporate borrowing is funded through overseas financial markets. And domestic corporates can borrow from foreign banks too. As such, tighter global financial conditions – for example due to higher global uncertainty or a reversal in risk appetite among global investors – can increase the cost or reduce the availability of funding for UK institutions.

The financial channels described above can interact and amplify each other. As the GFC illustrated, a drying-up of liquidity in international wholesale markets can cause a credit crunch in the UK. More generally, mismatches between the asset and liability sides of financial institutions’ balance sheets could force banks to raise funds through selling other assets and, at the extreme, result in fire sales. Sharp falls in asset prices would affect UK consumption and business investment and could trigger an increase in the rate of loan defaults across the economy. As banks sustain losses from borrowers defaulting on their loans and mortgages, they may in turn reduce their lending to the economy. This would jeopardise the macroeconomic outlook further, amplifying the impact of the original shock. These interactions are more likely to be amplified when households, businesses and banks are highly leveraged, as credit constraints result in fire sales, defaults or reductions in willingness to lend.

Looking back: how much have global shocks mattered for UK GDP?

In this section, we attempt to quantify the impact of global events on the UK economy using an empirical model with multiple countries.^{footnote [2]} The model is similar to that developed by Cesa-Bianchi et al (2020), and captures the trade and financial channels of interdependence described above.

Our model accounts for the fact that different countries in the global economy can experience the same shock, but with different impacts. Additionally, it can separate out the effects of global ‘real’ shocks and global ‘financial’ shocks. ‘Real’ shocks to global output arise from changes in demand and supply. Financial shocks relate to changes in risk attitudes and reactions to news, which then affect global GDP through financial channels.

Within the model, a global real shock that generates a 1% fall in global GDP (after one year) leads to a fall in UK GDP of around 0.6% (after one year), in part because of a tightening in global financial conditions. A global financial shock that affects all countries and generates a 1% fall in global GDP (after one year) gives rise to around a 1% reduction in UK GDP.^{footnote [3]}

On average over the 1997–2019 period, global shocks explain 52% of the variation in UK GDP and 90% of the variation in our UK financial conditions index (FCI).^{footnote [4]} The global financial shock plays a more important role than the global real shock for UK financial conditions and UK GDP. This underscores the importance of foreign financial developments in particular for UK financial markets and the overall economy.

To assess the importance of these global shocks for the UK economy over time, we look at how the model interprets historical movements in UK GDP and the UK FCI (in deviations from their long-run trends). Chart 5 reports the results from this exercise, for the 2000–19 period.

Chart 5: Estimates of the impact of global and domestic shocks on the UK economy

Footnotes

• Source: Bank calculations based on model developed in Cesa-Bianchi et al (2020).
• Notes: Black lines show the values of UK GDP and FCI over time. Three types of shocks explain these values in each quarter. Shocks are estimated, and assumed to have occurred independently.

The decompositions in Chart 5 highlight that global real and financial shocks are both major drivers of developments in UK GDP and financial conditions. This was particularly evident around the GFC and the euro-area debt crisis. UK financial conditions tightened markedly in 2008 and in 2011, driven in large part by global shocks. These developments were also associated with a rapid and persistent fall in UK GDP, relative to its long-run trend. The global financial shock played a particularly important role during those episodes compared with the rest of the 2000–19 period. This emphasises the importance of amplification mechanisms in the global economy – for example outsized moves in asset prices and the availability of credit – that can result in large spillovers in tail events.

Looking ahead: how do foreign developments affect growth risks in the UK?

The previous section showed that global events have played a key role in driving UK GDP and financial conditions. Many policy actions can be viewed, at least in part, as responses to global shocks – for example reductions in interest rates during the GFC, and the range of policy actions in response to Covid. But it takes time for policy actions to take effect. So forming a view on what could be coming in the future is crucial. And when doing this, this section shows that monitoring developments abroad is as important as monitoring developments at home.

At any point in time there could be many different possible paths for future UK GDP growth. We can think of this as a bell-shaped distribution of potential outcomes with different probabilities attached. Events in the ‘centre’ of the distribution are more likely. But the more extreme outcomes in the ‘tails’ – like a very severe recession – are more rare. In this section, we focus on possible large GDP contractions – the left tail of the distribution. In particular, we look at how the fifth percentile of the GDP-growth distribution, which captures the severity of a ‘1-in-20’ bad outcome, is affected by global developments.

The model we use to explore how developments at home and abroad affect the distribution of future GDP growth, including these ‘1-in-20’ bad outcomes, is developed in Lloyd et al (2021).^{footnote [5]} It accounts for the possibility that developments abroad can affect the tails of the domestic GDP distribution differently to the centre of it. For example, foreign credit growth can often support UK economic growth, by financing economic activity abroad that, in turn, can spill over positively to the UK via trade and financial linkages. But it can also be associated with greater risk-taking and loose lending conditions that can increase the probability of a severe economic downturn, both abroad and at home. Indeed, the GFC that originated in the US mortgage market eventually gave rise to a severe global recession – in part due to UK-based banks’ foreign credit exposures and reliance on wholesale funding.

Our results highlight that faster foreign credit-to-GDP growth has significant negative effects on the most severe possible outcomes for UK GDP. The estimates for the median of the distribution in Chart 6 highlight that an increase in foreign credit-to GDP growth on average leads to a slight expansion in domestic GDP growth in the near term (one quarter ahead), followed by a small reduction in domestic GDP growth further out (two years ahead). However, we find that the same one standard deviation rise in foreign credit-to-GDP growth is associated with a fall in the fifth percentile of domestic GDP growth two years ahead of around 0.9 percentage points – almost five times larger than the estimated fall in the median.

Chart 6: A rise in foreign credit-to-GDP growth worsens the medium-term outlook in the UK, with stronger downward pressure for the left tail

Impact of a one standard deviation increase in foreign credit-to-GDP growth on the distribution of domestic GDP growth one quarter and two years ahead

Footnotes

• Source: Lloyd et al (2021).

Accounting for global factors improves our ability to predict a build-up in UK GDP tail risk, as Chart 7 illustrates in the run-up to the GFC. The teal line shows the predicted distribution of UK GDP growth two years ahead, based on the information available about domestic vulnerabilities only in 2006 Q4 (around two years prior to the downturn).^{footnote [6]} The red line shows the same thing, but also uses information about global vulnerabilities to form the predicted distribution.

Both estimated distributions point to a deterioration in downside risk between 1998 (shown in the grey line) and 2006, shown by the significant widening in the left tails. But adding foreign variables into the model helps to pick up a substantial additional worsening in downside risk two years before the start of the crisis. We find the estimated fifth percentile of future UK GDP growth is about two times more negative in the run-up to the GFC once we account for foreign variables (shown by the red and teal dots). This highlights the importance of monitoring global developments when assessing tail risks in the UK.

As well as helping to monitor tail risks over time, our model can assess the main drivers of fluctuations in tail risk. We find that, on average, global shocks drive up to over two thirds of variation in the estimated fifth percentile of UK GDP growth at medium-term horizons. And we find that they explain a higher variation in the left tail of the distribution than they do for the centre of the distribution – consistent with the result in the previous section that foreign shocks drive around 50% of the variation in expected UK GDP growth.

Chart 7: Estimated predictive distributions for two year ahead UK GDP growth

Footnotes

• Source: Bank calculations based on Lloyd et al (2021).

This begs the question of what the appropriate response from policymakers should be to mitigate potential risks from abroad. We turn to this question in the next section.

Safe openness in the face of spillovers

Policy frameworks – in the UK and globally – seek to ensure safe openness. In this way, economic and financial openness can deliver benefits, while minimising the potential costs. In the following subsections, we discuss policy reforms to foster safe openness in the financial sector and global trading system in turn. We first highlight how financial policy reforms helped to build a resilient system after the GFC. We then consider the case for reforms to the global trading system following Covid, drawing on insights presented in D’Aguanno et al (2021).

Reforms to the financial system since the global financial crisis and the need for future reform

While financial openness can foster diversification and offer opportunities to access funding from a wider range of sources, the GFC illustrated how it can also expose countries to greater volatility. In response, global policymakers embarked on policies to increase the resilience of the system, taking ‘the high road to a responsible, open financial system’ (Carney (2017)).

This has included internationally co-ordinated reforms to increase the resilience of the financial system to shocks and tackling the issue of the largest banks being ‘too big to fail’. Specific examples of changes implemented include increased capital requirements for banks and the establishment of resolution regimes.

Thanks to these efforts, financial institutions operating across borders are subject to similar regulations, regardless of geography. In turn, this can support the overall resilience of the global financial system by guarding against regulatory arbitrage – which, if left unchecked, could otherwise result in a build-up in vulnerabilities abroad that spill over domestically. Internationally, efforts have also been made to tackle the risks associated with cross-border capital flows, which can amplify the effects of shocks across borders (for instance, the International Monetary Fund’s Integrated Policy Framework).

Taken together, these efforts have made the core of the financial system more resilient during the Covid pandemic. Improvements to capital and liquidity positions over the past decade (eg Lewrick et al (2020)), in combination with the additional flexibility built into the international regulatory framework, have helped banks to continue to support the economy during a severe economic downturn (Giese and Haldane (2020)).

The Covid pandemic did expose vulnerabilities in other parts of the financial system however. Indeed, the NBFI sector, which was subject to fewer reforms post-GFC, saw significant stresses during the acute phases of the Covid pandemic, highlighting the need to enhance the resilience of market-based finance (Box A).

The case for reforms to the global trading system post-Covid

The global pandemic emphasised countries’ dependence on their trading partners in providing critical goods, and motivated calls to build greater resilience in the international trading system. In light of that, a recent Bank of England Financial Stability Paper explores the extent to which GVC integration can be a ‘double-edged sword’: increasing productivity, but also raising volatility. The paper concludes that there is no compelling reason to fear the double-edged sword: a blanket reduction in GVC integration would impose economic costs without necessarily, or significantly, reducing economic volatility. It also shows that reshoring can lead to a rise in output volatility for a given country because it increases exposure to domestic shocks. On the other hand, diversification of supply chains among foreign suppliers can achieve greater resilience by lowering the exposure to any single country.

The paper also explains how policy reforms aimed at strengthening multilateralism in the global trading system could yield benefits. These future reforms could include building global frameworks to support safe openness through co-operation, introducing stress-testing frameworks for critical supply chains, and efforts to enhance the collection and dissemination of more timely data on GVC trade.

Conclusion

The UK is a highly open economy. It trades goods and services internationally, as well as financial assets. Over the recent past, events abroad have affected the UK in both positive and negative ways due to this deep integration within the global financial and trading system.

This article has set out the channels through which events abroad can transmit to the UK. And it has outlined some of the quantitative approaches we use to gauge the importance of global spillovers for UK GDP and macroeconomic tail risks. We showed that foreign developments account for around half of the variation in UK GDP and for over two thirds of the variation in a measure of tail risk. Finally, it has discussed policy levers available to ensure the resilience of the UK to shocks from abroad while reaping the benefits of openness.

The GFC and the Covid pandemic reinforced an old lesson: openness can be a double-edged sword, coming with many benefits but also potential risks from shocks spilling over from abroad. While the UK’s exposure to foreign events is nothing new, the potential impact on the UK is large – as illustrated by the quantitative estimates presented in this article. And, of course, the way in which events can spill over to the UK can change with the times. As such, it is important that the Bank of England monitors these connections, evaluates new risks as global networks evolve, and works to maintain the ‘safe openness’ of the UK economy and financial system by co-operating with other institutions both home and abroad.