Decomposing uncertainty: How foreign policy risks shape Chinese stock market dynamics

Abstract

This study examines the transmission mechanism of foreign economic policy uncertainty (FEPU) on the Chinese stock market from 1997 to 2022, using a vector autoregressive adaptation of the dividend discount model. By decomposing excess returns into cash flow (CF), excess return (ER), and risk-free rate (RF) components, we disentangle the effects of FEPU shocks on these distinct factors.

Our findings indicate that FEPU primarily leads to a significant but temporary overestimation of impacts on cash flows and excess returns, with the market typically correcting itself after an initial overreaction. This pattern suggests a complex interplay between investor sentiment and market dynamics. Notably, trade stability amplifies the impact on CF, while closer monetary policy coordination enhances the transmission to RF and ER expectations. Additionally, economic cycles play a moderating role: downturns exacerbate the negative impacts on CF and RF, while bullish conditions foster resilience. Investor sentiment emerges as a crucial factor, with negative sentiment intensifying FEPU's adverse effects during economic contractions.

This research contributes a detailed perspective on how international relations, policy harmonization, and market psychology collectively influence FEPU transmission and affect China's financial stability amidst global uncertainties. Our decomposition method illuminates the dynamic forces that drive market reactions over time, offering critical insights for refining risk management strategies and crafting policy measures that buffer the financial system against external economic shocks.