Role of credit in equity market booms and busts focusing on the role of credit in equity price booms

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Transcript of Role of credit in equity market booms and busts focusing on the role of credit in equity price booms

  • Working Paper 04/2009 23 February 2009

    ROLE OF CREDIT IN EQUITY MARKET BOOMS AND BUSTS

    Prepared by Lillian Cheung and Chi-Sang Tam1 Research Department

    Abstract

    Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions. This paper studies whether credit is a pertinent indicator of future equity price booms, and thus provides a signal for potential financial instability. Our analysis shows that excess credit does increase the probability of an equity price boom ahead. We argue that a policy response worthy of consideration would be a strengthening of the system-wide focus of the prudential framework coupled with monetary policy rules that take into account occasional development of financial imbalances to prevent potentially significant financial strains from developing. To this end, greater co-operation between monetary and prudential authorities is important, not just in managing crises, but also in preventing their emergence. JEL Classification Numbers: E51, E52, E58, G01 Keywords: financial stability; monetary stability; equity price booms and busts; excess

    credit Author’s E-Mail Address: lcheung@hkma.gov.hk; cstam@hkma.gov.hk

    1 The authors are grateful to Hans Genberg, Dong He, and seminar participants at the Hong Kong

    Monetary Authority, for their valuable suggestions and comments.

    The views and analysis expressed in this paper are those of the authors, and do not necessarily represent the views of the Hong Kong Monetary Authority.

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    Executive Summary: • The current financial crisis has demonstrated how financial imbalances can be

    built up in a low-inflation environment reflecting monetary stability, and how devastating the consequences on economic and financial stability can be with high-cost busts in asset prices and financial markets. While the rescue measures introduced by governments in various countries may allay the panic in the financial markets, they do not address the prevention of future financial crises.

    • This paper studies the conditions pertaining to potential financial strains by

    focusing on the role of credit in equity price booms and busts, and the implications for monetary policy.

    • Our analysis suggests that excess credit has been a leading indicator of the

    probability of an equity price boom, and points to the importance of studying rare episodes of large booms and busts rather than average historical relationships as in most studies.

    • Our findings also suggest the importance of the macroeconomic environment in

    determining financial stability and provide valuable information for policy makers on potential booms that could lead to increased risk of financial instability.

    • A policy response worthy of consideration would be a strengthening of the

    system-wide focus of the prudential framework coupled with monetary policy rules that take into account occasional development of financial imbalances to prevent potentially significant financial strains from developing.

    • To this end, greater co-operation between monetary and prudential authorities

    is important, not just in managing crises, but also in preventing their emergence. While our analysis provides a first step in discerning factors pertaining to equity price booms, further analytical work will still be required in understanding the dynamics between financial and real economic factors.

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    I. INTRODUCTION

    Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions. The current financial crisis has demonstrated how financial imbalances can be built up in a low-inflation environment reflecting monetary stability, and how devastating the consequences on economic and financial stability can be with high-cost busts in asset prices and financial markets. While the rescue measures introduced by governments in various countries may allay the panic in the financial markets, they do not address the prevention of future financial crises.

    Although there is a combination of many symptoms which could lead to potential financial crisis, booms and busts in asset prices are one of a richer set of symptoms. Indeed, large swings in asset prices figure prominently in many historical accounts of financial instability. This is true for both industrial and emerging market countries alike. Typical examples in recent decades include Latin America in the late 1970s to early 1980s, the Nordic countries in the late 1980s, and East Asia in the mid to late 1990s. A study by Gochoco-Bautista (2008) provides evidence that asset prices booms raise the probability of extremely bad macroeconomic conditions (i.e. large excess supply and high inflation) in Asian economies. In particular, asset price bubbles that are associated with credit booms present particular challenges, as they often magnify the subsequent disruptions to financial instability and their damaging effects on the real economy.

    However, the difficulties in identifying financial imbalances are

    artificially magnified when the question is put in terms of asset price bubbles. While it is almost impossible to reach a consensus about whether a particular asset price boom period should be considered a bubble or not, the question whether a boom is a bubble is for many practical purposes more semantic than of real importance. For policymakers, the important question is whether a combination of events in the financial and/or real sectors can be identified, which expose the financial system to a significantly higher level of risk. A financial crisis can make it very difficult to maintain price stability. This is demonstrated by the fact that all major deflationary episodes in the world have been related to substantial falls in asset prices. The identification difficulties look less daunting when the issue is analysed on this basis.

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    In this paper, we study the possibility of discerning the conditions

    pertaining to potential financial strains on the basis of ex ante information, and focus on the role of credit on equity price booms and busts, and the implications for monetary policy. The paper is structured as follows. The next section discusses the role of credit as a signal of equity price booms and hence future financial instability. Section III gives some case studies on selected episodes of equity price booms and busts over the past two decades, and examines the characteristics of credit and macroeconomic conditions during these periods. Section IV then presents our empirical testing of the hypothesis of whether credit booms increase the probability of equity price booms ahead based on experience from a number of advanced equity markets in Asia and the Nordic countries using a probit model. Finally, the last section discusses the role of monetary policy in maintaining financial stability and concludes. II. CREDIT AS AN IMPORTANT FACTOR IN EQUITY PRICE BOOMS

    While not all asset price booms are dangerous, booms are likely to be costly if associated with high leverage. Historical experience suggests that developments in the monetary aggregates and credit play an important role in the development of asset price boom episodes. Although the issue of empirical causality between asset prices on the one hand and money and credit developments on the other is a complicated one, the potential role of credit in driving asset prices is straightforward.

    A bubble is more likely to develop when investors can leverage their

    positions by investing borrowed funds. Indirectly, expenditures on goods and services tend to generate an upswing in economic activity, helping cash flows and brightening prospects for future income on assets, thereby buoying their valuation. In turn, higher asset values strengthen the net worth of borrowers and hence their borrowing capacity by increasing the value of collateral. A self-reinforcing process can easily develop. Further on, a high level of outstanding debt will increase the negative effects of asset price declines through the forced liquidation of leveraged positions and possible defaults, which in turn put additional pressure on asset prices. An interesting finding by Detken and Smets (2004) based on some stylised facts for financial, real and monetary policy developments during asset price booms in some OECD countries suggests that while booms followed by little real output loss (i.e. low-cost booms) have no significant relation with macroeconomic activities,

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    there is evidence that booms followed by large real output loss (i.e. high-cost booms) are associated with significantly looser monetary conditions over the boom period, and they seem to follow rapid growth in real money and credit.

    Indeed, credit excesses appear to be the root cause of the current crisis. According to Shin and Adrian (2008), there is evidence pointing to procyclical leverage where financial intermediaries adjust their balance sheets actively, and doing so in such a way that leverage is high during booms and low during busts. During the boom, the intermediaries utilise surplus capital by expanding their balance sheets. In the US sub-prime mortgage market, when balance sheets were expanding fast enough, the urge to employ surplus capital was so intense that even borrowers