Financial Market Frictions, Beliefs, and the Macroeconomy; An Application to the Case of China
Lead Research Organisation:
University College London
Department Name: Economics
Abstract
Project 1: "Limited Commitment and the Effects of Monetary Policy"
In this project, we will study how financial frictions affected by beliefs of market participants, and the implication for monetary policy (such as a change in interest rates on productivity and growth). The expansionary monetary policy (higher money supply growth or easier lending conditions) in China after 2011 did not have the same expansionary effects on inflation and output as in the previous years. We will study how the presence of a particular type of frictions, limited commitment, significantly affects the impact of monetary policy and can explain the different effects observed in recent years. This study could shed light on the conduct of monetary policy, which will depend on the beliefs in the credit market and the firm size-productivity distribution.
Project 2: "Search-and-matching for Liquidity in Financial Markets and Government Policies"
According to World Bank data, between 2000 and 2013 in China, the quantity of money (M2) grew at a yearly rate of 16.2%: in the same period, the average yearly inflation rate was 2.4%, and the average yearly real GDP growth rate 8.7%. This means that, even after taking into account the high real GDP growth, the inflation rate in China has been systematically lower than what one would expect on the basis of the money supply growth rate.
Chinese financial markets are still not fully developed, and many privately issued assets are not very liquid. As a result, besides the transaction motive, economic agents' hold money also because of liquidity needs. The purpose of this project is to study how the higher liquidity needs (due to the low liquidity of the financial markets) affect the relations between monetary policy, inflation and economic growth, when beliefs about liquidity affect market participations. We will apply the study to understand the Chinese practice mentioned in the beginning, and discuss whether it is sustainable.
We will study these issues by introducing asset liquidity frictions in an otherwise standard macroeconomic framework. In contrast to exogenous asset liquidity, expressed by a fixed fraction of assets sellable in a given period, endogenous asset liquidity is micro-founded and suitable for policy analysis.
Project 3: "Long Run Herd Behaviour and Volatility Clustering in Financial Markets"
In the third project, we turn to another form of financial frictions, asymmetric information.
Financial markets are crucial for good investment decisions. The ability of prices to aggregate dispersed information is fundamental for an efficient allocation of resources. We will study the informational efficiency of the Chinese financial markets through the use of novel financial markets models, with a specific focus on learning and herding. We will also study why asset prices exhibit time-varying volatility and the extent to which this is related to herd behaviour. We will then estimate the models using transactions data for the Chinese stock exchanges obtained from Wind Info. The structural estimation will allow us to quantify the drivers of herding and asset prices' time-varying volatility and their effect on market efficiency.
In this project, we will study how financial frictions affected by beliefs of market participants, and the implication for monetary policy (such as a change in interest rates on productivity and growth). The expansionary monetary policy (higher money supply growth or easier lending conditions) in China after 2011 did not have the same expansionary effects on inflation and output as in the previous years. We will study how the presence of a particular type of frictions, limited commitment, significantly affects the impact of monetary policy and can explain the different effects observed in recent years. This study could shed light on the conduct of monetary policy, which will depend on the beliefs in the credit market and the firm size-productivity distribution.
Project 2: "Search-and-matching for Liquidity in Financial Markets and Government Policies"
According to World Bank data, between 2000 and 2013 in China, the quantity of money (M2) grew at a yearly rate of 16.2%: in the same period, the average yearly inflation rate was 2.4%, and the average yearly real GDP growth rate 8.7%. This means that, even after taking into account the high real GDP growth, the inflation rate in China has been systematically lower than what one would expect on the basis of the money supply growth rate.
Chinese financial markets are still not fully developed, and many privately issued assets are not very liquid. As a result, besides the transaction motive, economic agents' hold money also because of liquidity needs. The purpose of this project is to study how the higher liquidity needs (due to the low liquidity of the financial markets) affect the relations between monetary policy, inflation and economic growth, when beliefs about liquidity affect market participations. We will apply the study to understand the Chinese practice mentioned in the beginning, and discuss whether it is sustainable.
We will study these issues by introducing asset liquidity frictions in an otherwise standard macroeconomic framework. In contrast to exogenous asset liquidity, expressed by a fixed fraction of assets sellable in a given period, endogenous asset liquidity is micro-founded and suitable for policy analysis.
Project 3: "Long Run Herd Behaviour and Volatility Clustering in Financial Markets"
In the third project, we turn to another form of financial frictions, asymmetric information.
Financial markets are crucial for good investment decisions. The ability of prices to aggregate dispersed information is fundamental for an efficient allocation of resources. We will study the informational efficiency of the Chinese financial markets through the use of novel financial markets models, with a specific focus on learning and herding. We will also study why asset prices exhibit time-varying volatility and the extent to which this is related to herd behaviour. We will then estimate the models using transactions data for the Chinese stock exchanges obtained from Wind Info. The structural estimation will allow us to quantify the drivers of herding and asset prices' time-varying volatility and their effect on market efficiency.
Planned Impact
Our research will be of interest to academics, policy makers, and financial markets professionals.
To reach the academic community, we will present our projects at various stages of development in seminars, workshops and conferences. We will aim to publish our work in the very top scientific journals both in economics and in finance, so researchers who are interested in our work can further build upon the published work.
To reach policy makers, we will also try to publish preliminary versions of our work in working paper series such as the IMF Working Papers, the FED Staff Reports and the ECB Working Papers. In fact, we have already regularly done so in the past, see, e.g., Cui W. and Soeren Radde, 2016, "Search-based Endogenous Asset Liquidity and the Macroeconomy," ECB WP1917; Cipriani M. and Guarino A., 2012 , "Estimating a structural model of herd behavior in financial markets," Staff Reports 561, Federal Reserve Bank of New York. An important task of the overall project is to show how policy should react when financial markets can be shaped by variations in beliefs.
We plan to organize at least two two-day conferences for academics and policy makers on the theme of financial markets and growth in China: one in London and one in Shanghai (for example, Shanghai Jiaotong University, where the principle investigator has already established long-term relationship). The conference will bring together scholars and policy makers from the UK and China to share knowledge and facilitate communication. We plan to invite industry experts in Chinese financial markets. Such events can increase the industry impact of our research, and, on the other hand, result in useful feedback on our work from practitioners.
Professionals in the private sector will be interested in using our techniques in their work. They could benefit from understanding the linkage between the Chinese macroeconomy and its financial markets in a structural way. We will make our computer codes publicly available and will aim to make our methods widely known by participating in events with a broader audience than just academics and policy makers. In the past, the co-investigator has written for magazines for financial professionals, such as Collier Capital Magazine. The principle-investigator will work with the co-investigator on generating reports on Chinese financial markets to the general publics in the UK and China.
We would also like to mention that UCL has a consolidated record in engaging with users. For instance, the seminar and teaching activities of CEMMAP (UCL based centre funded by the ESRC) typically reach a variety of users. In addition, from October 2017 we will establish a new Centre for Finance (CfF) within the Department of Economics (Antonio Guarino will be the director and Wei Cui a research fellow); we will also use the activities of the CfF to reach a variety of users.
Finally, we would like to make our research visible to an even larger audience by creating a blog on "China: Financial Markets and the Macroeconomy", which could potentially benefit their investment decisions and understanding of government policies in China. We will solicit experts interested in the Chinese economy, and, more in general, in developing economies, to contribute to the blog. We will also use other blogs, such as the Federal Reserve Bank of New York Blog ("Libertystreet Economics"), the LSE blog ("Usappblog") and the IFS bog ("Microeconomic Initiatives"), where we have already been invited to present our work.
To reach the academic community, we will present our projects at various stages of development in seminars, workshops and conferences. We will aim to publish our work in the very top scientific journals both in economics and in finance, so researchers who are interested in our work can further build upon the published work.
To reach policy makers, we will also try to publish preliminary versions of our work in working paper series such as the IMF Working Papers, the FED Staff Reports and the ECB Working Papers. In fact, we have already regularly done so in the past, see, e.g., Cui W. and Soeren Radde, 2016, "Search-based Endogenous Asset Liquidity and the Macroeconomy," ECB WP1917; Cipriani M. and Guarino A., 2012 , "Estimating a structural model of herd behavior in financial markets," Staff Reports 561, Federal Reserve Bank of New York. An important task of the overall project is to show how policy should react when financial markets can be shaped by variations in beliefs.
We plan to organize at least two two-day conferences for academics and policy makers on the theme of financial markets and growth in China: one in London and one in Shanghai (for example, Shanghai Jiaotong University, where the principle investigator has already established long-term relationship). The conference will bring together scholars and policy makers from the UK and China to share knowledge and facilitate communication. We plan to invite industry experts in Chinese financial markets. Such events can increase the industry impact of our research, and, on the other hand, result in useful feedback on our work from practitioners.
Professionals in the private sector will be interested in using our techniques in their work. They could benefit from understanding the linkage between the Chinese macroeconomy and its financial markets in a structural way. We will make our computer codes publicly available and will aim to make our methods widely known by participating in events with a broader audience than just academics and policy makers. In the past, the co-investigator has written for magazines for financial professionals, such as Collier Capital Magazine. The principle-investigator will work with the co-investigator on generating reports on Chinese financial markets to the general publics in the UK and China.
We would also like to mention that UCL has a consolidated record in engaging with users. For instance, the seminar and teaching activities of CEMMAP (UCL based centre funded by the ESRC) typically reach a variety of users. In addition, from October 2017 we will establish a new Centre for Finance (CfF) within the Department of Economics (Antonio Guarino will be the director and Wei Cui a research fellow); we will also use the activities of the CfF to reach a variety of users.
Finally, we would like to make our research visible to an even larger audience by creating a blog on "China: Financial Markets and the Macroeconomy", which could potentially benefit their investment decisions and understanding of government policies in China. We will solicit experts interested in the Chinese economy, and, more in general, in developing economies, to contribute to the blog. We will also use other blogs, such as the Federal Reserve Bank of New York Blog ("Libertystreet Economics"), the LSE blog ("Usappblog") and the IFS bog ("Microeconomic Initiatives"), where we have already been invited to present our work.
People |
ORCID iD |
| Wei Cui (Principal Investigator) | |
| Antonio Guarino (Co-Investigator) |
| Description | Please note that the grant's ending date has been extended to Aug 31, 2023. Some of the findings below will be finalized. 1. Findings during 2021 - 2023 The research team focused on Project 2: search-and-matching in capital markets and government policy implications in these two years. Because of the CoViD-19 travelling restrictions in China, essential collaborations with scholars in China were impossible until early 2023. As a mitigation, we spent most of the time building a theoretical model and using US data instead to assess the channel. This project studies economies where firms first acquire capital in centralized primary markets, as in standard growth theory; then, they retrade it in decentralized secondary markets after new information (idiosyncratic productivity shocks). In the interest of realism and generality, our secondary markets incorporate bilateral trade with search, matching, bargaining, and liquidity frictions, although each can be suppressed in special cases. A particularly novel feature is that we distinguish explicitly between full sales, where (in a bilateral deal) the buyer gets all of the seller's capital, and partial sales, where the buyer gets only some. Under constant returns to scale, it is socially efficient for firms with higher productivity to get all the capital, but that does not always happen in equilibrium. Indeed, the most desirable trades can be especially hindered by financial and monetary considerations. The analysis begins by documenting some facts about full and partial sales. The ratio of full sales to total capital expenditure (i.e., to new investment plus reallocation) is procyclical at the business cycle frequency. In contrast, the ratio of partial sales to total capital expenditure is countercyclical. In the longer run, the ratio of full sales to total capital expenditure has increased while the ratio of partial sales to total capital expenditure has decreased. Given that 42% of full sales are facilitated by cash or cash equivalent payments in the data (Thomson Reuters M&A Database, 1971-2018), we examine the relationship between reallocation and the cost of liquidity measured by inflation). In the longer run, full sales decrease while partial sales increase with inflation, but the pattern is reversed at the business cycle frequency. We then develop a formal model that endogenously determines the mix between full and partial sales. Theory predicts higher inflation raises the cost of liquidity, decreasing full sales and increasing partial sales, and since full sales are larger total reallocation falls. This result is consistent with the long-run facts. Then, we introduce shocks to credit conditions to get full sales to increase while partial sales decrease with inflation at the business cycle frequency. Easier credit increases total reallocation, increases full sales, decreases partial sales, and reduces firms' demand for money, leading to a short-term inflation jump. Thus, with credit shocks at business cycle frequencies, total reallocation is procyclical and moves with inflation, while partial sales are countercyclical. The idea is not that credit shocks are necessarily more transitory but that they increase the price level, implying a rise in short-run (but not trend) inflation. We also find that whether monetary policy can stimulate the economy depends on the interaction between primary and secondary capital markets. An inflationary monetary policy reduces the value of liquidity firms hold so that fewer transactions occur in the secondary capital market. Depending on the bargaining power between the buyer and the seller, there could be more primary investment as it is harder to obtain capital in the secondary market; in this case, the inflationary monetary policy stimulates investment, employment, and output. However, it could also occur that less primary investment is implemented since firms know it is harder to resell capital in the secondary market; in this case, the inflationary monetary policy contracts investment, employment, and output. 2. Findings during 2020 - 2022 CoViD-19 had a significant adverse effect on Project 1. It changed our plan to collaborate, analyze, process financial and macroeconomic data, and finalize the working paper in 2020. As an alternative to mitigate the impact, we finished a related research paper focusing on monetary policy's implications for risk-taking, which we still find a significant step moving forward. The research paper, supposed to be finished in 2020 (see below), will be resumed after the travelling restriction is eased, now possible in the summer of 2023. In this new but related paper, we put a lot more emphasis on the theoretical impact of leverage and interest rate policy on risk-taking behaviours. It fits broadly to the aim of the reward: analyzing the impact of financial market frictions and various policy measures. We have new findings that we are excited about. We studied the impact of liquidity constraints on firms' risk-taking. Both leveraged returns and leveraged volatility are considered. We uncover a non-monotone relationship between liquidity and firms' risk-taking. Relaxing financing constraints may or may not encourage risk-taking. Firms are willing to take less risk with easier credit if their leverage is low. However, they prefer to take more risks with easier credit if their leverage ratio is high. This relationship between leverage and risk-taking highlights that liquidity/monetary policies can generate a non-linear effect on risk-taking and social welfare. A cut in interest rate may not encourage firms to implement risky but socially desirable projects when leverage is low. This result is because a cut in interest rate generates mainly a wealth effect, and firms would like to secure a higher wealth by investing in the risk-free project to accumulate more capital. However, a cut in interest rate can encourage risk-taking when firm leverage is high because the firm leverage amplifies the substitution towards higher return. We also find empirical evidence. By looking at stock return volatility (as a proxy to capture the volatility of firm performance) and the effect of the exogenously identified monetary policy shock on the volatility, we find that an interest rate cut indeed can encourage risk-taking when leverage is high while discouraging risk-taking when leverage is low. Our study implies that a low interest rate environment may not be socially optimal because of less risk-taking and lower productivity associated with the economy. A low interest rate policy may not stimulate firms to take more risky, but socially productive, projects, leaving marginal product of capital and interest rate down in equilibrium. A draft of this paper is attached below in the URL link. 3. Findings during 2019 - 2020 We focused on Project 1 of the Award research, and as planned, we studied beliefs and firm leverage in the Chinese economy through the lens of risk-taking by firms. Increased liquidity that raises leverage will increase funding opportunities in the economy. However, it may also encourage more risk-taking behaviours through default protections. We want to answer to what extent the second channel generates unintended economic volatility. To avoid endogeneity concerns, we designed a procedure using unique environmental data as instrument variables to find exogenous relaxation of the liquidity constraints influenced by local governments in China. We then examine how this affects the local firms' volatility in the stock market. Through the work, we discovered strong positive responses of a firm's stock volatility to the increase of liquidity: an increase of lending by 10% will increase the stock volatility by 8.7%. We further quantify its impact on the national level through a quantitative model and examine the effect of belief on leverage through this risk-taking channel. We also try to assess the impact of interest rate policy on firm performance. (This part took longer than we expected because of adjusting the model to fit the data. We originally estimated to have a working paper ready by the summer of 2020, but unfortunately stopped by the CoViD-19 pandemic.) |
| Exploitation Route | 1. Academica route: The usage of environmental data for the purposes of examining government credit policy on the level and the volatility of an economy is unique and effective. The model in Project 1's Paper 1 showing the impact of beliefs on risk-taking is also new to the best of our knowledge. The model in Project 1's Paper 2 to show the non-monotone effect of leverage and interest rate on risk-taking and productivity could stimulate new research ideas. The analysis in Project 2's paper can shed light on the debate of productivity, risk-taking, and low interest rates. 2. Non-academic route: The way we treat environment data may be of independent use to non-academics. The result of Project 1's Paper 2, i.e., the non-monotone effect of leverage and interest rate on risk-taking and productivity, could shed some light on current policy debates, especially the recent UK's low productivity growth. Project 2's paper has a similar contribution. |
| Sectors | Education,Financial Services, and Management Consultancy,Government, Democracy and Justice,Other |
| URL | https://drive.google.com/drive/folders/1SwLWbtdyL3550n82cxK_hmmgBbqDyqaM?usp=sharing |
| Description | One research paper has been included in the Bank of Canada working paper series. Please check https://publications.gc.ca/collections/collection_2022/banque-bank-canada/FB3-5-2022-27-eng.pdf This paper has been presented in various non-academic institutions, including regional Federal Reserve banks in the US. |
| Sector | Education,Government, Democracy and Justice |
| Impact Types | Policy & public services |
| Description | Collaboration on research on limited commitment, risk-taking, and monetary policy |
| Organisation | Shandong University |
| Country | China |
| Sector | Academic/University |
| PI Contribution | We provide our expertise and intellectual input in building the model of one paper. |
| Collaborator Contribution | Renbin Zhang from Shandong University provides intellectual input and designs numerical methods. |
| Impact | We now have one finished paper focusing on financial frictions (based on limited commitment) and risk-taking behaviours. We show how monetary policy may have a non-monotone effect on firm risk-taking and productivity growth. We are doing the follow-up paper by incorporating survey data about Chinese financial markets. These data contain useful information about investors' beliefs. |
| Start Year | 2020 |
| Description | Collaboration on research on search-and-matching in capital markets, liquidity, and monetary policy |
| Organisation | University of Wisconsin-Madison |
| Country | United States |
| Sector | Academic/University |
| PI Contribution | We provide our expertise and intellectual input in building the model and designing numerical methods for one research paper. |
| Collaborator Contribution | Prof Randall Wright from the University of Wisconsin Madison provides intellectual input in building the model as well as very generous input in delivering the research paper. He also presented the paper in many conferences and workshops. |
| Impact | We now have one finished paper that focuses on search-and-matching and liquidity in the secondary capital markets. We show how inflation is linked with new investment and secondary capital spending. The research paper is now revise-and-resubmit to the Journal of Political Economy, one of the top 5 general-interest journals in economics. |
| Start Year | 2020 |
| Description | Joint annual conference on macroeconomics and financial markets with Shanghai Jiao Tong University |
| Organisation | Shanghai Jiao Tong University |
| Country | China |
| Sector | Academic/University |
| PI Contribution | We started an annual conference in Shanghai in 2019 on macroeconomics and financial markets, with an emphasis on beliefs. The conference invites a senior economist and a group of junior economists for facilitating discussions. We invite some conference participants and we cover their travel costs. We also cover conference dinners. |
| Collaborator Contribution | The partner contributes to booking hotel accommodations, coffees, and lunches for all conference participants. The partner also invited some other speakers and cover their cost of transportation and accommodations. |
| Impact | The conference facilitates lively discussion on financial markets and macroeconomics in different countries. We plan to hold this conference every year. We also broadcast ESRC and of course UCL at the same time. Shanghai Jiao Tong University is arguably one of the top 5 universities in China. Please see the website here for further reference. http://macro-finance-workshop.weebly.com/ |
| Start Year | 2019 |
| Description | Joint workshops on macroeconomics and financial markets with LSE |
| Organisation | London School of Economics and Political Science (University of London) |
| Country | United Kingdom |
| Sector | Academic/University |
| PI Contribution | The team organized three workshops on recent research on macroeconomics and financial markets, with an application to the Chinese economy. The workshop invited many economists working in related areas, all based in the UK (so there is less concern about travel restrictions in 2022). |
| Collaborator Contribution | Shengxing Zhang from LSE (visiting UCL) invited distinguished Economists from many higher education institutions, including Princeton University, the University of Cambridge, LSE, Queen Mary, and many others. Provided generous feedback and comments to the research of our team and workshop participants. We rotate the organization between LSE and UCL. |
| Impact | The workshop provides lively discussion on financial markets and macroeconomics in the US, the UK, and China. We planned to hold this type of workshop more often in the UK, given that many countries still had travel restrictions in 2022. We also broadcast ESRC and, of course, UCL at the same time. |
| Start Year | 2022 |