Financial Market Frictions, Beliefs, and the Macroeconomy; An Application to the Case of China

Lead Research Organisation: University College London
Department Name: Economics


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.

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.


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Description 1. Findings during 2019 - 2020 AY

We carry out the research as planned on beliefs and firm leverage in the Chinese economy, through the lens of risk-taking by firms.

Increased liquidity that raises leverage will increase the funding opportunities in the economy. However, it may also encourage more risk-taking behaviours through default protections. We want to pin down to what extent the second channel generates unintended volatility to the economy.

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 we examine the effect of belief on leverage through this risk-taking channel. We also try to shed light on the effect of interest rate policy on firm performances. This part takes a longer time than we expected because of adjusting the model to be fit to the data. We estimate to have a working paper ready by the end of this summer.

2. Findings during 2020 - 2021 AY
CoViD had a significant adverse effect on the project. It changed our plan to collaborate, analyze and process useful 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 impact on risk-taking, which we still find significant step moving forward. The research paper supposed to be finished in 2020 will be resumed after the travelling restriction is eased, hopefully in the summer of 2021.

In this new but related paper, we do not focus on beliefs, but instead, put a lot more emphasis on the theoretical impact of leverage and interest rate policy on risk-taking behaviors. 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 happy 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 is high.

This relationship between leverage and risk-taking highlights that liquidity/monetary policies can generate a non-linear effect on risk-taking and on social welfare. A cut in interest rate may not encourage firms to implement risky but socially desirable projects when leverage is low. This is because a cut in interest generates mostly a wealth effect, and firms would like to secure a higher wealth by investing in the risk-free project to accumulate more capital. When leverage is high, however, a cut in interest rate can encourage risk-taking, because the substitution towards higher return is amplified by firm leverage.

Our study implies that 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/or interest rate low in equilibrium.

A draft of this paper is attached below in the url link.
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 the first paper (to be finished) showing the impact of beliefs on risk-taking is also noval to the best of our knowledge.

The model in the second paper to show the non-monotone effect of leverage and interest rate on risk-taking and productivity could stimulate new research ideas.

2. Non-academic route:
The way we treat environment data may be of independent use to non-academics.

The second paper's result, 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 low productivity growth of the recent decade observed in the UK.
Sectors Education,Financial Services, and Management Consultancy,Government, Democracy and Justice

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 Shanghai Jiao Tong University and 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 book hotel accommodations, coffees, and lunches for all conference participants. The partner also invites 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.
Start Year 2019