Liquidity And Asset Price Fluctuation

This paper endeavours to provide a comprehensive analysis of the nature and the possible importance of "excess liquidity", a concept which has attracted considerable attention in recent years. "The excess liquidity" reflects in three places:money market, commodity market and capital market. In money market, it embodies that money supply increase rapidly, and there is plenty of liquidity exist in financial institutes; In commodity market, the demand of domestic consume is insufficient and the pressure of inflation is high; In capital market, the asset price was soaring and the "bubble" existed. However, in late 2008, following with the U.S. "sub-prime crisis", global capital market experienced huge decline, and Chinese stock market is not a except with a maximum of 73% decline in the end of 2008. It seems that global economy suddenly dropped into a situation of "liquidity shortage".The plans issued by every government are all in one common:to recover the liquidity. During one year period, it is too early to say that the global economy has touched the bottom and bounce back up, whereas, in the irritation of economy policy, the global liquidity seems get ample back again, especially in China. Following with the change of liquidity, the asset price (defined by stock and housing price in this thesis) is also experiencing volatility, which largely affects the development of global economy.The variation of liquidity is disscussed by examining the liquidity condition in China during recent years. Depite of short time of "liquidity shortage" in 2008, the liquidity recover to nomal rapidly due to the expanding monetary policy and active fiscal policy laid down by government. In the three markets, i.e. money market, commodity market and financial market, "The excess liquidity" is embodied in different forms. We concluded that there exist relationship between liquidity and asset price.Whether the forms of "liquidity shortage", "excess liquidity" or "the transition of liqudity between them" reflect a kind of relax or tight money environment, and both executor and investor concern the character of changing asset price under different monetary policies. The theoretic relationship between the liquidity and asset price is addressed in the follows:the transmission mechanism of money policy told us that the increase of liquidity would induce the decrease of short term interest rate, which causing the decline of long term nominal interest rate and then causing the rising of stock price. The quantity theory of money and neoclasical economic theory demonstrate that in underemployed condition, the rising of liquidity would increase the outputs and the CPI would not largely fluctuate and asset price remain stable. However, in full employment condition, output would not rise together with the incease of excess liquidity, and the excess liquidity would flow into asset market and casuse the rising of asset price.The"excess liquidity" can affect the determinants of asset value and cause the revaluation of the asset (lower risk free rate of return, lower risk premium and temporal higher earning power of asset). In this process, the investor would revaluate the asset upward and push the asset price soaring. When this process proceeds, the likelihood of asset bubble is increasing. We test the relationship between the returns of three kinds of asset (stock, real asset and bond) and the currency liquidity by using the quarterly data in China during the period between 1998 to 2008. The results show that the stock and real estate return have positive relationship with currency liquidity, while the bond rerun have negative relationship.After testing the relationship between liquidity and asset price, we conclude the reasons of "excess liquidity" in the following:Global background factors:Huge amount of "hot money"swarms into China's capital market, casusing the liquidity to be excess and pushing the asset price to soar.The expansionary monetary policy performed by majority of governments pour the economy in too much liquidity.The enhanced process of globalization to reinforce and redistribute the "excess liquidity" from westen countries to China.Domestic background factors: The currency demand caused by monetization in China's economy is declining, while the authority still increase the currency supply irrelevantly;The currency demand caused by monetization in China's economy is declining, while the authority still increase the currency supply irrelevantly;The exchange rate system in China is improving but still lack flexibility, which cause that foreign currency exchange force the increase of currency supply.The "global excess liquidity" exists in many counties. Much foreign "hot moeny"which speculates the appreciation of RMB and China's capital market swarms into china and increase foreign currency reserve considerablely.The increase of GDP in China depends on international trade largely which cause a huge foreign trade surplus.The structure of the financial market is unbalance. The currency can not be transferred into capital timely and overstock in the banking system, which intensifies the excess liquidity.The interest rate controlling system and high reserve mental of Chinese people bring the bank of plenty of loanable funds.All the above reasons cause the excessive increase of currency supply, which lead to "excess liquidity".In macro economy, the "excess liquidity" normally can be absorbed by two channels:One of them is absorbed by commodity market which can cause inflation; the other is absorbed by capital market and increase the asset price. The CPI in China has been kept comparatively stable during recent periods; it is assumed that the excess liquidity has run into the capital market. When the supply of these assets is limited, the irrational booming of the asset price is inevitable.Asset price bubble will be formed when the irrational rising of the asset price reaches a certain extent, which could threaten the security of our financial market and even cause economic crisis. What happened in USA and Japan has given us some good examples and should be carefully studied.The Chinese government should lay down active strategies to control the "excess liquidity" and prevent the further growth of asset price bubbles. In the short run, it is crucial to avoid pricking the bubbles by using monetary policies, controlling the credit supply strictly, increasing the supply of the stock market to control the "excess liquidity", laying down the transparent policy to form stable and steady expectations. At the same time, adequate preparation is crucial for increasing the liquidity once the asset price bubbles breaks. In the long run, it is ought to expand and improve the capital market, establishing and perfecting financial system, pushing the interest rate and exchange rate to be more market-oriented, adjusting investment, increasing consumption, reducing trade surplus.