Throughout the boom of the last few years, while central banks loosened their purse strings and many of us tried to find new ways of justifying why it was different this time, the Bank for International Settlements (BIS) has been a voice in the wilderness calling attention to growing risks. It’s worth taking a look, therefore, at two new papers published by the BIS in the Asian markets.
The first of them, “Asset Prices and Monetary Policy: Booms and Fat Tails in East Asia” by Maria Socorro Gochoco-Bautista of the University of the Philippine School of Economics, deals with the impact of asset price booms in the housing and equity markets on the real economy. The author says that a distribution characterized by “fat tails”, one in which the probability of being in the tail of bad outcomes, for example, is higher than if the distribution were normal. The existence of such “fat tails”, she says, will worsen the expected losses from asset booms. Why should this be a concern? Because, if it’s proved that the result of an asset price boom is a below-trend growth in output at a later period or a higher-than-trend inflation level, then there’s a reason for the central bank to take asset prices into account while deciding policy.
The researcher has studied data from eight East Asian countries—Hong Kong, Indonesia, Japan, South Korea, Malaysia, the Philippines, Singapore and Thailand. Boom periods start with rising asset prices and are typically periods of large positive deviations from trend, followed by declines in asset prices. This is true in practically all cases, with Hong Kong having the most number of distinct boom episodes. The exceptions are the cases of Indonesia and Thailand, in which the boom periods identified begin with flat rather than rising asset prices before sharp declines in asset prices are experienced. These countries saw much lower housing prices from previous highs in the aftermath of the Asian Financial Crisis of 1997. The main findings are: “(i) Asset price booms in housing and equity markets, either separately or jointly but especially in housing, significantly raise the probability that (a) the real output gap will be in the left tail of its distribution, in which output is significantly below trend, and (b) the price-level gap will be in the right tail of its distribution, in which the price level is significantly above trend.”
The Reserve Bank of India, for instance, has been concerned about the rise in housing prices and had taken steps to cool down the sector by measures such as raising the risk weight on loans to housing. The results of the study show that central banks would do well to look at asset prices while formulating monetary policy. If they had done so, perhaps Western central banks could have nipped the credit bubble earlier in the bud. As the author puts its: “This study implies that asset price booms are unlikely to have benign effects on the economy and can compromise the goals of monetary policy.”
The second paper tries to find out what determines foreign fund flows into Asian equity markets. The paper, “Understanding Asian equity flows, market returns and exchange rates” by Chayawadee Chai-Anant and Corrinne Ho, seeks to answer these questions: Are exchange rate gains/losses more of a driver or a consequence of foreign investor activity? How does foreign investor activity relate to Asian equity market returns? Do foreign investors tend to see the various equity markets in the region as similar entities? Do they tend to flock to Asian markets when times are good and rush for the exit together at the first sign of trouble? The authors study data from six emerging Asian markets: India, Indonesia, South Korea, Taiwan, the Philippines and Thailand.
What are the findings? Market strategists have said that with a weaker dollar, it makes sense for investors to put their money in non-dollar assets. However, the study finds that currency returns matter relatively little for net equity purchases. That seems rather counter-intuitive, till the authors point out that all it means is “stock market returns measured in foreign currencies tend to be dominated by the local currency return component rather than the exchange rate return component.” In other words, it’s the rise in the stock price that matters more. On the other hand, the currency markets are certainly affected by net equity flows. That’s rather clear these days, with the rupee going down to 40 to the US dollar as a result of FII outflows. The authors also find that foreign investors do on average chase returns, which means they buy more when returns are high and sell more when returns are less. That too is pretty obvious: the most egregious example of the short-sightedness of FIIs was evident in the Reliance Power IPO.
But there’s one finding that could provide some source of comfort. The authors point out that: “It is quite common to see foreign investors net-buy or net-sell equities in five or all six markets, simultaneously, on a given day. This result is not surprising, given that Asian equities are known to be influenced by common external factors such as US equity market returns or volatility. However, a more curious finding is that foreign investors tend to net-buy in multiple markets more often than net-sell. Thus, it seems that during our sample period, equity inflows are more a regional phenomenon, while outflows are more idiosyncratic.” This offers the hope that, once the dust settles, foreign investors may once again turn their attention to the relatively high-growth Indian market.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at email@example.com