By Zhuo Xian, Department of Development Strategy and Regional Economy of DRC

Research Report Vol.17 No.3, 2015

Since the international financial crisis in 2008, China’s economy is currently facing the severest downward pressure with the year-on-year GDP growth in the first quarter increasing by 7.0%, the lowest in the past six years. However the stock market rallied all the way from the second half of last year. At the end of April this year, the Shanghai composite index was 4441 points, more than the double of 2048 points in late June of 2014. Why do asset bubbles appear during the economic slowdown? Can bubbles only do harm to the real economy? What impacts do various bubbles have on innovation and economic transition after they burst? What can be done to prevent moderate economic bubbles from developing into bubble economy where economic transition stalls? This paper proposes countermeasures against bubble economy based on the analytical framework of interactions between economic transition and asset bubbles.

I. Asset bubbles are likely to develop during the transition period

A bubble is the state where an asset, such as stock and real estate, is traded at a price or price range that deviates from its value. In The New Palgrave Dictionary of Money and Finance, Kindleberger describes the word “bubble” as follows. “A bubble may be defined loosely as a sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers--generally speculators interested in profits from trading in the asset rather than its use or earnings capacity.” Proponents of the efficient market hypothesis (EMH) deny the existence of bubbles. They believe rational investors will drive asset prices down to their intrinsic values by risk-free arbitrage should the prices deviate from the intrinsic values. But in reality, cognitive limitations will lead to overoptimism, overconfidence and the sheep-and-flock effect in the market, and irrational exuberance deviating from the fundamentals.

Asset bubbles easily show up during the golden stages of economic growth driven by technological revolutions. For example, the railway craze in the United Kingdom and the canal craze in the United States in the early stage of industrialization are bubbles emerged in the process of rapid industrialization and urbanization. In some countries however, the economic growth slowed down while asset prices rose during the economic transition. South Korea is an example. Since the mid 1980s, the growth rate of per capita GDP started to drop from 10%, while the price-earnings ratio (or P/E ratio) did not stop rising until negative growth appeared as a result of the Asian financial crisis in 1998 (see Figure 1). Stocks in China’s A-shares market are traded at about 28 times earnings. As the valuation of the overall stock market is not high, the P/E ratio at the SME board and at the GE board is 63 times and 114 times respectively. Besides, more than half of the stocks of A-shares are traded at over 70 times earnings (Ha Jiming, 2015). Even as China’s economic growth slows down, some stocks have the same P/E ratio with those at NASDAQ before the popping of its bubbles.

Figure 1 Relationship Between Economic Growth and P/E Ratio in South Korea

Source: Wind, “medium and long-term development” database of Development Research Center of the State Council (DRC).

Bubbles show up during the economic transition because market participants have different behavior preferences. The reason why an economy transforms is that the structural imbalance between supply and demand arises, which hinders the improvement of production efficiency and weakens drivers for economic growth. During the transition period, changes take place in the behavior preferences of all market entities. Enterprises earn less profits from investing in traditional industries, but high earnings in the high-growth period drive investment into assets that will appreciate in the short term. From 1985 to 1990, for example, among the 405 trillion Japanese Yen financed by Japanese companies, 64% was invested in financial assets instead of equipment (Yukio Noguchi, 2004). Considering more uncertainties will come from investment during the transition, financial sectors define collateral, such as stocks, bonds, real estate, and land, as prerequisites for financing. Those investing in such assets are easier to finance, which creates the “accelerator effect” and boosts asset prices. In the transition period, government still regards high growth as the norm and adopts loose fiscal and monetary policies to expand demand as the economy slows down. In this case, bubbles will probably be produced.

For late-developing economies emerging after the Second World War, bubbles are more likely to appear during the transition. First of all, late-developing economies have a longer economic boom, more room for economic slowdown, and possibilities to accumulate more asset bubbles in the period of high-speed growth. Second, late-developing economies, especially those in east Asia, have incomplete price mechanisms for factor markets like land and capital. There are plenty of financial regulations and implicit government guarantees. Moreover price signals cannot fully reflect the relation between supply and demand. “Quantity bubbles”, like excessive construction in infrastructure, will probably emerge before “price bubbles”. Third, to push forward the transition, late-developing economies tend to implement financial reforms, represented by interest rate liberalization. Should reforms are not carried out properly, rising financing rate, caused by interest rate liberalization, will increase the cost of capital of the enterprises in real economy, lower the marginal revenue of capital in the traditional industries, weaken entrepreneurs’ enthusiasm in investing in real economy, and increase their interest in assets like real estate and stocks.

II. Productive bubbles drive innovation

Bubbles include productive bubbles and speculative bubbles. With the emergence of bubbles, comes the reallocation of capital and other relevant resources. If bubbles promote resources to gather in new technologies, new industries and new business models, and high prices reflect potential high earnings, such bubbles are productive bubbles. But if financial activities deviate from real economy, and high prices are caused by speculation, speculative bubbles will present themselves. Productive bubbles promote innovation. In the process of transition, innovation must, like steam engines, electrical technologies, and computers, be able to be applied into a variety of fields and to greatly expand the production possibilities frontier. The difficulty of such epoch-making innovation not only lies in technical feasibility but also economic feasibility due to the falling prices of key intermediate goods. Scientific researches can put cost aside. During the Second World War, Turing, funded 100,000 pounds by the British government, developed computers that are able to crack German codes.

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