We’ve discussed on two previous occasions (which you can find here, and here) how the business cycle has been flattened due to higher productivity growth, snazzy technology, and a shift to services. However, this set in motion forces that made the creation of asset bubbles much more likely. How should central banks respond to this?
We could even say that the traditional business cycle has been superceded by some kind of boom-bust asset markets cycle. As lower inflation and higher productivity growth enabled much lower interest rates, asset markets gorged on the ensuing money creation.
How should central banks deal with those? There are basically three real world examples, The European central bank (ECB), The US Federal Reserve (Fed), and the Chinese central bank. Each has a different way of dealing with the new asset market dynamics.
The Chinese model
The Chinese central bank uses, somewhat unsurprisingly, the markets for political ends, although one has to say, quite successfully so. Policy makers see the stability of the vast country, which is undergoing an industrial revolution that took other countries a couple of centuries, as a prime goal.
Presently, one of the biggest challenges is how to employ all the workers that come from the poorer hinterland in search for a better future in the cities. This is one of the backbone’s of China’s growth, employment moving out from low productivity sectors in the countryside, to higher productivity sectors (industry and services) in the cities.
For this enormous transition to happen smoothly (sort off), the economy just needs to grow at a break-neck pace, otherwise, there won’t be enough jobs available and social unrest might flare up, or so the thinking goes.
But, such a fast growing economy also produces very good opportunities for stocks, needless to say. And since stockmarket investing is a rather recent phenomenon for some, not every investor has the required background knowledge, they can get carried away a little.
We have seen that in the last couple of years, when the Shanghai index exploded sixfould in two years. A couple of months ago, Chinese oil company PetroChina was theoretically the first company with a trillion dollar market capitalization.
Theoretically, because it was based on a small IPO in Shanghai, were it immediately traded at a staggering premium vis-à-vis it’s listings in Hong-Kong and New York. (Arbitrage is not possible, unfortunately as mainland Chinese can not invest in overseas markets yet.)
That was a good illustration of how wild things can get, and having learned from the Nikkei fall from it’s height set in December 1989 (it is still trading at less than half the top!) And the Nasdaq plunge from March 2000, the Chinese authorities intervened.
What did they do?
- Higher interest rates
- More stringent reserve requirements for banks
- Higher taxes on share transactions.
It worked. Since it’s peak in mid October 2007, the Shanghai index lost 50%. With the Olympic games coming up, that might have been a little ovedone, so at the end of last month, the decreased the share tax again by a token amount.
Investors were quick to take the cue from the authorities, the index moved up 15% in the two days after lowering the tax. Two conclusions:
- The Chinese authorities actively manage the asset markets
- The seem to be doing it pretty effectively, at least until now.
However, it’s doubtful whether other countries could follow a similar model. We’re pretty sceptical if the same kind of measures that seem so effective to steer the stockmarket are anywhere near as effective elsewhere.
That doesn’t mean authorities could not actively intervene in asset markets, as the next example shows, the American model, but we’ll leave that for the next time.