Macro abc

Asian Economics Global Research

 Little has changed: easy money still risks

The Anatomy of blowing asset bubbles across the region

 Impending monetary loosening in the US

Bubbles will only aggravate Asia’s policy dilemma
Touched up and improved
 We explore the evolution of bubbles with
insights from behavioural economics

Here we go again
Regular readers will recall our series on the anatomy of asset
bubbles last year, warning of the risk of loose monetary and
financial conditions. This call remains well on track. We thus
thought it would be worthwhile to issue an updated version of
the series, drawing renewed attention to Asia’s policy dilemma.

Asset bubbles are curious animals. They evolve in stages,

rather than in a straight line. Excessive caution usually breeds
policy inaction with ultimately fatal consequences. A better
understanding of their evolution is essential for investors and
officials alike to avoid the pitfalls strewn across their path.

Averting asset bubbles is easier said than done. No doubt. As

we noted elsewhere (see The options: what can Asia do about
bubbles?), the region faces a tough set of policy challenges.
The options include appreciation, rate hikes, capital controls,
tighter financial regulation and fiscal consolidation. No single
measure will prove sufficient. Only a mix will do. This raises
policy risks. The next few months, therefore, could be rather
volatile: the West eases and the East needs to respond. Decisive
action is needed. Whether it is coming is by no means clear.

Chapter one looks at the initial conditions required for the

21 October 2010
Frederic Neumann
Economist
The Hongkong and Shanghai Banking Corporation Limited
+852 2822 4556 fredericneumann@hsbc.com.hk
View HSBC Global Research at: http://www.research.hsbc.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc,
and is not registered/qualified pursuant to FINRA regulations
Issuer of report: The Hongkong and Shanghai Banking
Corporation Limited
Disclaimer & Disclosures
This report must be read with the
disclosures and the analyst certifications
in the Disclosure appendix, and with the
Disclaimer, which forms part of it
occurrence of asset bubbles. Uncertainty is needed to keep
policy-makers forgiving, even as investors ready the lotion
and jump in the pool. Chapter two deals with what’s needed
to sustain the run. Leverage is essential, and rising asset values
render marginal tightening ineffective. Chapter three closes
in on the end, when a powerful narrative justifies dizzying
valuations, and even the most hawkish policy-makers can
get carried away with the frenzy before the show unravels.
We pay particular attention to psychological findings and
what new behavioural insights teach us. If you think it’s still
about strict rationality, we suggest you open a newspaper
every once in a while.
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Uncertainty rules
 Asset bubbles have their origin in prolonged policy accommodation,
with officials worrying more about faltering growth than investors
 The current outlook for global growth remains precarious, leaving
policy-makers, especially in Asia, reluctant to tighten aggressively
 The recent run in asset prices, however, will require a breather for
a true asset bubble to develop, otherwise it will wither prematurely

We just don’t know
In the beginning there is uncertainty. Economic
prospects at this stage are extremely difficult to
judge and risks are deemed to be extraordinary in
an historical context. This, then, elicits a
prolonged period of policy accommodation: rates
are kept low, or extra cash may even be injected
into the economy, to guard against tail-risks of
economic calamity. It is difficult to appreciate in
hindsight the uncertainties that are involved in
policy decisions at any one point in time. But, the
future, as our readers well know, remains
impossible to predict. One is left, therefore, only
with the certainty of contemporary facts, which at
this stage draw a dark, discouraging picture of
possible economic abyss.
Only think of the US housing bubble. It is now
commonplace to suggest that one of the main
contributing factors was an extended period of
low interest rates between about 2001 and 2004.
Other factors, of course, mattered as well, such as
the inflow of foreign savings and new financial
instruments; but monetary accommodation in the
run-up to the bubble played a central role. Why
were interest rates not raised earlier?
Wind back the clock for a moment. In the aftermath
of the tech bust, concerns in the US centred on the
risks of deflation. After the dreadful experience that
Japan had just suffered through, and with various
price gauges plunging to unaccustomed depth,
monetary officials worried that the United States
might slip into a similar trap where prices would
fall and turn the tech rout into a decade-long slog.
To top things off, a dramatic terrorist attack kept
everyone on edge, as did a subsequent war in Iraq.
At the time, it hardly seemed justified to raise
interest rates to prevent a housing bubble that
could conceivably develop years down the road.
They aren’t alike
All pretty straight-forward. But one puzzle remains:
if uncertainties are such that policy-makers will
not tighten monetary policy, why would investors
venture out and start to buy assets, kicking off an
asset price spiral that years later ends up in a full-
blown bubble? After all, the same information is
available to all. If investors are brave enough to
jump into the pool in spite of lingering uncertainties,
officials should act as well and put an early stop
to the incipient party.

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The answer to this puzzle relates to asymmetric pay-
offs between policy-makers and investors. Officials,
by and large, fear losses more than investors, while
investors have a greater yearning for gains. A central
banker, to put it bluntly, will not see his life changed
if growth rebounds swiftly and pushes towards or
even beyond trend. But, should the economy remain
stuck in recession, or fail to meet expectations, he
will surely be saddled with most of the blame.
The daring investor, on the other hand, can reap
very substantial rewards by buying assets early in
the cycle. No doubt, he fears losses, too, but the
prospect of outsized gains handsomely
compensates for taking risks.
In short, under uncertainty, policy-makers are biased
towards leaving in place monetary accommodation,
fearing a continued, re-renewed, plunge in activity.
Investors, meanwhile, facing the same degree of
uncertainty, nevertheless venture to buy assets
because their potential returns help compensate
them for any risks they are taking.
Recent insights from behavioural finance add
another layer to this analysis. There is evidence
that the subjective interpretation of relative risks
depends greatly on the potential pay-offs that
someone receives. So, if central bankers are
relatively more exposed to losses than to gains,
they will tend to interpret available information in
a more cautious light. On the other hand, investors,
who would gain relatively more from a strong
rebound in growth and financial markets, are more
likely to see green-shoots sprouting. Under
uncertainty, in short, the conclusions that officials
and market participants draw about the prospects
for growth and relative risks will tend to differ.
Why we care
Currently, uncertainties about the future path of
growth remain extraordinarily large. As a result,
officials have maintained monetary accommodation
even as asset markets have started to rally. What’s
striking is that the interpretation of officials and
investors of economic risks is also differing
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markedly: central bank statements, and official
pronouncements, continuously underline the
ongoing risks to the world economy, while
investors seem to shrug off those worries. As a
result, monetary policy has stayed accommodative
even as financial assets rallied impressively.
The question is, what happens next? Given the
severe dislocation in financial markets and industrial
output over the past two years, the unusual nature of
this recession, which centres on a US financial bust
with persisting deleveraging pressures, and the
enormous challenges of global rebalancing that this
episode has exacted, we suspect that growth
uncertainties will linger for quite some time. Thus,
monetary accommodation will not disappear any
time soon, whether in Asia or elsewhere, laying the
ground for a secular rally in Asian asset markets.
There is, however, a nuance to this story that is well
worth remembering. Uncertainty is partly a function
of the performance of financial markets: prolonged
rallies can help dispel some of the uncertainties
about future growth, not least because powerful
wealth effects begin to kick in. If this occurs, then
officials are no longer biased towards monetary
accommodation, becoming far more confident in
their assessment of economic recovery. The upshot,
then, is this: if markets continue to rally as they have
over the past few months, the risk rises that policy-
makers will tighten the reins and put a stop to the
incipient bubble. True asset bubbles, in short, require
a periodic eruption of uncertainties over future
growth prospects sharp enough to prompt a
temporary correction in financial markets.
Needing a breather
Note that we don’t think that the recent rally has
been strong enough to fully dispel lingering doubts
among policy-makers about a lasting rebound in
growth. Still, a sustained asset bubble in Asia,
fuelled by loose monetary policy, is only possible
if asset markets take a breather every once in a
while to preserve a modicum of uncertainty.
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There is another insight from behavioural finance
that is worth addressing. Periods of consolidation
are also needed because they help reshuffle investor
participation. True, sustained bubbles draw in a
broad range of participants over time; but new
buyers only emerge if prices settle temporarily.
The reason for this is simple psychology: the most
powerful reference point for any investor in deciding
whether to part with his cash is the recent price
history of an asset. A big jump in prices tends to
discourage new investors more than it lures them.
What’s needed is a periodic lull in activity that
convinces potential buyers that they haven’t missed
the boat entirely. Fundamentals, in fact, matter far
less than they should, at least according to
conventional models.
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Runaway asset prices, in short, tend to narrow the
investor base, rendering it less likely that a rally
will mature into a full blown bubble. Periods of
consolidation are thus required to offer others the
opportunity to participate in the run-up at a
seemingly decent price. When such a period of
consolidation will occur in this particular rally is
extremely difficult to say. But, after an impressive
run-up over the last few months, we may be getting
closer to the point at which such a breather
becomes necessary. Otherwise, this rally may never
mature into a true asset bubble, either because
policy-makers step in, or because potential
investors take fright at the seemingly ineluctable
rise in prices.
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Need marginal buyers

 The cash for asset purchases must come, over time, from either
profits or leverage, with the latter often associated with bubbles
 Interest rates are low across the world, but Asia has the balance
sheet strength to lever up, which is why bubbles are a risk here
 Apart from leverage, every bubble requires a narrative that justifies
the escalation of asset prices, and Asia’s story is quickly unfolding

A sustained rally, or a bubble, requires a marginal
buyer of assets. Funds for such purchases have
only two sources: profits and leverage. In general,
the former is associated with sustained rallies,
while the latter is more commonly found in asset
bubbles. Over the coming years, the outlook for
profits remains a little challenging as excess capacity
and rising raw material costs squeeze margins. So
leverage remains the main source of cash for
marginal asset purchases. Asia is among the few
regions in the world able to lever up. That’s why
bubbles are more likely to occur here.
The bigger picture
We are all a little too caught up in the daily grind
of financial markets. It helps to take a step back
every once in a while. What drives asset prices
over time is not so much the relative performance
of a company or sector, or the relative preference
of investors for bonds and stocks. These things
matter, of course. But in the long-run any run-up
in asset prices can only be sustained if extra cash
is being generated for their marginal purchase.
Broadly speaking, there are only two sources for
such funds. The first arises if past economic
investments yield healthy returns. The resulting
profits, then, generate the cash that can be used
for asset purchases. What’s more is that the robust
returns on such investment, as long as they prove
sustained, justify rising asset prices. The second
source is financial leverage whereby the financial
system generates extra cash that ends up fuelling
the demand for assets. Note that financial leverage
can occur when underlying profits are not rising,
although investors certainly expect profits, whether
speculative or economic, to increase in the future.
Of interest here are only rallies sustained over the
course of a few years, not the short-term gyrations
that financial markets are prone to. Take the
stunning rebound since the lows markets reached
in March of last year. The move has surely been
impressive. But, arguably, it doesn’t include the
ingredients of a sustained rally. For one, there has
been no jump in structural profits in the economy:
cyclically, of course, profits have begun to recover,
but this reflects merely normalization after an
unusually deep slump. In addition, with the notable
exception of China, there has been no real rise in
leverage. Rather, the Western financial system is
still de-leveraging, a process that will continue for
quite some time.

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From an economic perspective, therefore, all that has
occurred is that asset prices have normalized after a
tremendous confidence shock: marginal purchases
have been driven by cash returning from the
sidelines after a major sell-off. Technically,
therefore, this has been merely a rotation in asset
allocation away from money. An additional source
of funds, evidently, has been central bank purchases
of assets with newly created cash. On the whole,
however, we would hardly regard this as the primary
driver of the recent rally, though certainly a useful
confidence boost. In any event, central bank money
creation is not a sustainable source of cash for
marginal asset purchases, even if some central banks
in the West may be gearing up again to print cash.
Looking for a driver
We’ll leave our strategists to comment on the near-
term performance of financial markets, a call that
depends much on when and where residual cash
holdings will be deployed. Suffice to say here that
from an economic perspective, the recent rally can
hardly prove sustained without a rise in structural
profits or financial leverage. On both fronts,
however, the global economy is facing challenges.
Take profits first. It is true that in the United
States, for example, corporate profits have been
surprisingly resilient. This, however, is largely
due to the relentless rationalization of the labour
force rather than fundamentally higher returns on
capital investment or a rise in structural productivity
(there was, admittedly, an increase in cyclical
productivity, which is associated generally with
rationalization, rather than structural increase such
as the discovery of a new technology).
It remains to be seen, therefore, whether the gains
in profits can be sustained. In the US and elsewhere,
there are reasons to remain sceptical about a lasting,
structural improvement in profitability: not only are
capacity utilization rates still at extremely depressed
levels, but raw material prices are also rising for
structural reasons. Profit margins, in short, will
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remain under pressure for quite some time. Beyond
rationalization, the only way profits can continue
to grow is with gains in total factor productivity,
which usually requires an increase in capital
investment, preferably of the judicious kind, and
rapid improvements in technology. We are not
arguing that these are impossible to achieve, but,
at the current juncture, such advances certainly do
not feature in the justification of asset price gains
and we would suggest that advances of that nature
are still quite some time away.
This leaves leverage. Here, too, it is difficult to
see the global financial system leveraging up in
the coming years. The process of deleveraging, as
noted, will persist for many years in Western
economies. As a result, it appears misplaced to
expect the emergence of an asset bubble in these
markets so soon after the last has collapsed. But,
this doesn’t mean that local asset bubbles could
not develop elsewhere in the world. Most notably
in Asia, balance sheets, whether among firms,
financial institutions, or households, remain in
fairly robust shape. Excess liquidity, coupled with
record low interest rates, a state that we expect to
persist, provides a powerful ferment for rising
leverage across the region.
Need to believe
But, even if the ingredients of flush liquidity, robust
balance sheets, and low interest rates are in place,
this in itself doesn’t necessarily entail rising
leverage. For this to occur, an additional factor is
required: confidence. Even with cash in hand, the
marginal buyer will only step forward if he truly
believes that the future is bright. It is, of course,
difficult to judge whether sufficient optimism will
take hold in Asia for leverage to build and an asset
bubble to ensue. But, recent insights into behavioural
patterns of investors offer some clues and suggest
that the region may indeed be gaining the confidence
to step up its game.
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The first observation relates to risk appetite among return to the old days of heady growth. Whether
investors over time. Bubbles and busts appear with this view is justified or not is not the point: rather,
a remarkable periodicity, usually some 10 to 15 confidence in Asia remains such that risk appetite
years apart. This has both institutional and may well continue to flourish.
behavioural reasons. Institutionally, many financial
There is another insight from the behavioural school
market participants of previous busts are no longer
that is useful. Rather than being strictly objective,
around and a younger, more aggressive crowd has
investors need to frame their decisions. As tempting
taken over. This matters because most investors
as it is to believe that profit projections and other
therefore no longer possess the necessary dose of
such forecasts have a scientific foundation in
risk aversion, which a bursting bubble inevitably
analysts’ models, in reality they are contingent
instils. But even among those market participants
upon a qualitative assessment of the future. What
who lived through the previous bust, the impression
matters, therefore, is an interpretative paradigm of
fades over time, with some studies suggesting that
where the economy is currently headed in order to
the rate of decay of such recollections is exponential.
anchor subjective expectations as well as the various
Asia’s bust is now 13 years in the past and the risk assumptions that ultimately feed into our models.
aversion that the financial crisis originally Such narrative is all the more important because
engendered has now disappeared. The region, in financial markets trade on expected, rather than
short, is ready to leap once more. In fact, upon realized, profits.
closer inspection, it is evident that Asia started to
Looking at past bubbles, it quickly becomes
re-lever already in late 2006 or early 2007,
apparent that an essential ingredient is a perceived
concluding a ten-year period of continuous de-
“game changer”, or the “next big thing”, which
leveraging and lingering risk aversion. Loan to
supposedly alters the way the economy operates
deposit ratios, for example, started to increase
and thus affects prospects for returns. The tech
again around that time, while asset values, most
bubble is perhaps the most notable in this respect,
notably property, started to rise rather briskly.
with investors being swept into a frenzy about how
This process was only temporarily interrupted by
the internet would change the world. But, every
the Lehman bust, and we have now quickly
such episode evolves from a particular narrative:
returned to a giant re-leveraging cycle that was
even the housing boom in the United States was
already underway before the recent crisis hit.
justified by the assumption that interest rates had
There are other indications that confidence has reached a permanent low due to superior monetary
returned in Asia more swiftly than elsewhere. policy and financial wizardry. We only remind our
Consumer confidence indices, for instance, have readers of the tale about the “Great Moderation”.
rebounded sharply after the Lehman shake-up,
In Asia today, a bubble mentality may well be
unlike similar measures in the West. This underlines
taking hold. No longer trapped by risk aversion,
a crucial point: the crisis, while devastating for
financial market participants in the region are
industrial output in Asia, had nowhere near as
displaying a remarkable appetite for assets despite
large an effect on confidence as it did in the West.
the severe slump over the last few months.
There is a prevailing sense, quite evident for
Arguably, the recent crisis itself has provided the
residents in the region, that the financial crisis was
region with the next paradigm it requires: that
fundamentally a Western affair and that, while
Asia has matured enough to shape its own destiny
representing real challenges, Asia will swiftly
irrespective of developments in the United States.

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And as with any such narrative, there is an

element of truth in it, although to what degree this
justifies run-away asset valuations remains to be
seen. The paradigm now concerns the issue of
Asia, and foremost of China, coming of age. After
all, what investor, Asian and Western alike, can
resist the lure of almost three billion consumers
finally starting to spend? And so, the story begins.

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It feels good
 Bubbles develop their own momentum, first slow, then speedy,
but, as the years wash by, progressively more difficult to stop
 Incremental tightening quickly loses its effectiveness as investors
shrug off hikes and rising asset values ease financial conditions
 Harsher policy steps are often avoided until it’s too late, with even
determined hawks blinded by the levity that asset bubbles entail

Once an asset bubble gets under way, it becomes
exceedingly difficult to stop. Conventional
monetary policy is swiftly overwhelmed by the
momentum of an asset price spiral, and marginal
rate increases lack the potency to stop the train in
its tracks. This highlights the need for pre-emptive
rate hikes in order to prevent a bubble from
forming in the first place. But policy-makers fear
losses more than gains in the early stages and
remain accommodative. Once the bubble matures,
euphoria grips officials as well, enabling them to
buy into the rationalization for the dizzying rise in
asset prices. Until the bubble pops.
Hitting the accelerator
One of the curious aspects of an asset bubble is
that it is immune to marginal interest rate increases.
Consider, again, the recent experience in the US:
once economic uncertainties and perceived risks
of deflation dissipated in 2004, the Federal Reserve
embarked on a series of interest rate hikes. Yet,
monetary tightening had no influence on the
housing market. Rather, the hot phase of the
property rally was between 2004 and 2006,
precisely the time when the Fed tightened the
screws. This is quite a common feature of bubbles:
asset price increases and interest rate hikes can
coexist for quite some time, with seemingly no
effect of the latter on the former.
What is the explanation for such impotency of
monetary policy? Two answers. First, consider the
notion of the financial accelerator. This essentially
states that rising asset prices boost the value of
collateral for loans. In turn, banks become more
willing to lend, loosening lending criteria and terms.
An initial cut in interest rates, therefore, carries
through over time via rising asset prices that
effectively prolong the impact of monetary easing.
This effect may eclipse the rise in interest rates so
that financial conditions – as opposed to monetary
conditions – become progressively looser and not
tighter, further fuelling asset price gains. The
financial accelerator, in short, reduces the potency of
rate hikes once an asset rally is under way.
The fact that banks loosen their lending criteria
during a run-up in asset prices is partly a behavioural
phenomenon. Bankers, along with everyone else,
are eventually infected by general euphoria about
prospects for growth and the consequent justification
for rising asset values. But, this is not an
instantaneous reaction to any rally. It takes time

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for loan officers and risk managers to react to
developments in asset markets. In any decision,
proximate experiences feature far more prominently
than more distant events. Initially, therefore, risk
aversion prevails following a bust. The longer the
rally endures, however, the more prevalent becomes
the impression of rising asset prices and lending
conditions are subsequently eased.
These insights hold immediate relevance for us
today. Despite the debate about the timing of exit
strategies of central banks, it is far from certain
that a gradual tightening of monetary conditions
over the coming quarters would have a similar
impact on financial conditions and therefore
curtail the appreciation of asset prices. Following
the recent bust, lending criteria, even in Asia,
remain tight and are only now showing signs of
being gradually relaxed. Even the most hawkish
advocates of rate increases hardly expect a big
jump in policy rates by late 2011. Gradual rate
hikes, therefore, may well be offset by a loosening
of lending criteria among commercial banks.
Of course, there are notable differences among
countries. In China, if anything, lending criteria
may be tightened after being extremely loose over
the past two years, although even here rising asset
prices may offset some of the intended tightening
effect. Elsewhere in Asia, the run-up in asset
prices is likely to serve as a more powerful
financial accelerator: bank lending guidelines are
less controlled by policy-makers and because
commercial banks had tightened criteria more
during the crisis than in China, they still have
some way to go towards normalization. In the
West, meanwhile, lending criteria may be relaxed
more gradually than in Asia, reducing any
immediate risk of an asset bubble. Moreover, even
if bank officers are starting to ease conditions in
these countries, the disappearance of the shadow
banking system will weigh on the overall availability
of credit for years to come.
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Getting used to it
Apart from the financial accelerator, there is a
second reason why the potency of rate hikes can
be surprisingly limited. Once again, consider the
US housing bubble. The Federal Reserve, as
mentioned, raised interest rates considerably
between 2004 and 2006. However, long-term
interest rates did not rise in accordance, something
termed a “conundrum” at the time. This, in effect,
allowed the housing bubble to flourish despite
hikes in the Fed Funds rate. One explanation
frequently put forward was that inflows of foreign
savings, especially by Asian central banks with a
penchant for secure long-term investments, pushed
down benchmark rates along the yield curve.
There may be something to this explanation,
although we wouldn’t push that argument too far
since it is not clear that there was indeed a global
glut of savings as many had argued at the time.
Rather, our argument concerns market psychology
and the strategy for US rate hikes. The Federal
Reserve raised interest rates at 25bp increments
over a period of more than two years. This was a
fairly predictable and consistent pattern of
monetary tightening, justified in part by the
prevalent belief among central bankers that
monetary policy needs to be as transparent and
unsurprising as possible to allow the market to
properly price risk. The trouble with this
approach, however, is that it engenders something
termed “habituation” among investors: consistent
and predictable policy rate hikes lose their
potency because they are anticipated by the
market, pushing down the risk premium on long-
term bonds even as the policy rate rises.
Currently, with uncertainties over the future path
of growth extraordinarily large, and central
bankers still wedded to the concept of the need for
predictability and transparency in monetary
policy, we fear that officials will repeat the
mistake of the past, which was to tighten too
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21 October 2010
gradually and predictably. This, in turn, may once
more lead to habituation among investors, who
will come to shrug off any rate hikes as essentially
inconsequential for their investment prospects.
What would be needed, in fact, is for central banks
to inject a degree of “deliberate uncertainty” into
financial markets in order to avoid habituation and
thus raise the potency of any rate hikes. Such
uncertainty may be generated by raising rates
more than the market anticipates at any particular
policy-meeting, thus preserving a certain level of
policy risk premium in the pricing of securities.
How likely is it that central banks will follow these
insights from the behavioural school? We doubt
officials will adopt strategies of injecting deliberate
uncertainty into financial markets. In the West, a
number of central banks have already committed
themselves to keeping interest rates low and stable
for a long time, implying rate hikes will materialize
only gradually and likely in a predictable manner.
In Asia, central banks have in the past acted a little
less predictably. Only this week, officials in China
hiked rates to everyone’s surprise. In Korea and
Taiwan, too, the authorities are prone to throwing
the occasional curve-ball at the market. But, in a
region of general asset price appreciation over the
coming years, and given the scale of the
dislocation of monetary conditions, even this may
not be sufficient to inject the necessary policy
uncertainty to prevent bubbles from growing.
One possibility, however, is that policy-makers use
surprise regulatory tightening to shake things up.
As we noted elsewhere (see The options), Asia is
facing a number of policy constraints currently,
making it necessary to resort to a mix of different
measures to prevent asset bubbles, including fiscal
consolidation, capital controls, exchange rate
appreciation, and financial regulation. The variety
of measures, and in many cases their untested
nature, certainly raises investor risk and may lead
to surprise policy announcements over the coming
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months. But, whether this is enough to redress the
structural imbalance in world monetary condition
requirements (Western easing, Eastern tightening)
remains to be seen.
Caught in the act
Once bubbles are in full swing, central banks
evidently need to tighten aggressively and
surprisingly in order to derail asset price momentum.
But, over the latter stages of such rallies, policy-
makers tend to remain comparatively inactive as
well. There is a behavioural reason for this. The
supporting narrative for the rally eventually acquires
some plausibility among everyone involved,
including officials. Especially in emerging markets,
rising asset prices are often taken as a sign of
economic success. Given that policy-makers in these
economies are usually more intimately involved with
guiding the economy than in advanced markets,
there is a tendency to interpret a rise in asset prices
as corroborating the expediency of public policy,
rather than being a folly of the market. This is, in
fact, quite human: decision-makers are prone to
interpreting available information as
substantiating their prior actions.
With economic policy thus remaining
accommodative, asset prices continue to rise,
usually at an ever-accelerating pace, until the final
collapse arrives. While it is tempting to think that
public policy usually puts a stop to bubbles, this is
in fact incorrect: most such rallies tend to fizzle out
on their own, mostly because the cumulative
misallocation of capital over the course of the
investment boom starts to generate losses that
gnaw at the confidence of investors. With falling
profits and declining leverage, the marginal buyer
of assets, so crucial to sustain the run, eventually
disappears. The collapse, then, comes hard and fast.
And policy-makers are tasked to clean up the mess.
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Our world, now How likely is an asset bubble in Asia over the
coming few years? Quite. Although hardly
In the first three chapters we outlined the different
inevitable. Already, markets have rebounded
stages of asset bubbles, paying particular attention
sharply as idle cash was rapidly deployed. A
to new insights from behavioural economics. In the
breather may eventually be necessary to sustain
first stage, unusual economic uncertainty leaves
the run in asset prices, given that a consolidation
policy-makers biased for accommodation, fearing
would allow policy-makers to remain
a relapse into recession more than investors do.
accommodative and other investors to buy into the
Markets, in this phase, rally as idle cash is deployed
market. Economic uncertainties are likely to remain
from the sidelines, leading to a quick rebound from
such that officials are not in a position to tighten
the panic sell-off that gripped the market during
monetary policy aggressively any time soon.
the earlier bust. A cash rally, however, only carries
Moreover, even if profits may not materialize, the
so far and for the run-up to be sustained either
region’s financial systems remain capable of
profits need to rise or leverage has to build.
generating substantial further leverage to power a
As valuations approach bubble territory, a sustained run in asset prices.
powerful narrative emerges that justifies higher
Lastly, there is palpable optimism that the region
asset prices still. Eventually, these help to lift
will indeed be the “next big thing” on the global
growth and dispel residual uncertainties about
economic agenda. The key, therefore, is whether
economic prospects. At this stage, policy-makers
policy-makers will eventually step up to the task
begin to tighten monetary policy. But, marginal
and spoil the party. History suggests that this is
rate hikes often have little impact, being eclipsed
extremely difficult to do and the current mindset
by the rise in collateral value, which loosens
among the region’s central bankers makes
financial conditions further. As the bubble matures,
decisive action arguably less likely. Not every
a more aggressive monetary policy response is
recession, of course, sets the stage for an asset
called for but not forthcoming: officials themselves
bubble, but, as things stand currently, this looks
start to be caught up in the narrative, in part
like one of those times.
because the alleged economic gains reflect positively
on the conduct of public policy. As losses mount,
the run in assets eventually turns into a rout.

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Asian Economics abc
21 October 2010

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Asian Economics abc
21 October 2010

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14
 abc

Global Economics Research Team

Global Emerging Europe, Middle East and Africa
Stephen King Alexander Morozov
Global Head of Economics +7 495 783 8855 alexander.morozov@hsbc.com
+44 20 7991 6700 stephen.king@hsbcib.com Murat Ulgen
Karen Ward +90 212 376 4619 muratulgen@hsbc.com.tr
Senior Global Economist Simon Williams
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Europe Latin America
Janet Henry Argentina
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+44 20 7991 6711 janet.henry@hsbcib.com Chief Economist, South America ex-Brazil
Astrid Schilo +54 11 4344 8144 javier.finkman@hsbc.com.ar
+44 20 7991 6708 astrid.schilo@hsbcib.com Ramiro D Blazquez
Germany Senior Economist
Lothar Hessler +54 11 4348 5759 ramiro.blazquez@hsbc.com.ar
+49 21 1910 2906 lothar.hessler@hsbctrinkaus.de Jorge Morgenstern
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United Kingdom Andre Loes
Stuart Green Chief Economist
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Mexico
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Lorena Dominguez
Stewart Hall Economist
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Asia Pacific
Qu Hongbin
Managing Direct, Co-head Asian Economics Research and
Chief Economist Greater China
+852 2822 2025 hongbinqu@hsbc.com.hk
Frederic Neumann
Managing Direct, Co-head Asian Economics Research
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Seiji Shiraishi
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