Chen Daofu, Research Institute of Finance of DRC

Research Report No.002, 2008

I．Three Factors Drive the Surge of Stock Market and Real Estate Market in China

In recent two years, the price surge in Chinese stock market and real estate market has drawn common concern. What are the reasons behind such huge price increase?

1. Excess liquidity constitutes the necessary condition for the price surge in assets

Currently, it is commonly recognized that excess liquidity is the major reason behind the rise of asset price. In other words, excess liquidity is one of the necessary conditions for price hike in all domestic and international asset markets. But we should not conclude that excess liquidity directly leads to price hike in assets. Excess liquidity is a necessary condition rather than a sufficient condition for the price hike. Price hike in any kind of assets must be supported with certain amount of fund. However, fund support does not necessarily drive up asset price because some other factors are needed as well to raise the asset price.

The relation between asset price and excess liquidity can be clearly reflected in the history of excess liquidity and stock market fluctuation. The excess liquidity started emerging in China in 2002, yet due to various reasons, the stock market remained in bear market and was under valuation from 2002 to 2004 . It did not go up until the end of 2005. While in real estate market, slight growth took on in 2002 but huge price increase didn't appear until 2005.

In the meanwhile, we should understand that, rather than completely detached from each other, the price surge in assets and excess liquidity are correlated. Even under the circumstances where credit expansion is stringently restricted, the price surge in assets can create liquidity to some extent. If liquidity is mostly created for the purpose of speculation, excess liquidity will be brought about. Generally speaking, only a small part of credit is directly created by price rise in stock market as leverage measures haven't been introduced into Chinese stock market, even there are some credit transactions which violate regulations and price rise in stock market may influence credit expansion indirectly. By contrast, the price rise in real estate market will accelerate credit expansion of bank and create more liquidity, as mortgage is generally applied and the first payment is usually low at its initial stage. In other words, there is a huge financing leverage in real estate market. In short, price surge in assets and liquidity creation constitute an interactive process, which can never be analyzed separately. As to banks, credit creation is related to capital expansion. In China, bank credit is expanded mainly on the basis of assets in society (secured loan). In recent years, the expansion of non-credit assets play a more and more important role in the credit expansion of the bank . Therefore, the price surge in assets reinforces the foundation for credit expansion. In a suitable macroeconomic environment and on favorable interest conditions, the liquidity in society will be greatly increased through either raising bank capital adequacy ratio or directly promoting bank credit expansion.

The current price surge in assets in China, particularly the price surge in stock market, is mainly the result of adjustment to citizens' financial assets distribution, or rather the result of structural adjustment to funds stock Over the long run, the financial investment channel in China is narrow. Lacking effective channels of financial investment, residents have to deposit money in the bank. As income grows, the saving deposit rises as well. Residents' awareness of financing is reinforced as the financial competition gets fiercer. They pay increasing attention to reasonable allocation of their deposits. Vigorous stock market attracts lots of residents' deposits so that the growth rate of saving deposits has dropped drastically in 2007. There even appeared negative growth rate in terms of saving deposits during several months. All this indicates that the capital in Chinese stock market is mainly transferred from saving deposits rather than created by bank itself. In micro-sense, stock market in China chiefly reflects the re-distribution of residents' wealth. Saving deposit represents the accumulation of excess liquidity from the past and is the result of structural transformation of the financial assets liquidity in the society.

Therefore, in spite of bolstering the price rise in real estate and stocks, excess liquidity is not the only reason that causes the price rise in assets. It is for sure that we should reverse the current situation of excess liquidity, because the price will naturally fall down as long as excess liquidity is reduced to normal. However, we cannot therefore come to the one-to-one-correspondent conclusion between liquidity and price rise in assets. The subprime mortgage crisis in the United States has ignited credit crisis in society, causing huge fluctuations in financial market after the sudden reverse of excess liquidity. It shows that excess liquidity and asset price are closely related to rather than independent from each other. Money supply is a necessary condition supporting price rise in assets. When the supply is tightened, assets price will fall and exert influence on the real economy.

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