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| How Leverage Affects Asset Prices: Evidence from a Natural Experiment in China's Bond Markets |
| WANG Yongqin, XU Hongxun
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| School of Economics, Fudan University |
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Abstract Asset leverage has been the focus of academic research since the recent global financial crisis, and deleveraging has been at the heart of policy discussion. Leveraging and deleveraging are associated with the rise and fall of asset prices.
In the modern financial system, collateral-based financial markets and monetary markets have become increasingly important. Investors can use their assets as collateral to borrow money. For instance, if a haircut is 20%, they can borrow an amount equal to 80% of the asset value (here Loan-to-Value, or LTV is 80%). Generally, for an asset, the following holds: leverage=1/(1-LTV)=1/haircut. The haircut reflects the lender's fear that the value of the collateral will fall in the future. The greater the fear, the higher the haircut, hence the leverage will be lower.
Leverage theory a la Geanakoplos shows that an increase in leverage will increase the asset price, because higher leverage better reflects optimism about the price; while due to short-sale constraints, the pessimistic view cannot be incorporated in the price. Leverage-induced boom-bust cycles lead to a fragile financial system and a volatile economy. Leverage cycles are a recurring historical phenomenon. Margin finance in the stock and housing markets is related to the Great Depression of 1929–1933 and the Great Recession following the 2008 financial crisis, respectively. China's stock market crash of 2015 is also related to margin finance.
Although theory and history both have shown the importance of the leverage cycle, due to the endogeneity of leverage and asset prices in the financial system, it is notoriously hard to establish the causal effect of leverage on asset prices. This study is the first to exploit a natural experiment in China's bond markets in which the same type of bonds traded in both the inter-bank market and the exchange has differential regulatory margin requirements. It exploits this experiment to identify the causal effect of leverage by using data on bonds issued from January 2017 to August 2017 in these two markets.
The study makes the following contributions. First, it is among the first to use a natural experiment to identify the causal effects of leverage on asset prices. Second, it sheds light on the market microstructure in the bond market; third, it sheds light on macro-prudential regulation and monetary policy.
The natural experiment is as follows. The China Securities Depository and Clearing Corporation Limited (CSDC) is in charge of the registration, depository, and clearing of bonds listed on the exchange, while the Shanghai Clearing House is in charge of those listed in the inter-bank market. On April 7th, 2017, the CSDC adjusted the pledging qualification for corporate bonds and removed from the collateral basket all corporate bonds listed on the exchange with a rating below AAA. This change only affected bonds issued after April 7th, 2017.
In this context, this paper tries to show that the change in spreads of AA bonds listed on the exchange is significantly larger than those listed on the inter-bank bond market.
The main idea is to exploit this new regulation as a natural experiment, thus the AA bonds listed on the exchange are taken as the treatment group and those in the inter-bank bond market as the control group. Using a difference-in-differences methodology, we test whether the collateral requirement (hence leverage) caused a change in price. The sample is the AA bonds issued on the exchange (including both the Shanghai and Shenzhen Stock Exchanges) between January and August 2017.
The paper finds that leverage can increase the price of a bond by as much as 70 basis points. This finding is consistent with theoretical predictions, and is robust to tests with different time windows for the new regulation and to placebo tests. This paper also tests for parallel trends to see whether companies in the sample strategically choose the venue of issuance, and finds that potential strategic shopping does not affect the results.
The paper thus establishes the causal effect of leverage on asset prices. It has important implications for financial markets and monetary policy. For a long time, economists and central bankers have regarded interest rates as the most important variable in the economy. However, in the modern collateral-based financial system, leverage is sometimes more important. In terms of monetary policy, central banks have never regarded leverage as a tool, and this neglect has caused the failure of interest rate-based monetary policy and the recurrence of leverage cycles. An ideal monetary policy should take both leverage and interest rates into account.
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Received: 06 July 2018
Published: 01 April 2019
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