By Elsa Maria Joseph
The prices of property, stocks, and precious metals have been rising. MSCI global stock market index has risen by 12% and the MSCI emerging markets stock index has increased by 17% in the last one year. Gold prices soared by Rs 990—its biggest one-day surge this year—to Rs 31,350. This asset price inflation is keeping the Reserve Bank of India on its toes as the prices flirt with the levels that existed before the 2008 financial crisis.
Asset price inflation is an economic phenomenon. It denotes a rise in the price of assets such as bonds, shares, and their derivatives, as well as real estate and other capital goods. Ordinary goods and services do not count as assets in this sense. This suggests that the GDP does not account for asset price inflation.
The creation of asset bubble
Consumer Price Index—the standard measurement of inflation—does not take into account the rising asset prices. The seller will own additional cash when the value of an asset rises. That cash can be used to save, spend or invest. It may be used to purchase additional goods or services at some point down the road. This can grow the GDP. However, this is a mere illusion. The rise in asset prices raises the value of assets without a rise in the economic activity of the nation. This would just be another asset bubble in creation.
There are many reasons why the financial system may not value assets correctly, leading to bubbles and imbalances. Investors have a tendency to look for information on the behaviour of other investors. So speculations can develop in financial markets based on very little genuine news. Imperfections in credit markets can lead to boom bust cycles in money, credit quantities and asset prices. ‘Moral hazard’ could bring about excessive risk taking by financial intermediaries who try to exploit naïve investors, debt-holders or the depositor safety net provided by governments.
Last but not the least, the inherent human decision-making limitations mean that actual human beings often fail to take the rational choices usually assumed in the standard academic literature. Asset-driven inflation widens income inequalities. One needs a huge amount of capital and significant knowledge to be able to ride on the speculation of gold, real estate or any other commodity. And only the rich can afford such huge amounts of capital. Thus, the rich get richer in this exercise if the odds turn in their favour when it comes to speculation.
Strong regulation and monitoring needed
Firstly, the general monitoring and analysis of asset price developments and potential financial imbalances must be improved. Secondly, a strong macro-prudential framework has to be built up. The micro-prudential regulatory framework too should be strengthened through better liquidity and capital provisions. Ensuring the stability of individual banks is not enough for the stability of the system as a whole.
It is crucial that central banks and regulatory authorities be aware of effects of asset price inflation on the stability of the financial system. Lending activity based on asset collateral during the boom is hazardous to the health of lenders when the boom ends. One way that authorities can curb the distortion of lenders’ portfolios during asset price booms is to have capital requirements in place that increase with the growth of credit extensions collateralised by assets whose prices have escalated. Financial institutions will be able to maintain their soundness if they avoid this pitfall.
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