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“Economics Works In Mysterious Ways”: Is China’s Wealth Effect Being Substituted?

May 8, 2024

“Economics Works In Mysterious Ways”: Is China’s Wealth Effect Being Substituted?

Is the wealth effect being substituted?

Summary

  • China’s real estate market suffered heavy losses early this year while stock market investors continue to face huge uncertainty.
  • This will add to the deterioration of household balances and as such could influence private domestic (consumer) demand.
  • While the wealth effect predicts a deterioration of consumption, the substitution effect would predict the exact opposite.
  • This paper concludes that the substitution effect is more likely in the case of real estate.
  • This could be explained by the fact that housing is still expensive despite declining housing prices while at the same time wages are suppressed and youth unemployment is high.
  • But more explanations (like prepayment risks) could be given for the positive correlation between housing prices and the savings ratio.

Introduction

The new year in China kicked off with turmoil on China’s stock markets. Amongst others, the decision of the court in Hong Kong to liquidate real estate giant Evergrande further undermined investors’ confidence in China’s stock market. A market that already had been battered during the last three years due to ongoing worries about China’s economic prospects, regulatory crackdowns, a changing geopolitical landscape and a real estate sector in crisis. While China’s stock markets have pared some of the most recent losses due to (expectations of) increased government support, investor sentiment will likely remain fragile for some time to come. Moreover, many of the recently imposed government regulations, such as short selling curbs, are likely to be temporary assuming China is really serious about attracting more foreign investments. This follows from the fact that a full functioning market environment includes the possibility to sell stocks short and let market forces determine market outcomes.

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