The Limit of Evil: Effects of Inflation and Public Debt on Capital Market Development

Hong Kong Monetary Authority Research Memorandum, 2019, 02

15 Pages Posted: 14 Feb 2019

See all articles by David Leung

David Leung

Hong Kong Monetary Authority

Wenzhe Li

The People's Bank of China (PBC); Tsinghua University, PBC School of Finance

Alfred Wong

Hong Kong Monetary Authority

Jiayue Zhang

Hong Kong Monetary Authority

Date Written: January 24, 2019

Abstract

It is almost self-evident that capital markets can thrive only in a benign macroeconomic environment. What is often overlooked is that malign macro factors such as inflation and government debt, provided that they are kept under control, can have their bright sides. Previous studies typically presume that the impact of inflation or government debt on capital market development is monotonic, thus precluding the possibility that these factors could be beneficial within a certain limit or threshold. In this study, we take into account this possibility. Our study finds an inverted U-shaped relationship between inflation and the size of the stock market. Hence, inflation within a certain limit may act as a lubricant to the market and help lower the cost of capital in real terms. However, when inflation is too high, long-term investment decisions would be difficult, which is detrimental to stock market growth. An inverted U-shaped relationship is also found between the size of the government bond market and that of the corporate bond market. This suggests that public debt under a certain threshold can benefit corporate bond market development, supporting the notion that the sovereign yield curve plays an important role in pricing private sector debt securities. However, excessive public debt would stifle it.

Suggested Citation

Leung, David and Li, Wenzhe and Wong, Alfred and Zhang, Jiayue, The Limit of Evil: Effects of Inflation and Public Debt on Capital Market Development (January 24, 2019). Hong Kong Monetary Authority Research Memorandum, 2019, 02. Available at SSRN: https://ssrn.com/abstract=3330936 or http://dx.doi.org/10.2139/ssrn.3330936

David Leung (Contact Author)

Hong Kong Monetary Authority ( email )

3 Garden Road, 30th Floor
Hong Kong
Hong Kong

Wenzhe Li

The People's Bank of China (PBC) ( email )

No.32 Chengfang Street, Xichengqu
Beijing, 100800
China

Tsinghua University, PBC School of Finance ( email )

No. 43, Chengdu Road, Haidianqu
Beijing, 100083
China

Alfred Wong

Hong Kong Monetary Authority ( email )

3 Garden Road, 30th Floor
Hong Kong
Hong Kong

Jiayue Zhang

Hong Kong Monetary Authority ( email )

3 Garden Road, 30th Floor
Hong Kong
Hong Kong

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