Stock Market Liquidity and the Macroeconomy: Evidence from Japan

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1 WP/05/6 Sock Marke Liquidiy and he Macroeconomy: Evidence from Japan Woon Gyu Choi and David Cook

2 2005 Inernaional Moneary Fund WP/05/6 IMF Working Paper IMF Insiue Sock Marke Liquidiy and he Macroeconomy: Evidence from Japan Prepared by Woon Gyu Choi and David Cook 1 Auhorized for disribuion by Sunil Sharma January 2005 Absrac This Working Paper should no be repored as represening he views of he IMF. The views expressed in his Working Paper are hose of he auhor(s) and do no necessarily represen hose of he IMF or IMF policy. Working Papers describe research in progress by he auhor(s) and are published o elici commens and o furher debae. In a liquid financial marke, invesors are able o sell large blocks of asses wihou subsanially changing he price. We documen a seep drop in he liquidiy of he Japanese sock marke in he pos-bubble period and a seep rise in liquidiy risk. We find ha, during Japan s deflaionary period, firms wih more liquid balance shees were less exposed o sock marke liquidiy risk, while slowly growing firms were highly exposed o liquidiy shocks. Also, aggregae liquidiy had macroeconomic effecs on aggregae demand hrough is effec on money demand. JEL Classificaion Numbers: E50; G10 Keywords: Sock marke liquidiy; Liquidiy shocks; Vecor auoregression Auhor(s) Address: 1 Woon Gyu Choi is a senior economis a he IMF Insiue of he Inernaional Moneary Fund. David Cook is an associae professor of economics a he Hong Kong Universiy of Science and Technology. We hank Tim Chue, Burkhard Drees, Shinichi Fukuda, Takaoshi Io, Charles F. Kramer, Andrew Rose, Makoo Saio, Sunil Sharma, Ling Hui Tan, and paricipans a he NBER Eas Asian Seminar on Economics meeings for commens. David Cook hanks he Research Grans Council of Hong Kong for financial assisance and Hao Li for valuable research work.

3 - 2 - Conens Page I. Inroducion...3 II. Measure of Liquidiy Risk...4 A. Measuring Sock Marke Liquidiy...4 B. Descripive Saisics of he Aggregae Sock Marke...7 C. Dissecing Changes in Marke Turnover...7 D. Properies of he Liquidiy Measure...9 E. Robus Measures...11 F. Measuring of Shocks o Marke Liquidiy...12 G. Liquidiy Risk and Asse Pricing...13 H. Banking Risk and Liquidiy Shocks...14 III. Cross-Secional Evidence on Marke Liquidiy and Growh...15 A. Firm-Level Variables and Descripive Saisics...15 B. Deerminans of he Liquidiy Premium...17 C. Liquidiy Exposure and Growh...19 IV. Time-Series Evidence on Marke Liquidiy and he Macroeconomy: Vecor Auoregression...20 V. Conclusions...23 Appendix I...25 References...27 Tables 1. Descripive Saisics of Sock Marke Aggregaes Liquidiy Measure and Liquidiy Bea Banking Risk Measure, Liquidiy Shocks, and Marke Reurns Descripive Saisics of Firm-Level Variables Firm-Level Regressions...18 Figures 1. Time-Series Liquidiy Measures Purchases of Shares by Type of Invesor Alernaive Liquidiy Measures Impulse Responses of a Five-Variable VAR Money and Ineres Rae Responses...23

4 - 3 - I. INTRODUCTION In he early 1990s, Japanese equiy prices fell drasically from heighs ha are now considered he effecs of a sock marke bubble. During he remainder of he decade, he value of he sock marke sabilized a much lower values. Here, we examine he link beween he liquidiy of he Japanese sock marke and he macroeconomy in a period of prolonged deflaion, slow growh, and near zero ineres raes. Recen research has shown ha he liquidiy of major world financial markes subsanially varied over ime and ha he unpredicabiliy of marke liquidiy is an imporan source of risk for invesors. In his paper, we documen a large and persisen decline in Japanese sock marke liquidiy during he 1990s. In illiquid sock markes, invesors are unable o sell large amouns of shares wihou a sharp decline in he price of he shares. We show ha he impac of sock rading on share prices rose subsanially afer he collapse of he bubble. In addiion, he volailiy of liquidiy shocks o he sock marke increased dramaically. A number of facors have led o a decline in asse marke liquidiy during he lae 1990s. Firs, Japanese financial inermediaries experienced a subsanial deerioraion in heir balance shees. If marke makers and oher invesors faced credi consrains, his may have reduced heir abiliy o ake advanage of high reurns by providing liquidiy o an illiquid marke. Second, during much of his period, Japan was operaing in a deflaionary environmen in which savers were able o earn real reurns simply by holding money. This may have reduced heir incenives o ake speculaive risks by providing liquidiy o he marke. Third, adverse shocks o liquidiy in he world and Eas Asian financial markes poenially increased he exposure of Japanese firms. A he microsrucure level, he Tokyo Sock Exchange implemens a coninuous-aucion based order sysem in he lae 1990s, dispensing wih marke makers (Tokyo Sock Exchange, 2003). 2 We consider some channels hrough which financial marke liquidiy shocks may affec he macroeconomy. Naurally, a rise in equiy risk ends o raise he cos of capial of firms hrough he cos of financing channel. Using cross-secional daa, we find ha exposure o liquidiy risk is an imporan deerminan of invesmen. Anoher channel perains o he effecs of shocks on he porfolio of asses. Kiyoaki and Moore (2001) consruc a heory in which liquid asses are held primarily as a hedge agains he illiquidiy of real asses. A rise in money held for financial liquidiy may reduce money available for ransacions. In an economy wih nominal rigidiies, an increase in money demand can have real effecs on he economy. Nagayasu (2003) finds evidence of a srucural break in money demand in Japan during he crisis. Indeed here is a sharp decline in he velociy of money in he lae 1990s. We find, using ime-series daa, ha shocks o 2 Buy and sell orders are mached firs according o price (highes buy o lowes sell offer) and second by ime of placemen. Also, imporan feaures of he Tokyo Sock Exchange include he inraday price limi rule and limiorder rading for he insiuional feaures of rading, see, for example, Ahn e al. (2002).

5 - 4 - financial marke liquidiy have effecs on he economy, which are similar o exbook effecs of money demand shocks. In measuring sock marke liquidiy, we closely follow Pasor and Sambaugh s (2003) measure of Unied Saes equiy marke liquidiy. They measure liquidiy by he degree o which he quaniy of socks raded affecs he marke price of socks. In a liquid marke, large sales of socks can be made wihou subsanially changing he price of he socks. In an illiquid marke, however, hey can have an adverse impac on sock prices. Amihud and Mendelson (1986) is an early sudy of he relaionship beween marke liquidiy and sock reurns. Campbell, Grossman, and Wang (1993) consruc a model in which risk-averse marke makers require a premium o buy large quaniies of sock. Chordia, Sarkar, and Subrahmanyam (2002) find ha aggregae liquidiy flucuaions in he Unied Saes affec boh bond and sock markes and are correlaed wih moneary policy. Sahel (2004) finds ha global liquidiy shocks affec sock markes in boh he Unied Saes and Japan. Hamao, Mei, and Xu (2003) find a dramaic decrease in rading volumes in he Japanese sock marke afer he bubble bus. Secion II describes he echnique for measuring sock marke liquidiy and some of he imeseries properies of marke liquidiy shocks. We find ha, during he 1990s, sock marke liquidiy fell, and he volailiy of liquidiy shocks increased. Moreover, he exposure of individual firms equiy shares o liquidiy shocks rose during he same period. Secion III presens some firm-level cross-secional deerminans of liquidiy risk and he real impac of exposures o liquidiy risk. We find ha he liquidiy of individual corporae balance shees predics how exposed heir shares will be o liquidiy shocks. Moreover, exposures o liquidiy shocks help deermine he capial growh and sales growh of firms during he crisis. In Secion IV, we examine he dynamic ineracion beween sock marke liquidiy and he macroeconomy using vecor auoregressions (VARs). An examinaion of money markes suggess ha a decline in sock marke liquidiy leads o a rise in he demand for real money balances. Secion V concludes. The daa used are described in an appendix. II. MEASURE OF LIQUIDITY RISK A. Measuring Sock Marke Liquidiy In measuring Japanese aggregae sock marke liquidiy, we closely follow Pasor and Sambaugh s (2003) measure for he Unied Saes equiy markes. For a group of Japanese common shares indexed by k, we esimae he effec of order flows on excess daily reurns for each monh from January 1975 o December Using ime-series ordinary leas squares (OLS), we esimae he following equaion: r = θ + θ r + θ sign( r ) vol + ε, (1) xs xs k, d, k, k, k, d 1, k, k, d 1, k, d 1, k, d, MKT where r kd,, is he reurn on he sock of company k on day d of monh. Define r d, as he equalweighed reurn on Japanese socks in he Pacific Capial Markes (PACAP) daabase (see xs MKT Appendix I). The excess reurn rkd,, = rkd,, rd, is measured as he difference beween he

6 - 5 - xs reurn on sock k and he marke reurn. The sign ( rkd, 1, ) variable is equal o 1 when lagged excess reurns are posiive and equal o 1 when lagged excess reurns are negaive. We define volkd,, as he value of shares raded, measured in billions of yen. The signing of he rading volume is mean o disinguish wheher rades are driven by selling pressure from invesors or by buying pressure. When invesors are selling shares in a company o marke makers or oher shor-erm liquidiy providers such as speculaors, excess reurns on ha company should be negaive. When invesors are buying from marke makers, excess reurns should be posiive. The lagged reurn is included o capure ineria effecs ha are no volume-relaed. 2 The parameer θ measures he degree o which sales affec reurns and hus migh be k, 2 hough of as a measure of liquidiy in ha paricular marke. One would expec θ k, o be negaive in general and more negaive when liquidiy is lower. This idea is rooed in Campbell, Grossman, and Wang s model (1993) in which a large value of shares raded generaes reversals in reurns in illiquid markes. 3 In heir model, risk-averse marke makers demand higher han expeced reurns o buy or sell a large volume of shares. When here are large sales a day d-1, he marke makers offer a relaively low price, generaing negaive excess reurns in period d-1 and predicing relaively high reurns in he subsequen period. Under his heory, rading volume should be associaed wih reurn reversals, if he sock is no perfecly liquid. Technically, he Tokyo Sock Exchange (Tokyo Sock Exchange, 2003) does no operae on a sysem in which specified marke makers are responsible for he rading of individual socks. The Campbell, Grossman, and Wang heory can apply more generally o a case in which here are a limied number of invesors willing and able o engage in shor-erm speculaion in individual socks. I is herefore ineresing o see wheher he Pasor and Sambaugh (2003) model capures some feaures of marke liquidiy in a marke wihou marke makers. 2 We esimae θ k, for each sock-monh for which here are a leas 9 usable observaions during he monh and for which boh he previous monh and he subsequen monh have a leas 9 usable observaions. To obain a consisen sample of firms during he 1990s, we choose from 2 he PACAP daabase a se of 828 non-financial firms for which we are able o esimae θk, for a leas 140 of he 144 monhs beween January 1990 and December 2001 and for which we can obain balance shee daa (from he same source) in years 1990, 1995, and To avoid conaminaing he sample wih he resuls of buyous or bankrupcies, we exclude firms whose equiy permanenly ceases rading a some poin. The upper lef panel of Figure 1 shows he number of shares, N, for which we are able o esimae he effec of rading value on reurns for each monh beween in he ime period beween January 1975 and December We begin wih approximaely 500 differen shares, a number ha grows wih ime. By consrucion, he number of firms afer 1989 is approximaely consan. (Oher panels of he figure will be discussed laer.) 3 Chao and Hueng (forhcoming) show ha reurn reversals are a prevalen phenomenon of he Japanese sock marke.

7 - 6 - Figure 1. Time-Series Liquidiy Measures Number of Observaions in he Sample Average Marke Capializaion in Millions of Yen Effec on Monhly Reurn of Trading 1 Billion Yen Condiional Variance of Liquidiy Shocks.08 Marke Liquidiy Millenium Big Bang Speech -.04 Russia Crisis -.08 Yamaichi Bankrupcy 9/ Noes: The figure shows he deails of aggregae marke liquidiy. The upper wo panels show he deails of he sample of firms including he number of firms in he sample observed in any period and he marke capializaion of hose firms. The boom lef panel shows he aggregae marke liquidiy measure, LIQ, which essenially is he average cos, in erms of reurns, of rading a 1 billion of 2001 yen. The boom righ panel shows he condiional heeroscedasiciy of shocks o an AR(2) process in LIQ. The final panel is a closeup of he lower lef panel wih he indicaion of episodic daes.

8 - 7 - Table 1. Descripive Saisics of Sock Marke Aggregaes Enire Period January, 1975 December, 2001 Early 1990s January, 1990 December, 1995 Lae 1990s January, 1996 December, 2001 Mean Reurn MKT PACAP Index r 0.80% 0.37% 0.55% Our Sample 0.61% 0.28% 0.49% Sandard Deviaion of Marke Reurn PACAP Index 5.90% 8.04% 6.97% Our Sample 5.74% 8.67% 7.38% Monhly Turnover TOPIX 4.38% 2.19% 3.22% Our Sample 5.08% 3.38% 3.62% Noes: This able characerizes some of he saisical properies of ime series from he Japanese sock markes. We compue he mean and sandard deviaion of reurns from an equal-weighed index calculaed by PACAP and hose from an equal-weighed average of our sample of firms. We also compare he urnover (raio of monhly value raded o marke capializaion) for he Tokyo Sock Exchange and our sample of firms. B. Descripive Saisics of he Aggregae Sock Marke Table 1 also shows some properies of he shares of our sample in comparison wih a broader index of socks from PACAP. The equal-weighed average monhly reurn (excluding dividends) for shares in he overall sample of firms is abou 0.8 percen per monh; in our smaller sample, he average reurn is slighly smaller a 0.6 percen per monh. We will focus on wo sub-periods: he early 1990s (January 1990 December 1995) and he lae 1990s (January 1996 December 2001). In boh he early and lae 1990s, mean reurns are negaive and slighly lower for he large sample han for our narrower sample. This may no be surprising since our sample drops hose shares ha sop rading a some poin during he 1990s. In all sub-periods, he sandard deviaion of he equal-weighed monhly reurns in our sample is similar o ha in he PACAP sample. The volailiy of reurns increases during he 1990s in boh samples and is larges during he early 1990s. C. Dissecing Changes in Marke Turnover To access sock marke liquidiy, we compare he average monhly urnover of he shares of our sample, relaive o he urnover of he socks measured in he Topix index of he Tokyo Sock Exchange. Turnover is defined as he value of shares raded in a monh as percenage of end-ofperiod marke capializaion (boom panel of Table 1). In he whole period, abou 4 percen of he value of shares in he Topix index is raded in he average monh. Our sample is slighly more liquid wih abou 5 percen of he value raded. While urnover is slighly higher in our sample han he Topix sample in boh sub-periods, i is lower in he early and lae 1990s han in he enire period in boh samples.

9 Figure 2. Purchases of Shares by Type of Invesor % of Marke Capializaion Foreign Traders Domesic Individuals Domesic Insiuions Proprieary Accouns Noes: The figure shows Tokyo Sock Exchange daa on he quaniy of shares purchased by four ypes of invesors relaive o aggregae marke capializaion. Daa repored are yearly averages of monhly daa. Given he overall decline in marke liquidiy, we look more closely a which invesors lef he marke. Figure 2 shows he pah, from 1988 o 2001, of average monhly purchases of socks (relaive o overall marke capializaion) by invesors rading for heir proprieary accouns and by hree oher ypes of invesors rading hrough brokerages. The hree ypes include domesic individuals, domesic financial insiuions, and foreign raders. All rading is repored relaive o he aggregae marke capializaion. Purchases by foreign raders grew hroughou he period, while rading by all hree ypes of domesic invesors iniially declined following he burs of he sock marke bubble. Over he course of he 1990s, rading on proprieary accouns recovered. However, rading hrough brokerages by individuals and insiuions persisenly declined during he firs half of he period. In paricular, by he end of he period he share raded by domesic insiuions had fallen o less han he half of is iniial level. 4 4 Wang (2003) shows ha insiuional paricipaion is a significan deerminan of marke liquidiy in he U.S.

10 - 9 - D. Properies of he Liquidiy Measure The aggregae measure of he marke value, m, of he shares for which we are able o calculaeθ 2 k, is given by m N = mkcap, (2) k = 1 k, where mkcap k, is he end-of-monh marke capializaion of sock k in monh, and N is he number of shares in monh. The upper righ panel of Figure 1 shows he average marke capializaion m N during each period. In he mid-1970s, he average firm in he sample had a marke capializaion of approximaely 45 billion yen. During he 1970s and 1980s, average marke capializaion grew rapidly o a peak of nearly 500 billion yen in lae 1989 before falling rapidly o a level near 200 billion yen. During he 1990s, average marke capializaion flucuaed beween 200 and 300 billion yen. Chordia, Roll, and Subrahmanyan (2002) find ha average marke liquidiy in he Unied Saes (as measured by bid-ask spreads) shows subsanial variaion over ime. Following Pasor and Sambaugh (2003), we measure average marke liquidiy, LIQ, as follows: LIQ m N 2 = θk, / N mdec,2001 k= 1 We average he liquidiy parameer across he firms wih usable observaions in a paricular monh. The parameer measures he effec of a billion yen rading on sock reurns. To reflec 2 he growh in size of he sock marke over ime, he average of θ k, across firms is muliplied by he raio of he sum of he marke capializaion of he firms o he marke capializaion a a fixed dae, December The lower lef panel of Figure 1 shows he ime pah of LIQ. The aggregae marke liquidiy is negaive in mos of he ime, suggesing in accord wih heory ha heavy rading resuls in reurn reversals due o illiquidiy. Furher, aggregae marke liquidiy varies subsanially. Table 2 (par A) shows ha he mean level of liquidiy is so ha sales of 1 billion yen (roughly in 2001 yen) resul in expeced reurns of 1.4 percen in a monh. The marke became less liquid over ime, and he average level of LIQ fell o 0.02 in he early 1990s and fell furher o below 0.04 by he lae 1990s, approximaely wice he enire period mean. A simple Chow breakpoin es a January 1996 rejecs he sabiliy of he mean a any reasonable criical value. However, an Adjused Dickey-Fuller es wih 12 lags rejecs he hypohesis of a uni roo a he 1 percen criical value (regardless of wheher a deerminisic rend erm is included). Alhough Pasor and Sambaugh (2003) documen subsanial and persisen variaions in he U.S. equiy marke, such variaions do no involve so prolonged liquidiy drough as observed in he Japanese marke in he lae 1990s.

11 Table 2. Liquidiy Measure and Liquidiy Bea Enire Period January, 1975 December, 2001 Early 1990s January, 1990 December, 1995 Lae 1990s January, 1996 December, 2001 A. Liquidiy Measure Mean Shock Volailiy Correlaion w/ PACAP Index Covariance w/ PACAP Index B. Liquidiy Bea Mean Sd. Deviaion % firms wih significan -saisics 32.6% 27.3% Noes: Par A characerizes he mean and sandard deviaion of our measure of marke liquidiy, LIQ, as well as is correlaion and covariance wih he PACAP equal weighed index. Par B characerizes he cross-secional disribuion of he parial beas from regressions of individual sock reurns on he aggregae index and liquidiy shocks. The characerizaion includes mean and cross-secion sandard deviaion of he coefficien on liquidiy shocks as well as he percenage of firms wih significan -saisics based on Newey and Wes s heeroscedasiciyauocorrelaion consisen sandard errors. The boom of Figure 1 shows more closely he ime series of aggregae marke liquidiy over he period (essenially a close-up of he lower lef panel of Figure 1). Over his period, marke liquidiy seems o reflec a response o boh naional and inernaional evens. Perhaps coincidenally, in he periods following he November 1996 announcemen of he Big Bang marke liberalizaion, here was a persisen decline in marke liquidiy, followed by a recovery over he summer of However, in November 1997, marke liquidiy suddenly plunged o a level dramaically lower han ha observed in any prior period. This episode coincides wih major urmoil in he Japanese financial sysem (as well as he Eas Asian financial crisis) since a number of inermediaries including he fourh larges securiies firm (Yamaichi Securiies) and one of he ciy banks (Hokkaido Takushoku) were forced ino bankrupcy. This low level of liquidiy persised hrough 1998, including a negaive spike in Sepember coinciden wih he Russian crisis and he collapse of LTCM. 5 Liquidiy recovered o more normal levels hrough However, a new persisen decline in liquidiy occurred in November 1999 and was puncuaed by a number of periods in which 5 Crises can be inernaionally ransmied hrough diverse channels. In paricular, a crisis in one marke causes insiuional invesors o sell liquid asses in oher markes o mee regulaor requiremens (a forced-porfolio recomposiion effec). Forbes (2000), using firm-level cross-counry daa, shows ha individual company s sock marke reurns are affeced by global rading liquidiy during he Eas Asian and Russian crises hrough a forcedporfolio recomposiion.

12 liquidiy increased rapidly bu emporarily. In one of hese periods, January 2000, liquidiy reached a level much higher han previously observed. During he urn of millennium period he level of bank reserves held a he Bank of Japan also spiked. We also observe anoher sharp decline in liquidiy afer Sepember 2001, despie ha Japan has undergone reforms o liberalize is financial markes in ways ha may allow he addiional paricipaion of exernal invesors and insiuions. Persaud (2000), however, argues ha he common use of modern risk managemen pracices leads o herding behavior ha may reduce marke liquidiy despie a large number of marke paricipans. Also, such a decline in liquidiy migh be associaed wih heighened percepions of risk afer he 9/11 erroris aack. E. Robus Measures We also examine some alernaive measures of liquidiy. Figure 3 (firs panel) shows he N 2 paern of θk, / N k, which is unadjused for changes in marke capializaion over ime. According o his measure, he impac of rading a billion yen worh of shares during he mid-olae sevenies was indeed very large and comparable wih more recen periods. However, during he 1980s, reurn reversals associaed wih large sock sales became much smaller, beginning o rise dramaically again in he 1990s jus as in he benchmark series, LIQ. The second and hird panels show alernaive measures of LIQ for differen ses of firms. The second panel perains o he se of firms ha includes all of he nonfinancial firms available 2 in which an esimae of θ k, is available in ha ime period. The number of firms ranges from abou 500 in 1975 o abou 1400 by The measure of liquidiy wih his broad se of firms shows a similar paern, compared o our benchmark measure of liquidiy. During he 1970s and 1980s, sock marke liquidiy was relaively high. During he 1990s, he aggregae liquidiy began o fall. Afer 1997, sock marke liquidiy on average dropped dramaically and he volailiy of liquidiy rose. 2 The hird panel depics a liquidiy measure defined by he average θ k, (weighed across ime by aggregae marke capializaion) of a group of approximaely 370 firms for which we are able o measure liquidiy for a leas 320 ou of he 324 monhs in he years beween 1975 and This measure of liquidiy shows again a similar pah wih a fall in liquidiy in he 1990s and a more dramaic decline afer 1997 along wih an increase in volailiy of liquidiy. The average level of liquidiy of his group of more esablished companies was higher han ha of he broader sample. 2 Finally, he las panel displays a weighed average of θ k, wih he weigh for each firm being he end of monh marke capializaion. This measure shows he same paern as he oher measures wih a marked drop in liquidiy in he 1990s. In he weighed average, he size of reurn reversals is smaller, indicaing ha big cap socks are more liquid.

13 Figure 3. Alernaive Liquidiy Measures Liquidiy (Unadjused for Changes in Aggregae Marke Capializaion) Broades Number of Shares Shares Consisenly Traded Since 1975 Liquidiy Average Weighed by Marke Cap Size Noes: Upper lef panel shows he average liquidiy in erms of reurn of rading a billion yen in curren dollars (unadjused for changes in aggregae marke capializaion). Upper righ panel shows he average liquidiy using a sample of all available firms including hose ha joined or lef he sample during he 1990s. Boom lef shows he average liquidiy of a group of firms ha were observed for he enire 27 year period beween 1975 and Boom righ shows he weighed (by marke capializaion) average liquidiy of he sample. F. Measuring of Shocks o Marke Liquidiy A measure of innovaions o liquidiy is he adjused average of innovaions o he liquidiy of each firm: N 2 2 m { θk, θk, 1} LIQ = m Jan,1990 N. Aggregae liquidiy shocks are esimaed as innovaions o he following dynamic process: LIQ = β + β LIQ + β LIQ + ω, where he prediced change in liquidiy depends on he lagged change and he deviaion of he lagged level from is long-run mean (impounded in β 0 ). The fied residuals are a measure of liquidiy shocks:

14 lshock = ˆ ω. Table 2 (par A) shows ha he average sandard deviaion of liquidiy shocks varies from period o period. The sandard deviaion for he enire sample is abou However, much of his volailiy is concenraed in he lae 1990s, where he sandard deviaion is above as compared wih ha of in he early 1990s. We conduc a Breusch-Pagan LM es for condiional heeroscedasiciy on he residuals and rejec condiional homoscedasiciy wih a p-value of less han 10-4 using any number of lags beween 1 and 12. We esimae a GARCH (1, 1) process for lshock. σ = σ lshock (0) (0.025) 1 (0.030) 1 (sandard errors in parenheses) (3) The boom righ panel of Figure 1 shows he fied value of he condiional variance of he shock. The volailiy of he liquidiy shock increased sharply during he early 1990s. Such a sharp rise was followed by a much larger rise in condiional variance in 1998 and finally an even larger jump in MKT We calculae he correlaion beween he PACAP equal-weighed sock reurn, r and lshock (par A of Table 2). The correlaion in he enire period is abou During he early 1990s, he correlaion beween liquidiy shocks and aggregae sock reurns was as high as 0.42 and fell o 0.25 in he lae 1990s. However, despie he fall in correlaion, he overall exposure of firms shares o aggregae liquidiy shocks rose over he decade because of he increased variance of shocks. The covariance beween he aggregae reurn index and he liquidiy shock was abou 20 percen larger in he lae 1990s sample han in he early 1990s sample. G. Liquidiy Risk and Asse Pricing To check if here is some relaionship beween liquidiy risk exposure and he average liquid reurns, we esimae a parial liquidiy bea, β k, period, by regressing he monhly excess reurn on he liquidiy shock over he period January 1990 December ( ) r i = α + β r i + β lshock + e, (4) MKT mk liquid k, 1 k, period 1 k, period k, where period is equal o he early 1990s or he lae 1990s, rk, is he monhly reurn on sock k, and i is he collaeralized overnigh call money rae. liquid liquid The average βk,90 95 across firms is abou 1.6 while he average βk,96 01 is slighly greaer han 0.5 (par B of Table 2). Noe ha he median is very close o he mean for boh figures. Alhough a given shock on reurns has a smaller effec in he laer period, he overall rise in he

15 volailiy of he liquidiy shock means ha he parial covariance of he shock (measured as he liquid produc of β k, period and he variance of lshock ) is higher in he laer period. Using Newey-Wes correced, heeroscedasiciy-auocorrelaion consisen sandard errors, we find ha he percenages of firms ha have significan exposures o he liquidiy shocks a he 5 percen level in wo sub-periods are no much differen: abou 33 percen of he firms have liquidiy bea s which are significanly differen from zero in he firs sub-period while approximaely 27 percen of he firms in he second sub-period do. H. Banking Risk and Liquidiy Shocks We examine he connecion beween liquidiy shocks and banking risk. Liquidiy shocks may be he resul of credi raioning which prevens speculaors from borrowing money which could be used o buy socks. We can measure banking risk by he premium ha Japanese banks pay o borrow from abroad. In he lae 1990s, Japanese banks paid a premium o borrow in euro markes. Io and Harada (2000) show ha his premium is conneced o incidens relaed o boh he failures of Japanese financial firms and he excess reurns on banking socks. The Bank of Japan collecs daa on he Japan premium from The Japan premium is persisenly high during 1997 and 1998, a period when sock marke liquidiy is also persisenly low. 6 Table 3 summarizes he regressions resuls for he relaionship beween liquidiy shocks, banking risk, and marke reurns. The esimaed coefficien (along wih Newey-Wes correced sandard errors) from a regression of liquidiy shocks, lshock, on he firs difference in he Japan premium, jpnprem, suggess ha increases in he Japan premium are associaed wih negaive shocks o sock marke liquidiy (Table 3, column 1). This associaion is significan a he 1 percen level. However, he adjused R 2 from he regression is less han 0.03, suggesing much of he variaion in liquidiy shocks is no direcly caused by he Japan premium. Table 3. Banking Risk Measure, Liquidiy Shocks, and Marke Reurns lshock r MKT r MKT r MKT lshock ** (3.35) * (2.13) Δjpnprem ** ( 2.67) ** ( 4.29) ** ( 3.53) Adjused R Noes: Regression resuls wih he PACAP equal-weighed sock index on liquidiy shocks and he change in he Japan premium. The Japan premium, as a measure of banking risk, is defined as he spread beween he ineres rae paid on dollar borrowing in he Japanese inerbank marke and he rae paid on dollars in London. The coefficien esimaes are repored wih Newey-Wes s heeroscedasiciy-auocorrelaion consisen -values (in parenheses). **, *, coefficiens are significanly differen from zero a he 1%, 5%, and 10% levels, respecively. 6 Banks whose credi raings deeriorae upon adverse aggregae shocks may drop ou of he inernaional inerbank marke. Such dropous are posiively correlaed wih counry risk and hus refleced in he measured Japan premium.

16 To examine how liquidiy shocks and he Japan premium are associaed wih innovaions o sock reurns, we regress he PACAP equal-weighed marke reurn, r MKT, on lshock and jpnprem over he period January 1997 December Posiive innovaions in liquidiy are associaed wih relaively high sock reurns (column 2). The associaion is saisically significan in each case a he 1 percen level. Increases in he Japan premium are significanly (a he 1 percen level) negaively associaed wih sock reurns (column 3). Also, when we include boh variables (column 4), changes in he Japan premium are sill significan a he 1 percen level. The effec of he liquidiy shock remains significan for he equal weighed reurn a he 5 percen level, even wih he inclusion of he Japan premium. III. CROSS-SECTIONAL EVIDENCE ON MARKET LIQUIDITY AND GROWTH A. Firm-Level Variables and Descripive Saisics From PACAP, we exrac addiional firm-level variables ha we consider as facors o explain cross-secional exposure o liquidiy risk. Descripive saisics are repored in Table 4. Addiional informaion on he daa used in he paper is provided in Appendix I. Firs, a large percenage of shares of he firms in our sample are owned eiher by financial insiuions or by corporaions. Shares wih hese kinds of cross-holdings may be less liquid. We consruc a variable: o % of Socks Held by Banks or Corporae Secor he number of shares owned by financial insiuions plus shares owned by oher businesses divided by he oal number of shares in In 1995, approximaely wo hirds of he shares of he mean and median firm are held by banks and oher corporaions. Firms wih high liquidiy needs may be especially vulnerable o aggregae liquidiy shocks. We consruc a variable o measure shor-erm deb a he firm level: o Shor-erm Loans o Asse Raio The measure of shor-erm loans includes accouns and noes payable, shor-erm loans and paper (due wihin one year) as well as he curren porion of long-erm bonds and loans which are due wihin he year. Shorerm loans are normalized by dividing by oal asses in These liabiliies consiue approximaely 30 percen of asses for he mean and median firm, hough he number ranges beween 0 and nearly 95 percen. To conrol for overall leverage, we include oher kinds of liabiliies. o Oher Liabiliies o Asse Raio he sum of all oher liabiliies relaive o oal asses in Oher ypes of liabiliies are approximaely 30 percen of asses for he mean and median firm and are on average equal in size o shor-erm liabiliies.

17 Table 4. Descripive Saisics of Firm-Level Variables Variable Mean (S.D.) Median [Min, Max] % of Socks Held by Banks or Corporae Secor (0.115) [0.086, 0.921] Shor-Term Deb o Asse Raio (0.17) [0, 0.942] Oher Liabiliies o Asse Raio (0.146) [0.016, 0.964] Liquid Asses o Asses Raio (0.181) [0.019, 0.986] Log of Asses [8.666, (1.279) ] Financial Value o Book Asses (0.397) [0.780, 6.042] Reurn on Equiy [ 2.859, (0.152) ] Growh in Ne Fixed Asses (in log difference) End of 1995 o end of 2001 Growh in Sales (in log difference) End of 1995 o end of (0.419) (0.306) [ 3.573, 1.696] [ 2.961, 1.237] Noes: The able summarizes he descripive saisics for balance shee daa from PACAP for he period We also repor he growh in fixed asses and sales beween 1995 and If a firm has more liquid asses, i will be less exposed o liquidiy shocks. However, financially weak firms ha do no have access o financial markes will fear financial srains caused by insufficien reserves of liquidiy and hus ry o hold more liquidiy. Empirical sudies wih U.S. firm-level daa (Opler e al., 1999; Choi and Kim, 2001; Hubbard e al., 2002) sugges ha high-informaion-cos firms hold comparaively larger cash reserves han do oher firms. 7 Thus, conrolling for he size and qualiy of firms, we examine if firms wih more liquid asses are less exposed o liquidiy shocks. We consruc a variable which measures firms liquidiy posiions. o Liquid Asses o Asses Raio he currency, bank deposis, and markeable securiies held by he firm relaive o oal asses in Abou 30 percen of he average firms asses are liquid. Naurally, his consiues a large range. 7 Almeida e al. (2004) sugges ha financially weaker firms liquidiy posiion is more sensiive o cash flow shocks, compared o financially sronger firms. This reflecs ha financially weak firms srive o accumulae reserves of liquidiy o hedge agains liquidiy risk while financially srong firms can raise funds from financial marke in he even of financial srains.

18 Since liquidiy shocks may be less imporan for large firms, which have beer access o financial markes, han for small firms, we also include an asse variable as a proxy of firm size. o Asses he logarihm of he oal asses (measured in millions of yen). In addiion, we include some addiional balance shee measures o conrol for he overall qualiy of he firm. o Financial o Book Value he sum of oal liabiliies plus marke capializaion divided by oal asses in This measures he cos of purchasing he firm ourigh relaive o he accouning cos valuaion of asses which is considered as a proxy of Tobin s q- raio. o Reurn on Equiy ne income divided by book equiy value in The ypical financial-o-book value in he sample is approximaely 1.4. The average reurn on equiy in 1997 was approximaely 4 percen bu he range is exremely large. Furher, PACAP caegorizes firms by secor a he approximaely one- or wo- digi level. Appendix I liss he secors and he number of firms in our sample ha fall ino hese shares. B. Deerminans of he Liquidiy Premium To access he deerminans of he liquidiy exposure of individual firms during he liquidiy liquid rap period, we regress he parial liquidiy bea, βk,96 01, which are obained from esimaing equaion (4) for January 1996 December 2001, on our firm-level variables. We scale all coefficiens by muliplying each by he raio of he cross-secional sandard deviaion of ha liquid variable and dividing by he sandard deviaion of he dependen variable, βk, The resuls are repored in Table 5 (column 1), along wih heeroscedasiciy consisen -saisics. In general, we find evidence on he link beween firms exposures o liquidiy shocks and liquidiy in heir equiy markes or balance shees. Indicaors of equiy marke liquidiy are associaed wih less exposure o liquidiy shocks. We find ha large firms (in erms of asses) have less exposure o liquidiy shocks han small firms and his is significan a he 10 percen criical value. Firms whose shares are owned in large par by financial insiuions, non-financial corporaions or he governmen also have relaively high risk exposure, hough his is marginally insignifican a he 10 percen criical value (p-value=0.102). Perhaps more ineresingly, firms wih more liquid balance shees are less exposed o liquidiy shocks, whereas firms wih more shor-erm deb are more exposed o he shocks. A one-sandard deviaion increase in shor-erm deb is significanly associaed (a he 1 percen level) wih an increase in liquidiy exposure equal o 14.3 percen of a sandard deviaion. By comparison, a one-sandard deviaion increase in longer-erm liabiliies relaive o asses is associaed wih an increase in liquidiy exposure of 5 percen of a sandard deviaion. This associaion, however, is no significan a even he 10 percen level. Furher, firms wih large holdings of liquid asses are less sensiive o liquidiy shocks. A one-sandard deviaion increase in he liquid asses o asses raio will reduce parial liquidiy exposure by 8 percen of a sandard error: his relaionship is significan a he 5 percen level. The posiive link beween

19 Firm Characerisics Table 5. Firm-Level Regressions Parial Liquidiy Bea liquid βk,96 01 % Growh in Ne Fixed Asses End of 1995 o end of 2001 liquid Parial Liquidiy Bea: β ** k,96 01 ( 2.61) % of Socks Held by Banks or Corporae Secor (1.64) Shor-Term Deb o Asse Raio ** (2.77) Oher Liabiliies o Asse Raio (0.93) Liquid Asses o Asses Raio * ( 2.04) Log of Asses ( 1.89) Financial Value o Book Asses ( 1.85) Reurn on Equiy * ( 2.49) (0.48) ( 0.90) ( 1.49) (0.05) ( 0.63) (1.25) (1.12) % Growh in Sales End of 1995 o end of ** ( 4.89) (0.55) ** ( 6.34) * ( 2.28) * ( 2.07) ( 0.68) * (2.20) (1.80) Indusry Dummies Yes Yes Yes No. of Observaions R Noes: The able repors he coefficien esimaes of he regressions of measures of exposure o liquidiy risk and performance on firm characerisics. All variables have been scaled by heir cross-secional sandard deviaion so ha he coefficien represens he impac (as a share of one-sandard deviaion of he lef-hand variable) of a one-sandard deviaion increase in each righ hand side variable. Also repored are heeroscedasiciy consisen -saisics. **, *, coefficiens are significanly differen from zero a he 1%, 5%, and 10% levels, respecively. corporae balance shee liquidiy and sock marke liquidiy perhaps indicaes ha sock marke liquidiy shocks occur simulaneously wih broader shocks o liquidiy in he economy including credi markes. Higher qualiy firms have less exposure o liquidiy shocks. Firms wih high financial value relaive o book value and firms ha earn high profis relaive o book equiy have significanly less exposure o liquidiy shocks. These relaionships are saisically significan a he 10 percen and 5 percen criical value, respecively. Overall, he regression has an R 2 of abou 17 percen.

20 C. Liquidiy Exposure and Growh To examine he relaionship beween liquidiy exposure and firm growh, we firs measure he growh of a firm in erms of capial invesmen. o Growh in Ne Fixed Asses he logarihm of he raio of ne fixed asses in 2000 o ne fixed asses in Over 5 years from 1995 o 2001, our sample firms grew a 3.7 percen (an annual growh of abou 0.7 percen) in ne fixed asses. The cross-secional variaion of fixed asse growh is large wih a sandard deviaion of almos 40 percen. We also measure real growh in sales. o Growh in Sales he logarihm of sales in 2000 relaive o sales in Sales declined during he period by almos 1 percen on annual average. Again, here is large cross-secional variaion in his measure wih a sandard deviaion of over 30 percen. In Table 5 (columns 2 and 3), we regress measures of firm growh on liquidiy exposure and oher firm-level characerisics (as well as some indusry dummies). The measure of liquidiy liquid exposure is he parial liquidiy bea from he lae 1990s period, β k,96:01. The addiional firm characerisics are hose lised in he previous secion. We find ha firms ha have high liquidiy exposure also have saisically significanly (a he 1 percen criical value) slower capial growh. One-sandard deviaion higher in liquidiy exposure is associaed wih 13 percen of a sandard deviaion decline in capial growh (which is approximaely 1 percen lower fixed invesmen growh per year). None of he oher firm-level characerisics are significan a even he 10 percen criical value. Firms wih high liquidiy exposures also end o have lower sales growh. A one-sandard deviaion increase in liquidiy exposure is saisically significanly associaed (a he 1 percen criical value) wih a 15 percen of sandard deviaion decrease in sales growh (approximaely 1 percen lower annual growh in sales). Variables relaed o marke liquidiy, such as size and shares cross-held, are no significan. However, overall high leverage levels and, especially, high shor-erm deb are associaed wih slow sales growh. A one-sandard deviaion increase in he shor-erm deb o asse raio is significanly associaed (a he 1 percen criical value) wih a near 30 percen of a sandard deviaion lower level of sales growh (approximaely 3 percen annual lower sales growh). Oher liabiliies relaive o asses are also significanly associaed wih slow sales growh hough he effec is smaller quaniaively. Ineresingly, firms wih a high liquid asses o oal asses raio in 1995 have saisically significanly (a he 5 percen criical value) slower subsequen sales growh. This resul perhaps reflecs ha holding liquid asses o hedge agains liquidiy risk is cosly and ha such a precauionary liquidiy holding may pospone or hinder invesmen and producion for sales. A high marke-o-book valuaion of asses raio significanly (a he 5 percen level) predics subsequen sales growh and a high reurn on equiy in 1995 also significanly (a he 10 percen level) predics subsequen sales growh.

21 IV. TIME-SERIES EVIDENCE ON MARKET LIQUIDITY AND THE MACROECONOMY: VECTOR AUTOREGRESSION Moneary asses are par of larger porfolios of asses. Agens may hold more liquid asses as a hedge when he liquidiy risk of ineres or dividend paying asses rises. In Kiyoaki and Moore (2001), money is held enirely o as a hedge agains he illiquidiy of real asses. An increase in money demand migh lead o less liquidiy available for he purchase of goods and, as in sandard IS-LM analysis, lead o a decline in economic aciviy. Thus, one may propose ha a negaive shock o marke liquidiy increases money demand and affecs adversely economic aciviy. To assess his proposiion, we esimae a dynamic sysem wih a VAR wih erms for real shocks, money demand shocks and money supply shocks during he pos-bubble period ( ). We use an economic aciviy/producion index, y, for all secors of he economy (exceping agriculure) as a measure of real aciviy. Ueda (1993) argues ha Japanese moneary policy arges he call money rae, and Miyao (1996, 2002) describes as he operaing arge of he Bank of Japan during he period under consideraion. We include he uncollaeralized overnigh call money rae, call. We use broad real money balances as a proxy for real money demand. Specifically, he variable, mp, is he logarihm of he raio of M2 plus CDs which Io (1994) repors as he mos commonly used broad money aggregae for Japan divided by he core CPI (i.e., CPI no including food and energy). Sekine (1998) argues ha financial wealh is a deerminan of money demand. We include he log of he Topix sock marke index, opix, as a proxy for wealh and o conrol for he effecs of sock marke reurn shocks on marke liquidiy. This may be imporan as Bayoumi (2001) has shown ha shocks o asse prices have subsanial real effecs on he Japanese economy during his period. Since he sock marke does no display much in he way of secular growh during he posbubble period, we measure he level of liquidiy as he simple average of he response of reurns o signed rading volume. N liquidiy = θ / N (5) k, k = 1 We do no muliply his liquidiy measure by he aggregae marke capializaion ha may have macroeconomic effecs separae from financial liquidiy. The ime series for liquidiy is shown in he firs panel of Figure 3. We firs conduc ADF ess on each of he variables o es for uni roos. Using a specificaion wih four lags and including a rend erm, we are unable o rejec he null hypohesis of a uni roo a he 10 percen level for any of he variables wih he excepion of liquidiy for which he null hypohesis is rejeced a any reasonable criical value. Using he Johansen race saisic in a specificaion wih four lags and a rend erm we are unable o rejec he hypohesis ha y, mp, or call is coinegraed wih opix. We herefore esimae he VAR in a level specificaion.

22 We esimae a VAR in [y, call, mp, liquidiy, opix] wih 12 lags, a rend erm and a dummy variable for January 2000, he millennium period wih he anomalously large, posiive liquidiy realizaion. The Akaike Informaion Crierion indicaes a second order VAR. However, his srikes us as oo few lags o capure he dynamics of he monhly sysem. 8 Insead, we esimae he VAR wih 12 lags which may be fairly ypical for he VAR esimaion wih monhly daa. We idenify shocks o he sysem using he Choleski decomposiion inerpreing hem as, in order: real shocks, money supply shocks, money demand shocks, liquidiy shocks and sock price shocks. Ordering he variables in his way, [y, call, mp, liquidiy, opix], implies a number of idenifying assumpions abou he shor-run dynamics of he model. We assume each of he shocks could have immediae effecs on he price of he sock marke. In paricular, his ordering implies ha innovaions in he aggregae price of socks have no immediae impac on sock marke liquidiy. However, we do allow marke liquidiy o respond immediaely o all macroeconomic shocks. Following Miyao (2002), we rea exogenous innovaions in he call money rae as moneary policy shocks and allow he call money rae o respond immediaely o real oupu shocks. Also, we allow money demand o respond immediaely o oupu and he ineres rae. However, real oupu responds only wih a lag o moneary policy shocks. Figure 4 displays all of he impulse responses along wih wo-sandard error bands. However, we concenrae on discussing he effecs of liquidiy shocks on he macroeconomic variables and he effecs of various shocks on sock marke liquidiy. We find ha liquidiy shocks affec significanly macroeconomic variables. Liquidiy shocks affec oupu in he real economy, bu he impac of sock marke liquidiy on he economic aciviy index is small and shor-lived. A one-sandard deviaion increase in liquidiy resuls in an iniial increase in oupu of abou 0.2 percen. Afer 1 period, he increase in oupu is no saisically significan a even he 10 percen level. Liquidiy shocks never explain more han 7 percen of variaion in y a any frequency. Liquidiy shocks have persisen and saisically significan impacs on real balances. A posiive shock o sock marke liquidiy leads o a reducion in he demand for more liquid real balances. Indeed, variance decomposiion shows ha liquidiy shocks explain more han 16 percen of he variaion in real balances a a frequency of 18 monhs. Liquidiy shocks have macroeconomic effecs which are consisen wih persisen money demand shocks. A posiive liquidiy shock also leads o a saisically significan decline in (nominal) ineres raes, consisen wih he reduced money demand afer he shock. However, he effecs of liquidiy shocks on asse markes hemselves seem more ransiory. Liquidiy shocks have very shor-lived effecs on he sock marke index, opix, revering o mean afer a couple of periods. Nex, we find ha marke liquidiy is significanly affeced by shocks o oupu and opix bu no by shocks o money marke variables, call raes and real balances. Shocks o opix have a shor-lived impac on sock marke liquidiy, suggesing ha a rise in he sock price index aracs liquidiy o he sock marke a leas emporarily. Shocks o economic aciviy also have 8 In paricular, a very low order VAR suggess ha liquidiy shocks have fairly large and persisen effecs on oupu and real balances. In such a low order VAR, macroeconomic shocks have insignifican effecs on liquidiy.

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