Stock
Market And The Real Economy
By Jayati Ghosh
26 May, 2004
The
Frontline
The
mainstream press was almost unanimous in its hysteria. "Bloodbath",
"carnage" screamed the front-page headlines in the English
language press, while editorials sermonised disapprovingly of the apparent
irresponsibility of politicians. Was this all fury about mob frenzy
or state-sponsored riots on the scale of the Gujarat pogrom of two years
ago? No, it was simply that the stock market indices had fallen sharply
for the third day, after it became clear that a Congress-led formation,
supported by the Left parties, would constitute the government at the
Centre.
So much of the presentation
of economics news, especially in the financial press, is oriented to
the behaviour of stock markets that the uninitiated can be forgiven
for thinking that their movements actually reflect real economic performance.
Such an interpretation is not exclusive to India. Across the world,
ordinary citizens have been conned by the media into believing that
the relatively small set of players in international stock markets really
do comprehend and correctly assess the patterns of growth in an economy,
and that their interests are broadly in conformity with the economic
interests of the masses of people in those countries.
This is not simply
a deeply undemocratic position (as shown by C. P. Chandrasekhar in his
column in this issue of Frontline). It is also a completely false argument,
since it has been abundantly clear for some time now that stock markets
are very poor pointers to real economic performance. Stock market indices
are indicators of the expectations of finance capital, and they can
move up and down for a variety of reasons, most of which are not related
even to the current profitability of productive enterprises. They are
prone to irrational bubbles and sudden collapses that reflect all sorts
of factors, ranging from international forces to domestic political
changes, and may have very little relation to economic processes within
the economy.
Consider the latest
fall in the Indian stock market. While it is true that some of it is
clearly a reaction to the uncertainty created by the unexpected and
remarkable defeat of the National Democratic Alliance government at
the polls, it also should be noted that across the world, financial
markets have been in downswing in recent weeks. The New York Stock Exchange
composite index fell by 4 per cent between May 5 and 14, and other markets
across Europe and Asia have shown similar or even larger falls. Much
of this is because of rising oil prices, the failure of the economically
and politically expensive U.S. military occupation in Iraq, and fears
of interest rate hikes in the U.S.
It is true that
the Bombay Sensex fell by more than 10 per cent and the Nifty index
by 12 per cent over the same period, but this is still part of a more
general worldwide trend of decrease in stock values, and some market
analysts have even described these as necessary "corrections"
of the earlier inflated values.
For the past year,
Indian stock prices had been pushed up by large inflows from foreign
portfolio investors, who had recently "discovered" India as
an attractive emerging market that has not yet had a financial crisis.
This meant that, despite the fact that very little had changed in the
so-called "fundamentals" of the economy, there were substantial
inflows from financial investors that also caused the rupee to appreciate.
Foreign investors
use emerging markets like India to hedge against changes in other markets;
they also like to focus on particular countries in any one period, where
herd behaviour creates a boom and the countries concerned become the
temporary darlings of international capital. In India in the recent
past, the numerous concessions provided by the NDA government to such
mobile capital also allowed for large super-profits to be made through
such transactions.
Because the Indian
stock market still has relatively thin trading, these foreign institutional
investors made a big difference at the margin, and were responsible
for pushing up stock values well beyond what would be "sensible"
values according to standard international norms of price-equity ratios.
This is typical of the bubbles that have been created by internationally
mobile finance in various developing countries, especially since the
early 1990s.
It is inevitable
that such bubbles must eventually come to an end, whether through a
sharp burst in the shape of a financial crisis or through a slower and
more managed shrinking of values. When this happens, it is true that
a lot of players who have put their bets on continuously rising share
values will be affected, but this need not mean that there has been
any other bad news in the economy.
Of course, it is
always difficult to attribute causes to stock market movements, since
financial markets are notoriously prone to "noisy" and irrational
behaviour. However, more than the actual causes, the implications of
such falls are what matter to most of us, and this is where the mainstream
media have been the most misleading.
It is usually argued
that stock market behaviour is a reflection of "investor confidence"
and this in turn affects important real variables such as productive
investment in the economy, which is critical for growth and development.
This is not really the case, and has become even less true in the recent
period. Especially since the early 1990s, the stock market has experienced
huge increases and wild swings, while investment has not shown any such
volatility and indeed has barely increased in real terms.
This is evident
from the chart, which shows the index of stock market capitalisation
in India since the early 1980s. Stock market capitalisation increased
by around 4 times in the decade 1991-92 to 2001-02, with very large
fluctuations in between. By contrast, total gross fixed capital formation
in the economy increased much less even in current prices, and in constant
prices it barely doubled.
More to the point,
the large swings in market capitalisation were not associated with any
commensurate changes in investment, suggesting that the financial markets
dance to a bizarre tune that is all their own, and do not have much
impact on real investment in the economy. This is very important to
underline, because the reason that we are all supposed to be concerned
about stock market behaviour is because of its supposed effect on investment.
In fact, it is really only those agents who are dependent upon the return
from finance capital who are affected, while real investment depends
upon many other factors.
The other impact
that movements in the stock market has nowadays is on the exchange rate,
especially since so much of the change is caused by the behaviour of
foreign institutional investors. Their movements over the past year
have helped to build up Reserve Bank of India's foreign exchange reserves
to an almost embarrassing amount, partly because their inflows are not
being used to increase productive investment, and partly because RBI
kept buying dollars in an effort to keep the rupee from appreciating
even further.
While the large
forex reserves may have provided a macho feeling of false confidence
to some, in reality they were a reflection of huge macroeconomic waste,
since they implied that the capital inflows were not being productively
used. They were also expensive for the economy to hold, since the interest
received on such reserves by RBI is typically very low, whereas the
external commercial borrowing by Indian firms in the current liberalised
environment was at significantly higher interest rates.
In this background,
some dilution of the forex reserves may even be welcome. Of course,
if the current outflow turns into a capital flight which is also joined
by Indian residents, then clearly the situation can become more serious.
Such a possibility is now more open because of all the recent measures
liberalising capital outflow that the NDA government brought in the
closing months of its rule. The new government may have to address some
of these measures quite quickly, to prevent excessive capital outflows
which can then become another means of pressuring the government on
its economic policies.
But otherwise, the
current downslide in the stock markets is really not a matter of serious
concern for most Indians, and it should certainly not be much of an
issue for the new government either. The mainstream English language
media, whose business interests increasingly coincide with those of
finance capital, may continue to shout themselves hoarse about it. But
then, as the recent electoral cataclysm has shown, these media also
do not reflect the interests of the Indian people, nor do they even
understand them.